Zeev's Turnips Patch-No Politics (ZEEV)

[basserdan]

*** Stephen Roach 6-20-03 ***


Global: Endless Bubbles

Stephen Roach (New York)
June 20, 2003


With policy makers and financial markets now fixated on the great deflation debate, it’s easy to lose sight of what precipitated this state of affairs. In my view, it’s all traceable to asset bubbles -- the excesses they fostered on the way up and the wrenching adjustments they require on the way down. The big problem with bubbles is that they tend to be contagious across asset classes -- spreading from stocks to property to bonds. That’s been the case in Japan, and a similar pattern is now evident in the United States. The result is a seemingly endless array of bubbles that only heightens the perils of the post-bubble endgame.

Unfortunately, the policy response to asset bubbles virtually guarantees cross-asset contagion. That stems mainly from the behavior of central banks. The US experience provides a classic example of this multi-bubble syndrome. The Federal Reserve, in my view, played a key role in nurturing the equity bubble of the late 1990s. By setting monetary policy with an eye to the so-called New Economy -- a high-growth, low-inflation macro scenario -- the US central bank maintained a low interest rate regime that provided extraordinary valuation support for equities. A pre-Y2K liquidity injection was the icing on the cake. The persistence of low interest rates in the immediate aftermath of the popping of the equity bubble in early 2000 quickly became the great enabler for the US property bubble. And then when the Fed began cutting interest rates aggressively in order to combat multiple pitfalls -- recession, the subsequent anemic recovery, and newly emerging deflation risks -- a bubble emerged in the bond market. The Fed, in effect, has become a serial bubble blower.

The wealth effects derived from these asset bubbles became key sources of support to economic growth in the United States. Consumers first learned how to play this game in the late 1990s. On the heels of five consecutive years of 25% gains in the S&P 500, American households concluded that the stock market had become a new and permanent source of saving. As a result, consumer spending growth surged well in excess of disposable personal income and the personal saving rate plunged from 6.6% in late 1994 to 0.3% in late 2001. By the time the equity bubble popped in early 2000, consumers had moved on to a new strain of the asset or wealth effect -- taking advantage of home mortgage refinancing to extract newfound purchasing power from the ever-appreciating housing stock. This kept the magic alive for the ever-resilient American consumer in the early stages of the post-bubble shakeout. Then as property prices started to flatten out in 2002, the bond bubble kicked in -- providing cost-of-capital relief for corporate borrowers and a new source of asset appreciation for bond holders. And now, of course, as the bond bubble reaches what may believe is an advanced stage, there is hope that the game can start all over again with a resurgence in the equity market.

The legacy of these bubbles is a sad testament to the excesses of an increasingly wealth-dependent US economy: Consumers have now become addicted to the “extra” purchasing power they can extract from over-valued assets. But this is hardly a costless supplement -- it has given rise to a record overhang of personal indebtedness. Household sector debt is now in excess of 80% of US GDP, fully 15 percentage points higher than debt ratios prevailing in the early 1990s. We’re told repeatedly not to worry -- that the debt overhang is of little consequence in a low nominal interest rate climate. After all, it’s debt service that matters -- the ratio of interest expenses to disposable personal income. Yet even on that basis, there’s little ground for comfort. Federal Reserve estimates place the overall household sector debt service burden at 14.0% in early 2003; that’s down only slightly from the all-time high of 14.4% hit in late 2001 and well above the 12.9% norm of the 1990s. To me that says it all: Even in the face of 45-year lows in interest rates, the debt overhang is large enough to push debt service burdens to the upper end of historical experience. That’s hardly a comforting place for any economy. But with interest rates vulnerable to upside pressures in a US current-account adjustment and with personal income vulnerable to downside pressures if the pendulum of cost-cutting swings to labor, there is good reason to be worried about a potential debt problem. For a US economy on the brink of deflation, such concerns cannot be taken lightly.

All this underscores the continuum of moral hazards that prevails in this post-bubble era. At first, the equity bubble seemed too big to fail -- making the Fed very concerned over the repercussions of a sharp downdraft in the stock market. The Fed’s New Economy mantra added to investor convictions that there was little reason to worry about an interest-rate spike in a rapidly growing, fully-employed US economy. Once the equity bubble popped, interest-rate support to the home mortgage refinancing cycle then became essential in order to contain the damage. By stressing the importance of the “refi-cycle” as a source of economic growth in an otherwise perilous post-bubble climate, the Fed was, in effect, providing a guarantee that it would continue to provide the fuel for this wealth extraction process. And now as the Fed’s battle has shifted to the anti-deflation fight, a bond bubble has emerged -- a by-product of investor expectations that now envision the central bank keeping its policy rate unusually low for as far as the eye can see. At the same time, yield-starved investors have moved out the risk curve, taking credit spreads to amazingly low levels. Suddenly, the bond bubble now seems too big to fail -- symptomatic of yet another moral hazard. First it was the “Greenspan put” that supported equities and now it’s the “Bernanke put” -- the belief that the Fed is about to target bond yields in an effort to fight deflation -- that fuels the bond market. America’s Federal Reserve seems to be stopping at nothing in order to keep a post-bubble US economy afloat.

It’s hard to know where and how this all ends. The Fed’s strategy seems to be aimed mainly at buying time -- hoping for a gradual and benign endgame to the post-bubble workout. That’s certainly possible. But there’s also the distinct possibility that the Fed is hoping against hope. I would personally assign equal odds to the chance that there will be a more treacherous moment of reckoning. My concerns in this latter regard stem from the increasingly ominous current-account implications of a saving-short US economy. Courtesy of outsize Federal budget deficits and massive multi-year tax cuts just enacted by Washington, it is not that farfetched to envision a net national saving rate that falls from a record low of 1.3% in the second half of 2002 to “zero” over the next 12-18 months. If that were to occur, the current-account deficit could widen sharply further from its record 5.1% of GDP just reported for 1Q03 into the 6.5% to 7.0% range by the end of 2004. Such a massive and ever-widening US current-account deficit could well set the stage for the ultimate post-bubble endgame -- a full-blown dollar crisis that would deal a lethal blow to the global economy and world financial markets.

The biggest difference between my bearish view of the world and the more sanguine views of others can be traced to the bubble. More than three years after America’s equity bubble popped, there is an understandable temptation to believe that it’s time to move on. A massive dose of fiscal and monetary stimulus, in conjunction with a sharp rebound in the stock market, adds to that conviction. As I see it, however, the legacy of this monstrous bubble endures -- not just in financial markets but also in the form of the excesses that it has fostered in the real economy and in its balance-sheet underpinnings. Until those excesses are purged, I maintain my view that America still needs to be seen through the lens of a post-bubble workout. As one bubble morphs into the next one, the moral hazard dilemma only deepens. And the endgame -- including the risks of deflation and a dollar crisis -- appears all the more treacherous.

http://www.morganstanley.com/GEFdata/digests/20030620-fri.html
==============================================================Y

You're welcome..... <g>

Best regards,
Dan