Zeev's Turnips Patch-No Politics (ZEEV)

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*** Stephen Roach (12-1-03) ***

Global: Growth at What Cost?

Stephen Roach (New York)
December 1, 2003

With its China-like performance in the third quarter, a booming US economy is once again the envy of the world. In a classic pre-election gambit, Washington has pulled out all the stops in order to resuscitate what had been an unusually sluggish economy. On the surface, the returns appear most encouraging -- 8.2% GDP growth in 3Q03 and vigorous follow-through in the monthly data that points to spillover into the 4-5% range in 4Q03. While it’s tempting to extrapolate into the future on the basis of this seemingly spectacular upturn, there’s still good reason to be cautious, in my view. Two related issues keep me awake at night -- the quality and sustainability of this rebound. On both counts, I worry that the US will ultimately pay a steep price for squeezing too much out of an unbalanced economy.

No two business cycles are alike. But in my view, the current upturn is closest in character to that of a decade ago -- the so-called jobless recovery of the early 1990s. In that upturn, it took fully ten quarters after the economy technically bottomed in the first period of 1991 before real GDP finally entered a vigorous growth trajectory in late 1993. In the current cycle, it has taken eight quarters for the US economy to move into the “hot zone” of the cyclical recovery dynamic. By contrast, in most earlier cycles, vigorous cyclical snapbacks commenced much more quickly -- usually one or two quarters after the official end of a recession. Many believe that the delayed rebounds of the two most recent cycles simply reflect the unusually mild recessions that preceded them. That interpretation does not withstand the test of history: Unusually mild recessions in 1960 and again in 1969-70 were both followed immediately by quite vigorous cyclical rebounds. Something else has been at work.

That something, in my view, has been a confluence of fierce structural headwinds -- serious imbalances that inhibited cyclical recovery for an unusually long time. In both cases -- the early 1990s and today -- those headwinds were eventually met by a major policy gambit. If we compare the “effective turning point” of the current cycle with that of the upturn of the early 1990s -- points in time when anemic recoveries transitioned into something more far more vigorous -- the activist role of policy is quite apparent. That’s especially the case with respect to monetary policy. In late 1993, the nominal federal funds rate of 3.0% matched the core CPI inflation rate of 3.1%; in the current cycle, the nominal federal funds rate of 1.0% in 3Q03 was also in rough alignment with a core inflation rate of 1.3%. Moreover, in both cases, the Fed had been early in pushing its nominal policy rate below core inflation well in advance of these effective cyclical turning points. That provided the highly stimulative remedy of negative real interest rates -- the lagged impacts of which finally appear to be playing out. The big contrast lies in the future: In late 1993, the Fed was nearing the end of its policy accommodation, whereas today the central bank seems content to stay on hold for some time to come.

On the surface, the two fiscal gambits also appear to be comparable. Today’s federal budget deficit at 4.2% of GDP in FY2003 is not all that different from the 3.9% shortfall in 1993. Here, as well, the big differences lie in the future. While these fiscal snapshots look similar at this point in time, the “policy thrust” -- the directional shifts in budgetary policies -- does not. In late 1993, the deficit was already on its way down; it had averaged 4.6% of GDP in 1991-92 and was headed toward balance in late 1997, before recording four years of surplus over the 1998-2001 period. In the current climate, fiscal policy is moving in precisely the opposite direction -- federal deficits that seem likely to hold well above 4% of GDP through at least 2004-05.

Currencies are, in effect, a third dimension of the macro stabilization policy arsenal -- the relative price alignment with the rest of the world that shapes the external component of aggregate demand. In real terms, today’s broad trade-weighted dollar index is more than 15% higher than it was back in late 1993 -- pointing to a more severe currency restraint in the present environment. Yet in the context of today’s massive and record US current-account deficit, there’s plenty of room for further slippage in the dollar -- even more so that the 5% additional drop that occurred from levels prevailing in late 1993. I don’t think it’s an accident that the Bush administration has now backed away from America’s “strong dollar” policy. With the fiscal and monetary levers fully engaged, there is good reason to take out added pre-election insurance through stimulative currency policy in the event that America’s newfound cyclical revival starts to fade.

