Why Stephen Roach is feeling bearish again

On balance, I remain constructive on the structural prognosis while I have turned more pessimistic on the cyclical outlook.

Four months ago, I dared to pen my first constructive piece on the global macro outlook in years. Yet recently, I have warned of the mounting downside risks to world economic growth in 2007. How do I reconcile these seemingly contradictory points of view?

My optimistic assessment was primarily a call on the global policy architecture -- the structural framework that governs the cross-border interplay between national economies and world financial markets. I was encouraged because the so-called stewards of globalization finally seemed to be taking the threat of mounting global imbalances seriously.

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The 22 April meetings of the G-7 and the IMF were watershed events - singling out global imbalances as an increasingly worrisome threat to sustainable growth in the world economy. The IMF introduced a new paradigm of surveillance and consultation that moved from a single-country to a multilateral framework. I drew added encouragement from pro-consumption rumblings in China that pointed to a rebalancing of that economy away from excess dependence on exports and fixed investment.

For years, I worried that the authorities were asleep at the switch as an increasingly unbalanced world veered toward a highly disruptive strain of global rebalancing. With global policy makers finally waking up to the threat, I argued that it made sense to reduce the odds of a crisis endgame.

Notwithstanding the potential for an improvement in the global architecture, the cyclical outlook for the world economy has deteriorated in the past few months.

The major force at work is the long-awaited bursting of the US housing bubble. In my view, this spells consolidation for the asset-dependent American consumer as well as for export-led economies elsewhere in the world - especially in Asia but also in Europe and South America - that are heavily dependent on end-market demand in the US.

At the same time, the odds of a China slowdown are rising, as the authorities in that country now have little choice other than to impose additional cooling off measures on an increasingly overheated Chinese economy. And the European economic outlook seems to be deteriorating - reflecting the likely headwinds imparted by looming fiscal consolidation, together with the lagged effects of monetary tightening and a stronger euro.

While the four-year global boom is not exactly giving way to a bust, there are good reasons to believe that the world's growth cycle will shift markedly to the downside in 2007.

The macro prognosis always reflects a balance between structural and cyclical forces. In early May, I drew comfort from the structural piece of this equation - in particular, a shift in the policy response to the growing threat of global imbalances. I noted at the time, however, that cyclical risks still seemed very much in evidence - especially those bearing down on the American consumer. As a result, I concluded that it was not appropriate "to give an unbalanced world the green light." With the benefit of hindsight, I certainly wish I had placed greater emphasis on that caveat back in early May.

Over the past four months, the balance between structural and cyclical forces has been more heavily influenced by rapidly changing developments on the cyclical side of the equation - especially those that pertain to the bursting of the US housing bubble. Largely for that reason, the near-term global prognosis has deteriorated relative to conditions prevailing in early May when I turned more optimistic on the structural story. The surprise was more in the timing of the cyclical shift than in the tradeoff between these two sets of forces.

By definition, structural change is typically glacial while cyclical shifts unfold with considerably more speed. The bursting of the US housing bubble is a fast-breaking cyclical development that has gathered considerable force in the past couple of months. By contrast, there has been only modest follow-through to the late-April structural breakthroughs on the global policy architecture - namely, the IMF's prompt identification of the US, Europe, Japan, China, and Saudi Arabia as the first candidates for multilateral consultations.

In a world where the wheels of architectural change turn ever so slowly, this is actually speedy progress. But when judged against the rapidly changing state of the US housing market - or even the pressures building in an overheated Chinese economy - progress on the structural front has been swamped by the emerging downside pressures on the global business cycle.

The upcoming IMF meetings in Singapore later this month will provide an important opportunity for the stewards of globalization to build on the efforts of last April. Intent is one thing - results are another. Putting meat on the skeleton of multilateral surveillance and consultation is critical. So, too, is providing better balance to IMF member voting rights. Global rebalancing is a shared responsibility. Yet for most of its 60-year history, the IMF has been dominated by the US and Europe - with the developing world largely on the outside looking in. Currently, a proposal is on the table to expand voting rights for China, South Korea, Turkey, and Mexico. The intent of this US-sponsored initiative is to empower large developing economies as stakeholders in the governance of globalization. Passage of this proposal would be another important milestone on the road to architectural reform. So, too, of course, would be a restarting and successful completion of the Doha Round of trade liberalization. Structural reform of the institutions of globalization is a long and arduous process. Last April, an important breakthrough finally occurred. It is critical for an unbalanced and increasingly integrated world to build on that momentum. That won't offset serious cyclical problems that may be brewing in the world, but it could go a long way in providing a more robust framework for the global economy to cope with these problems.

The key message from my bullish call on the global economy pertains less to the near-term growth outlook and more to the risks of a crisis-type endgame for an unbalanced world. Rewriting the rules of engagement that govern the institutions of globalization is an unambiguous plus, in my view. It reduces the possibility that America's current-account adjustment will eventually result in a sharp plunge in the dollar and a concomitant back-up in real long-term US interest rates - outcomes that could have devastating consequences for a still-unbalanced world.

Alas, progress on the structural reform front does nothing to temper the cyclical risks that still pose more of an immediate threat to an unbalanced world. As the air comes out of America's housing bubble, those risks are now mounting. The bad news is an unbalanced world remains highly vulnerable to a consolidation of the asset-dependent American consumer. The good news is that the stewards of globalization are finally working together to temper the risks associated with such a shakeout. On balance, I remain constructive on the structural prognosis while I have turned more pessimistic on the cyclical outlook.

By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley's Global Economic Forum