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Monday, January 20, 2003

Oh Where Has All the Traction Gone?

This effectively is the question that Morgan Stanley's Stephen Roach keeps asking himself. By policy traction, he means the ability of the authorities to jump-start the global economy with traditional fiscal and monetary stimulus actions. As he points out, in today's world, with the US (and China....?) the only visible engine of global growth, global traction means US traction. But this is just where the problem starts. The US has economy has received an unprecedented reduction in the Federal funds rate, at the same time as fiscal policy has swung violently from small surplus to sustained deficit. Normally, two years into the problem, you should be seeing daylight at the end of the tunnel, so where is it? Could it be that most analysts are missing something? Roach says its the post-bubble hangover resulting from earlier excess. Yours truly suggests that it's a change in global headwinds resulting from yet-to-be-analysed consequences of structural changes in OECD demography, and the imminent arrival of the two incipient Asian giant 'tigers', China and India. Whatever it is, something is crying out for more explanation than its getting.

Policy traction should not be taken for granted. Under normal conditions, all it takes is a dose of fiscal and/or monetary stimulus and the real economy normally responds -- albeit with a lag. However, the key in understanding the concept of policy traction lies in what constitutes "normal conditions." Insofar as my view is concerned, there is very little that is normal about America’s post-bubble workout or about the lopsided nature of this US-centric global economy. Largely for those reasons, I remain highly suspicious of the consensus presumption that policy traction can be counted on to spur a solid recovery in the US and the broader global economy.

To better understand this conclusion, I think it helps to lay out what can be called a model of policy traction -- identifying the conditions under which policy stimulus leads to an acceleration in the pace of real economic activity. In my view, this model has five key ingredients:

* First is the purging of pre-recession excesses. Typical excesses include an overhang of unutilized business capacity, unnecessary construction activity, and unwanted inventories. Of course, there can also be financial excesses, such as too much debt or too little saving. Until these imbalances are eliminated, policy stimulus is unlikely to bite. If, in fact, these excesses endure, the result would be the functional equivalent of economic "headwinds" that would restrain any recovery or subsequent expansion.

* Second is the development of pent-up demand. This involves the deferral of goods and services during a recession -- for example, the cars that aren’t bought, the homes that aren’t built, and the business investment and hiring that is deferred. Once the recession comes to an end, consumers and businesses typically unleash that pent-up demand, thereby providing a spark to the early stages of the typical cyclical recovery.

* Third is the inventory cycle. Recessions are invariably accompanied by sharp production cutbacks outright liquidation of unwanted inventories. Accordingly, it takes an increase in production to bring any such destocking to an end. To the extent that the end of the inventory run-off coincides with a policy-induced improvement in final demand, traction in the real economy is usually reinforced and often magnified.

* Fourth is the nature of the policy stimulus itself. These days, stabilization policies are normally left in the hands of the monetary authorities. Of course, that doesn’t preclude the possibility of a fiscal stimulus. Nor does it rule the possibility of a foreign-exchange-induced stimulus brought about by currency devaluation.

* Fifth are the lags -- the variable and often long response time between policy actions and their impact on the real economy. In most economies, it takes about 12-18 months for the effects of monetary stimulus to begin to show up in the credit sensitive sectors of consumer durables, residential constriction, and business capital spending. Fiscal lags tend to be shorter, depending on the nature of the stimulus.

In my view, the usefulness of this model is that it enables us to frame the debate on policy traction in a reasonably objective and coherent fashion. On that basis, the first point to make is one of global context: In a US-centric world economy, global policy traction is tantamount to US policy traction. Barring the emergence of a new engine of global growth, the rest of the world is beholden to the US for any spark of cyclical revival. And yet just as America has played a disproportionate role in driving the global economy since the mid-1990s, it is now playing an equally important leadership role in applying policy stimulus. Consequently, a US-centric global economy awaits the outcome of America’s policy-traction debate with bated breath.
Source: Morgan Stanley Global Economic Forum

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