The bottom line on the policy gambit: While the current stimulus is comparable to that prevailing a decade ago, the prospective thrust of policy going forward is likely to be a good deal more reflationary. In that vein, it is critical to consider the ultimate costs of this Herculean stimulus campaign. As I see it, the verdict remains disconcerting, as lingering structural imbalances underscore the persistence of powerful headwinds that could lead to a relapse in the US economy once the impacts of counter-cyclical stimulus fade. The lack of discipline on fiscal policy is especially worrisome in that regard. As was the case in the late 1960s, Washington seems almost blasé in opting for both “guns and butter.” Back then it was the guns of Vietnam and the butter of President Lyndon Johnson’s Great Society. Today it is the guns of the war on terrorism and the butter of recently enacted tax and Medicare reforms. Back in the late 1960s, Washington took comfort from a productivity-led recovery as providing the means to rationalize such a fiscal gambit. A similar mind-set exists today. Unfortunately, that earlier policy blunder was key in setting the stage for the lost decade of the 1970s -- America’s worst period of economic performance in the post-World War II era.

Unfortunately, there seems to be little institutional memory of the late 1960s. Yet the United States is, in fact, less able to afford a fiscal policy blunder today than it was back then. America’s net private saving rate (for consumers and businesses, combined -- net of depreciation) currently stands at 5.0% of GNP -- well below the 9% average of the 1960s and the 6.9% reading of late 1993, when the previous recovery was shifting into high gear. Reflecting the resulting shortfall of domestic saving -- subpar private saving plus massive government budget deficits -- America is far more dependent today on foreign saving to fill the void. And that underscores one of the biggest imbalances of all -- the massive US current-account deficit that is required to attract such foreign capital. In 2Q03, the US current-account deficit stood at 5.1% of GDP, more than three times the 1.6% gap prevailing in late 1993. As a result, to paraphrase Tennessee Williams, America is more dependent than ever on the “kindness of strangers” to fund the excesses of a saving-short US economy. That hints at the distinct possibility that foreign investors eventually will want to be compensated for taking currency risk -- a compensation that will most likely take the form of higher real interest rates

Extreme dependence on foreign capital is but one dimension of the significantly increased role that the culture of debt plays in driving today’s US economy. American households have led the charge in this regard. Even though nominal interest rates have fallen to 37-year lows by some measures, debt service remains uncomfortably high when compared with the jobless recovery of the early 1990s. According to Federal Reserve statistics, interest expenses as a share of disposable personal income stood at 13.3% in 2Q03, well in excess of the 10.7% reading in late 1993. A similar pattern is evident in a new broader gauge just released by the Fed -- a measure of “financial obligations,” which also includes auto lease payments, home rental expenses, and homeowner insurance and property tax payments; this metric stood at 18.1% of disposable personal income in 2Q03, well above the 15.9% reading of late 1993. Debt service is high because of the extraordinary overhang in the absolute volume of consumer indebtedness; household sector debt outstanding rose above 80% of GDP in mid-2003, well in excess of the 65% share prevailing in 1993.

America’s seemingly open-ended appetite for leverage remains one of the most disturbing imbalances of the post-bubble period, in my view. For households, the debt culture took on a new role in the latter half of the 1990s, as America’s consumption dynamic shifted from being income-driven to one that was increasingly wealth-dependent. The first wave of wealth effects was supported by the equity bubble. Once that bubble popped, however, wealth support then shifted quickly into property markets. The difference between equity- and property-induced wealth effects is profound: Apart from margin debt, the former is funded mainly out of a psychological sense of well being; in the case of property, mortgage debt and its ever-frequent refinancing are the principal means of extracting incremental purchasing power from housing assets. The income shortfall of a jobless recovery -- a far more serious problem today than in the recovery of the early 1990s -- only heightens America’s dependence on wealth-based, debt-intensive support to aggregate demand. Such a shift in the growth paradigm appears to have limited the post-bubble fallout in the early years after the stock market plunged. In the end, however, as wealth effects have morphed into a far more pervasive cultural phenomenon of excess leverage, the ultimate post-bubble payback may be all the more severe. That’s especially the case if America’s coming current-account adjustment sparks the predictable consequences of higher interest rates.

America’s newfound cyclical vigor is hardly an accident. Washington has learned an important lesson from the early 1990s. Eight years ago, the credo was, “It’s the economy, stupid.” This year, it’s politics, stupid. Deep in our hearts, we all know predicting the future is next to impossible. It stretches the imagination to conjure up a macro scenario that is based on an exquisitely timed interplay of political and economic cycles. Yet that’s precisely the mind-set today -- heedless of the costs America will incur as Washington attempts to underwrite yet another Rosy Scenario.

http://www.morganstanley.com/GEFdata/digests/20031201-mon.html