The Last Line of Defense

Morgan Stanley's chief economist, Steven Roach, has a great column in today's Financial Times. Ordinarily, I would only link to it, but it's so good, I'll quote it in full:

In the end, it all boils down to the American consumer. It always does. Long the bedrock of the US economy, accounting for two-thirds of gross domestic product, America's high-spending households have become the world's consumer of last resort.

That is not all for the good. The excesses of the American consumer will, I believe, go down in history as one of the hallmarks of the Roaring Nineties. Recent statistical revisions reveal a 2001 recession deeper and longer than was previously thought. Less support from the consumer was the main culprit. But US households are still steeped in denial and the imbalances of the 1990s have yet to be fully corrected. The odds are there is more pain to come.

Personal consumption is driven by the combination of income and wealth effects. While empirical evidence suggests that income effects outweigh wealth effects by nearly 10 to 1, US consumers have not been shy about drawing incremental support from asset appreciation during the bull market. More recently, however, with stock markets sagging and residential property values rising, consumers have been tapping the home equity till.

There are structural pressures on consumption, too: a low saving rate, record debt, an ageing population and a lack of retirement security brought about by wider use of defined-contribution pensions.

Taken together, these factors suggest that the US consumer is about to be caught in a vice. Three powerful forces are at work: wealth destruction; a long-overdue US current account adjustment; and the coup de grâce: a negative income shock.

The carnage in the stock market speaks for itself: leading indexes have fallen to mid-1997 levels. Moreover, from 1984 to 2000 the annual return for the average fund investor was just 5.3 per cent, only about a third of the 16.3 per cent annualised return of the Standard & Poor's 500 over that period.

Residential property values have held up a good deal better, enabling consumers to shift their equity-extraction tactics to property. But there is good reason to believe the property cycle is about to turn as well. Courtesy of stronger-than-expected housing starts over the past couple of years, a supply overhang seems to be developing, especially if demand starts to weaken.

A current account adjustment should also put increased pressure on consumers. The massive current account deficit is an unmistakable symptom of a US economy that has long been living beyond its means. Here, too, the excesses of personal consumption growth are the key.

Between 1997 and 2000, real consumption growth averaged 4.6 per cent annually - a full percentage point faster than the 3.6 per cent average gains in real disposable personal income. With goods imports rising to a record 35 per cent of GDP by the end of the 1990s, this growth of excess consumption was the principal force behind the import-led deterioration in the US's foreign trade and current account balances.

Consequently, in my opinion, the coming current account adjustment cannot occur without a significant compression in consumer demand and a concomitant reduction in imports.

An income shock, if it occurred, would be the clincher. The trigger is likely to be another wave of redundancies and cost-cutting as companies at last face up to the seemingly chronic conditions of bloated structures and excess capacity.

US companies, battered by the stock markets, can hardly afford to breathe easy on the earnings front. With payroll costs accounting for 70 per cent of total business expenses, I do not see how another round of cost- cutting can occur without widespread redundancies.

Job cuts seem especially likely in the high-paid managerial ranks, where staffing has become excessive in recent years: managers now make up a record 25 per cent of the white-collar workforce in the US.

The outlook is strikingly reminiscent of the early 1990s. Then, a managerial shake-out kept the national unemployment rate rising for 15 months into a recovery. A decade later, the prospect of another white-collar shake-out conjures up the possibility of a second jobless recovery and below-trend growth in incomes and personal consumption.

It is at this point that politics and economics intersect. In their spare time, consumers are also voters. Elected politicians and appointed policymakers can be counted on to resist strongly any lowering of the US standard of living. Remember how, in early 1997, Washington resisted the initial efforts of Alan Greenspan, chairman of the Federal Reserve, to pop the equity bubble. It can be expected to respond with a similar outcry if the consumer bears the brunt of the long-overdue purging of America's bubble-induced excesses.

The pressure for reflationary economic policies can only intensify. Policymakers may conclude that the American consumer is too big to fail - setting up another in a seemingly unending string of moral hazards. Particularly disconcerting were Mr Greenspan's recent comments to Congress encouraging households to keep spending newly extracted equity from rapidly appreciating property values.

In the end, of course, there are no short cuts. Asset-based consumption growth and the excess leverage it spawns set any economy up for systemic risks and a serious shake-out. That, in turn, holds the potential for a significant reversal in public policy.

The domestic and geopolitical ramifications of a retrenchment by the American consumer would, admittedly, be profound. I worry most about Asia, which remains dependent on US-led external demand. Capitulation by the American consumer would threaten the region with a return to recession; political destabilisation could ensue. China would not be spared, either: its exports to the US surged at an annualised rate of 19 per cent in the first half of this year.

I suspect that the body politic in the US and around the world will do everything in its power to buttress America's last line of defence. Fiscal and monetary restraint could be cast aside, as could the deregulatory thrust of the past 25 years. Shocked? Do not be. In a post-bubble era, the macro usually gets turned inside out.