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A Collision of Forces
Morgan Stanley ^ | Stephen Roach

Posted on 10/29/2002 10:56:32 AM PST by sourcery

The world economy is at a critical juncture -- possibly at its most perilous point in 70 years. At work, in my view, is a confluence of two powerful forces -- globalization and post-bubble aftershocks. It is the interplay between these tectonic shifts that is so vexing. It is a highly deflationary combination. To the extent that global policy makers fail to treat these risks seriously, an already treacherous slope can only get slipperier.

Globalization expands supply curves. It’s really that simple. Eventually, supply creates its own demand -- one of the oldest economic axioms of all -- but the "eventually" piece of that statement probably has the longest lags of all. In the meantime, as trade barriers fall, cross-border flows of goods, services, financial capital, and information accelerate, and technological change gets disseminated increasingly rapidly around an ever-shrinking world, it’s the production side of the global macro equation that initially changes the most. National supply curves dissolve into the more amorphous global supply curve, and the world is suddenly awash with an abundance of everything -- goods and increasingly services alike.

All the metrics of globalization are flashing unmistakable signs of increasing integration of global supply. International Monetary Fund statistics reveal that growth in world trade volumes (goods and services combined) surged at an 8.2% average annual rate over the 1994-2000 period. That’s nearly 50% faster than the 5.6% average growth pace over the preceding decade, 1983-93. At the same time, the transnational activity of multinational corporations expanded far more rapidly than global trade. According to United Nations data, global foreign affiliate sales hit 60% of world GDP in 2001, fully two and a half times the 24% share in 1990. By contrast, world trade rose to "only" 24% of world GDP in 2001 -- a record share, to be sure, but a relatively small increase from its 19% base in 1990. Similarly, financial integration has increased dramatically, especially for the more developed portion of the world. The IMF estimates that external finance in the industrial countries (the sum of external assets and liabilities of foreign direct investment and portfolio flows) rose to about 100% of industrial world GDP by 2000, up dramatically from a 50% share a decade earlier.

Global integration is initially manifested in the form of increased global supply. Linkages of trade, capital, and ideas -- tied together by the hyper-connectivity of an increasingly ubiquitous Internet -- have brought a new meaning to the global supply chain. With this accelerated pace of global production eventually comes a surge of income generation -- the sustenance of aggregate demand. That demand creation lags, however. High saving propensities in the developing world, along with productivity-led constraints on job creation, act to restrain the expansion of global demand for those nations that are contributing the most to incremental shifts in global supply. China is a critical case in point, where the restructuring of state-owned enterprises continues to create a huge overhang of job displacement that inhibits domestic consumption in the world’s most rapidly growing production platform. Someday the demand will rise to meet this supply, in my view, but that convergence will not occur overnight.

The second piece of this puzzle is about asset bubbles -- and how the popping of bubbles in the world’s two largest economies has set the stage for a seemingly chronic deficiency in aggregate demand. It all started in Japan, of course, with the popping of its equity and property bubbles in the early 1990s. In response, domestic demand growth in Japan slowed to an anemic 1.3% average annual rate over the 1994-2001 interval, only about one-third the 3.8% average pace recorded over the preceding decade. There is a comparable risk evident in the United States. Following the popping of its equity bubble in early 2000, US domestic demand growth has slowed to a 1.7% average annual rate over the ensuing nine quarters; that’s less than one-third the pre-bubble pace of 4.3% recorded over the 1994-1999 period. Nor does either of these shortfalls appear to be behind us. If reforms ever take hold in Japan, intensified pressures can be expected on unemployment and income generation -- pushing consumer demand down further until this necessary but long overdue restructuring runs its course. And an increased preference for saving ultimately seems like the only way out for an overly indebted, aging, and saving-short American consumer.

Nor are there alternative sources of demand growth elsewhere in the world that stand ready to compensate for post-bubble demand shortfalls in Japan and the United States. A seemingly chronic deficiency in domestic demand in Europe is a case in point. In the year ending in 2Q02, domestic demand in Euroland was off -0.1%, and there are signs of further weakness ahead. Policy settings in the euro zone look decidedly pro-cyclical, with the Stability Pact closing off options for fiscal stimulus and an intransigent ECB intent on fighting inflation in a deflationary world. At the same time, the politicians seem to be co-opting the European reform process once again, and the region has yet to digest fully the lagged impacts of an appreciating currency that occurred in the first half of this year. Meanwhile, Germany -- the largest economy in the region -- may already have toppled into its own double-dip recession.

