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Saturday, February 22, 2003

One Recession Away

Well the weekend's finally come round again, and with it another Friday post from Stephen Roach. This week it's deflation he's worried about, and in his view the US is just one recession away from deflation. As he argues, many see the recent spike in producer prices as evidence of a receding deflation danger - others (such as yours truly), however, argue that it provides what threatens to be only a temporary respite, and one which at the same time complicates the picture for Greenspan by putting pressure on him to think about raising rates. Far from offering us any hope of an 'all clear', Roach is surely right to argue that the US, absent any other major engine for global growth, is still trapped in the relegation zone, in danger of being sucked down by the backdraft emanating from Japan, and now, as looks increasingly probable, from Germany. We also need to watch and wait to see what will happen in the UK when the housing bubble finally burns itself out. And if the 'geopolicital uncertainty' produced by the threat or reality of an Iraq war should push us all back into recession, then clearly that could be all that is needed to heave us over the edge. So far from stand easy, it seems more like a case of get ready to man the pumps.

And if I seem even more decided in this than Stephen Roach, the reason is to be found in one detail where I take my difference from him. Stephen's deflation case rests on three premises: post bubble excess global supply, globalised supply networks, and forces associated with the business cycle. On the first two of these we would I am sure, and theoretical niceties apart, be in fairly broad agreement - in place of simply excess supply I would probably develop a story based more on a Moore's Law type process of falling prices in several key technology areas, and in place of global supply chains I would spell out more directly China and India, but let's be reasonable, we're on the same wavelength. It's the third point that bothers me. To introduce the business cycle at this stage as an explanatory variable seems to me to duck the question. Again, leaving to one side all the tricky problems about business cycle analysis, the point it seems to me is that it is precisely the form that the present cycle, or stage of the cycle, is taking that needs to be explained. In fairness Stephen has his get-out: it's the oil shock. And this is fair game, since the portrait he paints concerning the dangers for an already weakened global economy of a sutained rise in oil prices are real enough. The point is why is global demand so weak. Why is it that this recovery, coming as it does after one of the most sustained periods of growth in the history of the world economy, and with all its attendant productivity miracles, is so damned weak, why the dickens is this 'soft patch' we've hit proving to be so difficult to shake off.

Well to understand this I think you have to understand the specific weight in the global economy of a limited number of high income countries, call it G6 or G23, the difference isn't especially important. The fact of the matter is that a relatively small proportion of the world's population is responsible for a relatively high part of it's wealth creation and it's wealth consumption (something which in itself is potentially unstable in any even). Now this population is rapidly becoming old, and this is happening at a time of accelerating technological change which is in itself devaluing the net worth of all that accumulated and aging experience. Hence, ever so subtly patterns of consumption are changing. Look at clothing. It's a world phenomenon, people are looking for cheaper, more buy-and-throw-away apparel. Cultural transition or aging process, you tell me. Then look at Japan, and look at the retail industry which seems to be more and more dominated by cheap outlets selling cheap Chinese imports. The future belongs to Wal-Mart. And now tell me again that the subtle downward shift we're seeing in consumption habits, the one that's causing all the fuss about the output gap, tell me it's got nothing to do with the changing age composition of our populations.

The case for deflation rests on three key premises: First is the post-bubble legacy of excess supply -- especially the overhang of redundant IT capacity that was put in place in the United States and Asia in the latter half of the 1990s. While America’s IT correction was fast and furious over the 2001-02 interval, the rest of the world has not been as quick to follow. Europe’s telecom carnage is an obvious exception but non-Japan Asia’s ongoing appetite for new IT capacity -- especially China -- has been an important offset. Against the backdrop of a post-bubble compression of aggregate demand, the world remains awash in excess supply. That’s a classic deflationary condition.

Globalization is a second force behind the deflation story. Courtesy of accelerating growth in world trade, the globalization of supply chains changes the balance between aggregate supply and demand. That is not only the case in tradable goods -- the so-called China factor comes to mind -- but is also evident in the “non-tradable” services sector. With service sector deregulation now a global phenomenon, surging cross-border M&A activity creating huge multi-national service behemoths that span the globe, and the Internet spawning the advent of IT-enabled service exports from countries such as India, service-sector supply curves have gone from being national to global. That magnifies the overhang of aggregate supply -- yet another reason for global pricing to adjust downward.

