I wish I had written this piece by Stephen Roach, formerly one of Morgan Stanley’s economists (and noted bear), now head of Morgan Stanley Asia. Roach does an elegant job of drawing connections between some issues that other commentators have treated separately.
Roach sees the oft-decried global imbalances (shorthand for countries like China, Japan and Saudi Arabia keep lending us money to fund our chronic current account deficit) as the result of the US’s low-to-nonexistent savings rate, which in turn is the product of our asset bubbles. Even the Wall Street Journal was touting the dubious reasoning that our savings rate wasn’t bad at all; just look at consumers’ balance sheets! With appreciating stocks and housing, who needed to save?
We’ve now learned that a good reason to have a bit of cash on hand is that not only do the tides of liquidity roll in, but they also go out.
As a result, Roach’s view is that America needs to quit depending on the kindness of foreigners and start saving. That implies both a fall in asset values and a lower proportion of consumption to GDP as households rebuild their balance sheets. That in turn means recession (and also a permanent shrinkage in some businesses that have been important to banks, like credit card and home equity lending).
As much as Roach’s prescription makes sense, I guarantee that American politicians will do everything in their power to prevent consumers from taking their medicine. It’s much easier to blame China than admit to our own profligacy and live leaner.
Nevertheless, I do differ slightly with Roach on the matter of China and trade generally. The US does a terrible job of negotiating with its trade partners. We cave too easily when our counterparties make lame protectionist excuses (Japan is a master of this tactic). We also seem to have adopted the view that manufacturing will inevitably be done elsewhere, which is an unwarranted assumption (I’m of the view that the US can compete in highly capital intensive, high skill manufacturing, as well as in niches that require quick turnaround, small lots, high production quality, particularly for US consumption. The Germans, for example, have been the #2 producers of machine tools behind, and Germany is not noted for being a low wage country). But generally, Roach’s point is well taken. We need to look internally rather than externally for solutions to our problems
From the Financial Times:
The US has been the main culprit behind the destabilising global imbalances of recent years. America’s massive current account deficit absorbs about 75 per cent of the world’s surplus saving. Most believe that a weaker US dollar is the best cure for these imbalances. Yet a broad measure of the US dollar has dropped 23 per cent since February 2002 in real terms, with only minimal impact on America’s gaping external imbalance. Dollar bears argue that more currency depreciation is needed. Protectionists insist that China – which has the largest bilateral trade imbalance with the US – should bear a disproportionate share of the next downleg in the US dollar.
There is good reason to doubt this view. America’s current account deficit is due more to bubbles in asset prices than to a misaligned dollar. A resolution will require more of a correction in asset prices than a further depreciation of the dollar. At the core of the problem is one of the most insidious characteristics of an asset-dependent economy – a chronic shortfall in domestic saving. With America’s net national saving averaging a mere 1.4 per cent of national income over the past five years, the US has had to import surplus saving from abroad to keep growing. That means it must run massive current account and trade deficits to attract the foreign capital.
America’s aversion toward saving did not appear out of thin air. Waves of asset appreciation – first equities and, more recently, residential property – convinced citizens that a new era was at hand. Reinforced by a monstrous bubble of cheap credit, there was little perceived need to save the old-fashioned way – out of income. Assets became the preferred vehicle of choice.
With one bubble begetting another, America’s imbalances rose to epic proportions. Despite generally subpar income generation, private consumption soared to a record 72 per cent of real gross domestic product in 2007. Household debt hit a record 133 per cent of disposable personal income. And income-based measures of personal saving moved back into negative territory in late 2007.
None of these trends is sustainable. It is only a question of when they give way and what it takes to spark a long overdue rebalancing. A sharp decline in asset prices is necessary to rebalance the US economy. It is the only realistic hope to shift the mix of saving away from asset appreciation back to that supported by income generation. That could entail as much as a 20-30 per cent decline in overall US housing prices and a related deflating of the bubble of cheap and easy credit.
Those trends now appear to be under way. Reflecting an outsize imbalance between supply and demand for new homes, residential property prices fell 6 per cent in the year ending October 2007 for 20 major metropolitan areas in the US, according to the S&P Case-Shiller Index. Most likely, this foretells a broader downturn in nationwide home prices in 2008 that could continue into 2009. Meanwhile, courtesy of the subprime crisis, the credit bubble has popped – ending the cut-rate funding that fuelled the housing bubble.
As home prices move into a protracted period of decline, consumers will finally recognise the perils of bubble-distorted saving strategies. Financially battered households will respond by rebuilding income-based saving balances. That means the consumption share of gross domestic product will fall and the US economy will most likely tumble into recession.
America’s shift back to income-supported saving will be a pivotal development for the rest of the world. As consumption slows and household saving rises in the US, the need to import surplus saving from abroad will diminish. Demand for foreign capital will recede – leading to a reduction of both the US current-account and trade deficits. The global economy will emerge bruised, but much better balanced.
Washington policymakers and politicians need to stand back and let this adjustment play out. Yet the US body politic is panicking in response – underwriting massive liquidity injections that produce another asset bubble and proposing fiscal pump-priming that would depress domestic saving even further. Such actions can only compound the problems that got America into this mess in the first place.
China-bashers in the US Congress also need to stand down. America does not have a China problem – it has a multilateral trade deficit with over 40 countries. The China bilateral imbalance may be the biggest contributor to the overall US trade imbalance but, in large part, this is a result of supply-chain decisions by US multinationals.
By focusing incorrectly on the dollar and putting pressure on the Chinese currency, Congress would only shift China’s portion of the US trade deficit elsewhere – most likely to a higher-cost producer. That would be the same as a tax hike on American workers. If the US returns to income-based saving in the aftermath of the bursting of housing and credit bubbles, its multilateral trade deficit will narrow and the Chinese bilateral imbalance will shrink.
It is going to be a very painful process to break the addiction to asset-led behaviour. No one wants recessions, asset deflation and rising unemployment. But this has always been the potential endgame of a bubble-prone US economy. The longer America puts off this reckoning, the steeper the ultimate price of adjustment. Tough as it is, the only sensible way out is to let markets lead the way. That is what the long overdue bursting of America’s asset and credit bubbles is all about.