It has often been said that timing is everything on Wall Street. With the benefit of hindsight, this was certainly not the best of times to have turned more constructive on the global economic outlook (see Is the global economy really on the mend?). With the Middle East in shambles, missiles flying in North Korea, and terrorist attacks in India, new fault lines have opened up in an already fractured world. Is it time to reassess my newfound optimism on the global economic outlook?
The global economic outlook: geopolitical climate
From a macro perspective, the outcome boils down to assessing the interplay between geopolitical shocks and underlying economic fundamentals. As the recent swirl of events indicates, the risks of escalating geopolitical tensions can hardly be minimized. The challenge is to figure out how precarious the situation truly is.
In an effort to do so, I’ve been reading a fair amount of history lately. I am especially haunted by Niall Ferguson’s latest tome on the tragic continuum of wars in the bloodiest of all centuries – the 20th century (see Ferguson’s The War of the World: History’s Age of Hatred, Penguin, London, 2006). I find Ferguson’s framework particularly relevant in attempting to put recent geopolitical developments in context. In his view, the destructive tendencies of the last century are traceable to the confluence of three powerful forces – ethnic conflicts, declining empires, and economic volatility. Unfortunately, there are worrisome signs on all three counts today.
The case for heightened ethnic conflict is painfully obvious. It’s not just the mounting tensions between the Islamic world and the West, but as the tragedy of Iraq underscores, it’s also the struggle going on inside of Islam. Terrorism has often provided an important spark for ethnic conflict – in fact, that’s what triggered the outbreak of World War I. But new IT-enabled capabilities have taken this threat to an entirely different level.
Nor can the role of declining empires be minimized. The United States – today’s sole global superpower – is stretched as never before. A zero net national saving rate, a record current-account deficit, and massive unfunded entitlement liabilities for the upcoming retirement of some 77 million aging baby boomers, all speak of a nation that may have an increasingly difficult time aligning a weakening economic base with its military and political outreach. At the same time, the ascendancy of new empires – especially China and quite possibly India – underscores the potential for a relative decline of the old ones.
Today’s volatility factor does not, however, match up with that which Ferguson identifies as being a key precipitant of “the war of the world.” Since 1990, most measures of the volatility of economic growth and inflation are sharply below those of earlier periods; moreover, since 2001, financial market volatility has been reduced sharply – especially for some of the asset classes that traditionally have been the riskiest, like emerging-market and high-yield debt. By contrast, the volatility spikes in the first third of the 20th century – underscored, of course, by the Great Depression – were a very destabilizing element in the world.
The current reduced state of volatility is an encouraging development – suggesting that the steady progress of global prosperity in this era of globalization may well have the potential to break the chain of a most painful history. The downside of that conclusion is that volatility in today’s world may simply be dressed up in new clothes – namely, in the form of ever-mounting global imbalances and widening income disparities between the rich and the poor. There is nothing comforting about these tough developments on the soft underbelly of globalization.
The global economic outlook: rebalancing an unbalanced world
Consequently, from a Ferguson perspective, at least two – probably more like two and a half – of the three pieces of this historical framework of world conflict remain very much intact. This is hardly an encouraging conclusion for global macro. But it is an important starting point as we then attempt to overlay these geopolitical characteristics of the current climate with our assessment of economic and market fundamentals. From my point of view, I stand by my basic conclusions of early May – that the stewards of globalization are now focusing a powerful policy arsenal on the rebalancing of an unbalanced world.
In particular, I continue to believe that the G-7, the IMF, and the world’s major central banks are not only collectively focused on the potential perils of mounting global imbalances but that they are making good progress in addressing this serious problem. The IMF is moving forward in establishing a new multi-lateral framework of surveillance and consultation involving the US, Europe, Japan, China, and Saudi Arabia. This brings together for the first time a small group of major industrial countries together with the world’s most powerful developing country and oil producer.
I am equally encouraged that major central banks seem relatively united in withdrawing excess liquidity from world financial markets – essential to temper the distortions in asset markets that have fostered destabilizing disparities between saving and trade flows.
The global economic outlook: resilience to a geopolitical shock
As I noted at the outset, timing may well be a key risk in all of this. The rebalancing fix I described above will take time – and, quite possibly, a good deal of it. In the meantime, a still precarious (i.e., unbalanced) global economy must come to grips with the immediacy of what could well be a very serious geopolitical shock – complete with sharply rising oil prices and related blows to consumer confidence. The best contribution the macro practitioner can offer in these circumstances is to assess the pre-shock resilience – or lack thereof – in underlying economic activity.
