Zeev's Turnips Patch-No Politics (ZEEV)

[Frank Pembleton]

Global: Services -- The Next Leg of Deflation
Stephen Roach (New York)

Although deflationary pressures are building in a US-centric global economy, there is still a sense that the aggregate price level will stop short of outright contraction. Central to that belief is the long-standing dichotomy between goods and services. Unlike the tradable-goods sector, which is increasingly exposed to the tough competitive pressures of cross-border trade, the so-called non-tradable services sector has long been shielded from such pressures. That was then. The globalization of services changes all that, and points to the possibility of a new leg of deflation in the United States and the world at large.

Services are by far the dominant component shaping the aggregate price level in the United States. They account for 53% of inflation-adjusted GDP and have a weight of 59% in the Consumer Price Index. During the modern-day, post-World War II era, services inflation has indeed played an important role in shielding the US economy from deflationary cyclical pressures that periodically arise in the goods-producing sector. That role is now changing, as pricing in the services sector is taking on a cyclical pattern normally confined to the goods-producing sector. That leaves the aggregate US economy far more exposed to the risk of outright deflation than ever before.

The latest trends speak for themselves. Services inflation (based on the services component of the broad GDP chain-weighted price index) was running at a 3.0% y-o-y rate at the last business cycle peak in 4Q00. In the six quarters since it has slowed by 0.8 percentage point to 2.2%. By contrast, in the previous six recessions, services inflation actually increased, on average, by 0.2 percentage point over the six quarters following the business cycle peak. Apart from the cycle of the early 1980s, when the US was coming out of a period of wrenching double-digit inflation, the current cycle has been by far the most disinflationary of the lot for services.

These results are all the more impressive when juxtaposed against the more extreme price cycles in the goods-producing sector. Goods inflation, which was running at a +0.7% y-o-y rate at the last business cycle peak in 4Q00, morphed into outright deflation of -0.8% in 2Q02. This swing of -1.5 percentage points over this six-quarter time frame is fully three times the average disinflation of -0.5 percentage point that occurred over the same six-quarter interval in the past six business cycles. The result is a rather extraordinary combination. Not only have the deflationary pressures in the goods-producing sector been far more intense in the current cycle than in those of the past, but there has been no effective offset from the heretofore-resilient services sector. As a result, the current business cycle is turning out to be far more deflation-prone than those of the past.

As always, a certain amount of the devil lurks in the detail -- especially when it comes to measuring inflation in the services sector. It turns out that the largest component of the services prices is shelter, with a weight of 31.5% in the total CPI. Fully 22 percentage points of that portion is what the US Bureau of Labor Statistics refers to as "owner’s equivalent rent of primary residences" -- in effect, the price of the service that is consumed by residing in a dwelling. Not only is this imputed rental price nearly impossible to measure, it is largely a theoretical construct that has little bearing on mark-to-market pricing of the real-life economy. And yet its impact leads to clear distortions of the overall price level. Government statisticians estimate that CPI-based services inflation would be running at a 2.6% y-o-y rate in August 2002 if the rent of shelter were excluded; that would be fully 0.5 percentage point slower than the 3.1% rate currently estimated for services as a whole. In other words, absent statistical distortions in the measurement of services pricing, the US economy would be even closer to outright deflation than now seems to be the case.

Measurement pitfalls aside, there is a much bigger story behind these trends. Now that America has moved firmly into its post-industrial era, there can be no mistaking the ascendancy of services in shaping the fabric of economic activity. It has become accepted wisdom that this transition has imparted a greater resistance to deflationary perils. If you can’t trade services, goes the logic, then their pricing must be determined largely by domestic forces that are immune to foreign competition. As services grow in importance, that immunity is presumed to be ever more powerful in shielding a mature economy from harsh competitive forces, including deflation.

