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Denial in Davos.

Stephen Roach is an economist for Morgan Stanley that I've been reading for a few years. He's had a very good record in the past at predicting problems in the world economy, but lately seems to have missed the boat. He sees great problems on the horizon due to trade imbalances between the US and the rest of the world (as I do), but everyone else has concluded that they don't matter. In 2003 the economy roared ahead, fearing nothing. But Roach thinks he's heard this song before:

The Davos consensus was quick to agree. With the entire world perceived to be on a de facto dollar standard, America’s rapid build-up of external dollar-denominated debt was not perceived to be a problem. After all, Asia is funding the bulk of the new increments to that debt, and most were utterly convinced that nothing could break the “daisy chain.” As long as America continued to buy Asian-made products, Asian investors would continue to buy American-made bonds — thereby avoiding the lethal back-up in real interest rates that such imbalances would normally spawn. One participant characterized this arrangement as “a massive Asian export subsidy program.” Another cited the artificially depressed US interest rates that fall out of this arrangement as a foreign subsidy to the spendthrift American consumer. Either way, no one could conceive of any circumstances that would cause Asian investors — private or official — to change their mind on the funding of America’s massive external imbalance. And so the Davos crowd believes the music will continue to play on.

Quite honestly, none of this really surprised me — these are precisely the assumptions that ever-frothy financial markets must be making in order to sustain asset values at current levels. If imbalances were perceived to be the problem I suspect they are, markets would be in a very different place. As predictable as this response was, I was totally unprepared for what hit me immediately after the conclusion of this opening session. Two of America’s leading academics rushed the stage — one a renowned economics professor and the other the president of a top university — and loudly proclaimed that the traditional macro of saving shortages and current-account deficits is a scam. America was not in any danger whatsoever, they argued vociferously. The imbalances that I worried about are simply the logical and entirely rational manifestations of a New Economy.

Seems to me I had heard that one before. But I held my tongue and pressed for more. The New Paradigm in this case is that America has now become an asset-based, wealth driven economy. As such, it need not worry about scaling its imbalances by national income — instead they need to be judged against economy-wide net worth. On that basis, debt loads — either internal or external — can hardly be characterized as worrisome when measured against the elevated wealth of the US economy. Sure, that wealth took a “bit” of a hit when the equity bubble popped in 2000. But the baton of the US wealth creation machine was quickly passed on to property markets, and the US economy never even skipped a beat.

This argument bears serious consideration, but I am convinced it is wrong. For starters, it makes the critical presumption that asset appreciation is permanent. When I pressed this point with my adversary, he bristled in response, claiming that permanently rapid rates of financial asset appreciation were entirely justified by the productivity breakthroughs of recent years. He went on to add that property cycles had all but been abolished — that the American home was a lasting store of ever-rising value. Needless to say, if that’s the case, then I’m the one who’s dead wrong. Ever-rising asset values would then qualify as permanent sources of saving — obviating the need for consumers to rely on traditional income-based saving strategies. Quite frankly, I couldn’t believe what I was hearing. Here we are, just a few years after America’s most devastating post-bubble carnage, and the apostles of the New Economy were back with a vengeance.

Here's a metaphor for how I see the world economy today. The richest guy in town is on a buying spree. Every day, he wanders through the market and chooses what he likes. The merchants want to sell to him, and are willing to accept his credit notes. After all, he's the richest guy in town! Everyone knows his credit is good. Eventually, the merchants exchange these credit notes with each other, and use them to purchase assets like real estate or shares of other businesses. This makes prices for these assets go up and makes the richest man in town (who owns many of these types of assets) even richer. He goes on a shopping spree to celebrate. Can this really go on forever?

One of the gimmicky rules at the Davos World Economic Forum this year was the banning of neckties. Roach refused and kept his on.


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Interesting comments. The necktie shtick was pretty sad. Three years after the rest of the corporate world is going back to professional dress, Davod takes the neckties of men who ae already wearing business suits. Next year, it'll be: step out of those wingtips and get barefoot. We're sellin' em for charity!

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