Over the years, it has been my experience that the shocks which matter the most are those that have hit an economy which has already been softened up by other factors. A good example is the US recession of 1990-91 – when an already faltering economy was hit by a brief oil shock triggered by the Iraqi invasion of Kuwait. The ensuing contraction was brief (3 quarters) and shallow (peak-to-trough decline in real GDP of 1.3%), but it was an unmistakable outgrowth of the interplay between a shock and an already weakened economy. That underscores the need to assess the pre-shock resilience of the global economy – whether, in fact, the world is tough enough to withstand the blows of a destabilizing geopolitical shock.
On the surface, the answer is actually quite encouraging. By our latest estimates, world GDP growth is on track to rise 4.7% in 2006 – the fourth year in a row of growth above 4%. In fact, the 4.6% average we now estimate over the 2003-06 period would mark the strongest four years of global growth since the 5.5% average burst over the 1970-73 interval.
Interestingly enough, the first oil shock of late 1973 came in a year when world GDP was booming at a 6.9% annual rate. Yet the subsequent supply disruption and a trebling of nominal crude oil prices within a year quickly turned a global boom into a bust – culminating in what was then the world economy’s worst recession in post-World War II history.
In the next two oil shocks, however, the global economy was hit when it was already softening. The second oil shock of 1979 came in a year of 3.8% growth in world GDP – far short of the 4.7% average annual pace in the pre-shock three-year period of 1976-78. The third oil shock of 1990 hit the world when it was slowing to only a 2.9% clip after three years of 4.2% average gains in 1987-89.
From a macro perspective, I would attach greater significance to the two latter oil shocks than to the first one. Back in the early 1970s, the post-World War II world was largely unprepared for the lethal interplay between geopolitical and economic shocks. By contrast, in the late 1970s and again in the early 1990s, the world had accumulated some tough experience in coping with these types of disruptions. Today’s post-9/11 world certainly has even more of that very painful experience under its belt.
Consequently, as seen from this historical perspective, the current vigorous pace of global activity speaks of a world with considerable pre-shock resilience. Our estimate of 4.7% world GDP growth in 2006 is about 40% faster than the 3.4% average pace in the year prior to the shocks of 1979 and 1990.
The global economic outlook: US consumer is the weakest link
The major shortcoming of this top-down analysis is that it masks the vulnerabilities of a still very unbalanced global economy. The world may not be as resilient as the aggregate global GDP growth suggests. I am certainly encouraged by the newfound vigor in Japan and even Germany, and China’s explosive growth continues to surprise on the upside.
But the American consumer – long the principal engine of global demand – is becoming an increasingly worrisome source of concern, in my view. The recent two-month deceleration of job growth only underscores the ongoing lack of support from labor income generation; by our calculations, over the 54 months of the current recovery, private sector compensation was running fully $420 billion below the trajectory of the past four long business cycle expansions.
Meanwhile, the asset-based underpinnings of the wealth-dependent US consumer are in even more serious trouble. By most accounts, the housing market is fading quickly and refinancing costs are rising sharply – painting a picture of a sharp moderation of home equity extraction that could prove quite problematic for income-constrained households who also must now come to grips with the added uncertainties of sharply higher oil prices. In other words, a very compelling case can be made for pre-shock vulnerability to the most important driver on the demand side of the global economy. For the rest of what is still a largely externally-dependent global economy, a consolidation of the American consumer can hardly be taken lightly. This remains the weakest link in the global growth chain, in my view.
The key in all this is to relieve the geopolitical angst. While comfort can be taken from the resilience of world GDP in the aggregate, lingering imbalances in the mix of the global economy are a worrisome source of vulnerability. A shock in that context – especially a shock that fits so closely with the continuum of the 20th century pattern of war and hatred as seen through the perspective of Niall Ferguson – is all the more disconcerting.
The bad news is that the events in the Middle East now seem to be spiraling out of control. If that continues to be the case, the conclusions of global macro would be unequivocally treacherous. The good news is that a good case can still be made for the improved fundamentals of an unbalanced world.
I would be the first to concede that the rebalancing fix that I found so encouraging in early May has not had any real time to be effective in tempering the risks of unbalanced world. The global economy needs time to heal and, more immediately, needs prompt relief from mounting geopolitical tensions. Inasmuch as I remain hopeful that sanity ultimately will prevail and the abyss avoided, I hold out hope for a more constructive turn of events in the global economy and world financial markets.
In the parlance of market practitioners, geopolitical relief could be enough to stem the bleeding and bring an end to the functional equivalent of a cyclical correction in a bull market. Of course, it never feels that way at the point of maximum fear.
By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley’s Global Economic Forum