That is the key presumption that the globalization of services is now turning inside out. A confluence of three powerful forces is at work -- a worldwide shift to deregulation, surging cross-border mergers and acquisitions and other forms of foreign direct investment, and new Internet-based technology platforms. The globalization of services is not new -- it has been under way for over 20 years (I first wrote of it in "Services Under Siege -- The Restructuring Imperative," Harvard Business Review, September-October 1991). What’s different today is that IT-based platforms have added a real-time connectivity to cross-border linkages in service organizations. Globalization has accelerated in response.

As a result, I believe competition in services must now be seen in an entirely different light. From telecommunications and finance to transportation and even retail distribution, vast multi-national services industries now span the globe. In effect, they redefine the concept of capacity in this segment of the US and global economy. Country-specific supply curves -- long a key determinant of service-sector pricing -- are now being replaced by global supply curves. In this context, pricing leverage in services is now increasingly determined by global forces that are comparable to those that have long been prevailing in the tradable-goods sector. All that acts to reshape the service-sector pricing equation on a secular as well as a cyclical basis.

Financial services are an obvious case in point. Less than a decade ago, there were five "bulge-bracket" firms in the global securities business. Today, courtesy of the rapid growth of the so-called universal banks, that number is now closer to eight or nine. Needless to say, this fundamental reshaping of the competitive playing field in the financial services market has had important deflationary implications for pricing, margins, and earnings. A wrenching correction in worldwide equity markets certainly hasn’t helped matters either.

There’s one more piece to the deflationary story in services -- the globalization of services outsourcing strategies. An increasingly wide array of service functions is now being performed offshore in places such as India, Ireland, and China -- nations with low-cost, high-quality, English-speaking labor pools that are now easily connected to multinational corporate networks through the Internet. Nor are these simply low-value-added remote call centers. The outsourcing of services is now involving increasingly higher-value-added activities such as software, remote e-mail help desks, accounting, production layout design, logistics tracking, network management, telemarketing, remote billing and subscriber management, transcription and translation services, engineering services, systems integration, and engineering services.

This has given rise to a whole new concept of "IT-enabled services (ITES)" -- activities that are now taking India by storm. A recent study by McKinsey and India’s National Association of Software and Service Companies (NASSCOM) estimates that India’s ITES industry will grow from US$1.5 billion revenue in 2001-02 to $17 billion by 2008 (see NASSCOM’s "The IT Industry in India: Strategic Review 2002," available at www.nasscom.org). Similar efforts are under way in China, although the language advantage obviously favors India insofar as services exports to the English-speaking world are concerned. Increasingly, courtesy of IT, price setting in a broad array of services is being defined at the margin by relatively low-cost operations in the Indias and Chinas of the world.

The combination of globalization and the IT revolution has fundamentally altered the concept of pricing leverage in the tradable-goods industry. Against a backdrop of restrained growth in worldwide aggregate demand, the resulting overhang of excess supply has led to an unusually powerful deflationary shock in the downleg of this global business cycle. The globalization of services challenges the conventional notion of a non-tradable segment of economic activity. And the facts speak for themselves: No longer can mature economies count on the inherent resilience of service-sector pricing to hold the line against periodic deflationary cycles in goods-producing industries.

All this has profound implications for America’s current battle against deflation. Overall GDP-based inflation is now running at just 1%, a 48-year low. Outright deflation of -0.6% for goods and structures, combined, is being offset by a lingering inflation of 2.2% in services. Many believe that this is a welcome development for a mature service-based economy such as the United States. With 78% of its private sector workforce toiling in the services sector, deflation in tradable goods is argued to represent an expansion of purchasing power for the bulk of the nation. So far, that’s still the case. But diminished pricing leverage in services is likely to test this model of the deflation-proof developed economy as never before. The US and a US-centric world are in the throes of the most disinflationary pricing cycle ever experienced in services. To the extent that the globalization of services is only in its infancy, the once-natural cushion against deflation is likely to get thinner and thinner. The endgame of global deflation can no longer be dismissed out of hand. Unlike the past, it will now be exceedingly difficult for services to save the day.
http://www.morganstanley.com/GEFdata/digests/20021007-mon.html