Even if demand shortfalls in Japan and Euroland turn out to be transitory -- and I am highly suspicious of such a possibility -- the upside does not appear to be strong enough to compensate for lingering post-bubble demand weakness in the United States. For the past seven years, the US has been the unquestioned engine of the global economy, accounting for 64% of the cumulative increase in world GDP (at market exchange rates). Moreover, during the height of the bubble -- a five-year period ending in mid-2000 -- domestic demand growth in America averaged 5%, whereas gains elsewhere in the world averaged a mere 2%. As I scan the world, no new engine of global growth is on the scene that is likely to take the place of the once-powerful US growth engine. That’s true of the industrial world, and it is equally true of the externally dependent developing world. All this paints a picture of a global economy that is likely to remain on a path of subpar aggregate demand for the foreseeable future.

These two pieces of the global puzzle fit together in a very deflationary way. Globalization is increasing the supply side of the equation at precisely the point when post-bubble shakeouts are impeding the demand side. Basic economics tells us that’s a classic setup for a reduction in the market-clearing price level. Moreover, the increased integration of the world economy brought about through globalization means it will be exceedingly difficult for any one nation to stand against the rising tide of deflation elsewhere in the world. As China and other low-cost producers play an increasingly important role in driving the engine of global trade, they become the world’s price setters at the margin. Nor does the post-industrial model of the service-based developed economy provide immunity from the deflationary endgame in tradable goods. The globalization of services brought about through worldwide deregulation, cross-border M&A activity, and the new connectivity of the Internet changes all of that (see my October 7, 2002 dispatch, "Services -- The Next Leg of Deflation"). The explosive growth of the IT-enabled outsourcing of services from low-cost platforms in India and China is the icing on this piece of the cake.

Whether it’s a result of coincidence, bad luck, or a series of policy blunders, the endgame is now in focus. As I see it, the world must come to grips with an inherently deflationary mismatch between aggregate supply and demand. The problem is we cannot use traditional macro to resolve such a conundrum. Two things have happened over the past decade that break the mold of such orthodoxy -- the legacy effect of asset bubbles, which will impede aggregate demand, and an accelerated pace of globalization, which leads to an expansion of aggregate supply. Ironically, this confluence of events occurred just as policy makers were achieving the ultimate victory in the long battle against inflation. With price stability nearly at hand, this deflationary shock looms as all the more perilous for the global economy.

TOPICS: Business/Economy; Foreign Affairs

1 posted on 10/29/2002 10:56:32 AM PST by sourcery
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To: handy; arete; rohry
2 posted on 10/29/2002 10:57:29 AM PST by sourcery
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To: sourcery
He speaks wisely. Question: What will spark new growth? Answer: For the next 20 years, maybe nothing. It will take China or India truly entering a middle-class-oriented phase of development, along with political reforms that enable that, to get to the next stage of growth.
3 posted on 10/29/2002 11:02:03 AM PST by eno_
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To: eno_
Question: What will spark new growth?

Or a war

4 posted on 10/29/2002 11:03:15 AM PST by 2banana
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To: eno_
>>New growth

Half price gasoline if we occupy and take over Saudi oil.
5 posted on 10/29/2002 11:24:41 AM PST by swarthyguy
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To: sourcery; swarthyguy; Orion78; skemper; EditorTFP; bat-boy; lavaroise; Jeff Head
The author is partially correct. He notes the coming deflation. However, like most shop keepers, he does not examine the geopolitical dimension at all. To him, the PRC are just another developing country and not an enemy of Western Civilization. In fact, in the shallow mind of the shop keeper, Western Civilization (and its allies) be damned; the whole world shall become a world of shop keepers and all cultural differences, and, the huge chasm between Western and Oriental values, will miraculously evaporate into a version of the suburban shopping mall culture. In making such mental mistakes, the author completely neglects the lessons of history. Of course, those, like him, who subscribe to the fraud of Thomas L. Friedman's "Fast World" and Francis Fukuyama's fractured fairy tales, foolishly believe that we are now beyond the end of history and are somehow immune to the geopolitical cycles that have affected the Earth for ages. Be it wishful thinking, comfort to investors, or downright naivete matters not. For at the end of the day, just as it did the last time there were idiotic promises of peace in our time that begat the masses to go get a good sleep, there will be an huge fall. What goes up must come down. First to come down are the prices, followed immediately by the false settlements between what are in fact violently opposed cultures, and finally, rockets. There can be no breaking of the long cycle of war and recovery by Man. Only God can break the cycle.
6 posted on 10/29/2002 11:50:13 AM PST by GOP_1900AD
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To: sourcery
It all started in Japan, of course, with the popping of its equity and property bubbles in the early 1990s.

There is a comparable risk evident in the United States.

Japan does not have any immigration, legal or otherwise. The Xenophobes here may deeply resent the illegal immigration from Mexico, but they are a major force in driving our economy. No I am not a Mexican.

Analyses like this sounds good, but I think it is 4 bit words and 2 bits worth of thought. It's real value is to show the hubris of investment analysis. That's worth 1 bit (25 cents).

7 posted on 10/29/2002 11:52:59 AM PST by elbucko
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To: weaponeer
8 posted on 10/29/2002 12:00:44 PM PST by weaponeer
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