But the latest twist can be found in the business cycle, the third piece to the deflation puzzle. Recessions are, by definition, deflationary events. Since the world economy entered its last recession in 2001 at a very low inflation rate -- a 1.3% increase in the advanced world GDP deflator in 2000, according to the IMF -- a close brush with outright deflation can hardly be judged a shock. In the parlance of macro, this recession opened up a positive “output gap” as a deficiency in aggregate demand and, in the context of excessive aggregate supply, virtually destroyed any semblance of pricing leverage for most global businesses. Normally, cyclical recoveries promptly close the gap between supply and demand, thereby restoring pricing leverage. That has not been the case in the decidedly subpar recovery that has occurred in the aftermath of the 2001 global recession. By our estimates, a 2.6% increase in world GDP in 2002 -- versus a longer-term trend of 3.6% -- actually led to a further widening of the global output gap and a concomitant increase in deflationary pressures. Against this backdrop, it would now take a fairly vigorous recovery in the global economy -- several years of world GDP increasing in excess of 4% -- to tilt the business cycle away from deflation.

Yet precisely the opposite now seems to be in the cards. Courtesy of a full-blown oil shock, the world is now flirting with yet another recession. Crude oil prices (as measured on a West Texas Intermediate basis) are now around $37 per barrel. Not only does that represent an 87% increase from levels prevailing at the start of 2002 (an average of $19.69 in January 2002), but today’s prices ($36.79 as of the close on 20 February) are nearly identical with the highs hit on 20 September 2000 ($37.20) that played a key role in triggering the recession of 2001. Unfortunately, oil shocks and recessions go hand in hand. That was not just the case in 2001 but also the outcome in the aftermath of the first OPEC shock of late 1973, as well as the result of the spike associated with the Iranian Revolution in 1979. And, of course, the same was the case following the sharp run-up in oil prices leading up to the Gulf War. In other words, show me an oil shock and I’ll show you a recession. It’s hard to believe that the current oil shock will be the one exception.

Another recession at this juncture could well reinforce the cyclical piece of the case for global deflation. Our global forecast is currently “under review” as we assess the twin impacts of looming war and higher oil prices. Our baseline scenario for 2003 world GDP growth currently stands at 2.9%. While I do not want to prejudge the outcome of our deliberations, I would place the ultimate downside somewhere in the 2.0% to 2.5% range. With global recession widely viewed as anything below the 2.5% world GDP growth threshold, there can be no mistaking the potential consequences of this oil shock -- a second worldwide downturn in two years. But the key insofar as the macro-analytics of deflation are concerned is the implications for the global output gap -- the discrepancy between aggregate supply and demand. When judged against the world economy’s 3.6% long-term trend line -- a good proxy for potential growth, or global supply -- a sharp downward revision to our 2003 baseline forecast has critical implications for the global output gap. Taking the midpoint of the 2.0% to 2.5% world GDP growth range noted above as an illustration, that would represent a 1.4-percentage-point shortfall from trend. Such a further widening of the global output gap would come on the heels of a 2.4 percentage point shortfall that opened up over the 2001-02 interval. That would bring the cumulative shortfall from trend to nearly four percentage points since 2000 -- large by any standards of the past.

Therein lies the risk. In my view, it was the widening of the global output gap in 2001-02 for a low-inflation world economy that led to the subsequent lack of pricing leverage and the close brush with deflation. And now -- courtesy of another oil shock -- that global output gap is set for a sharp further widening. As I see it, that can only intensify the lack of pricing leverage, taking the world all the closer to the brink of outright deflation. In other words, the current oil shock should not be interpreted as an inflationary event along the lines of the outcomes of the 1970s. It is, by contrast, very much a deflationary shock. Prior to this oil shock, I would have depicted the world economy as being only one recession away from deflation. To the extent that recession may now be in the offing, the case for deflation actually looks more compelling than ever.
Source: Morgan Stanley Global Economic Forum

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