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Monday, March 03, 2003

Critical Shock Analysis

Vive la difference. This is not a reference to Frances supposed cultural exception, but rather a critical reflection on the state of shock analysis in macro economic theory. It is simple but it is true: each shock is different. This is why all those macro provisions have such a hard time of it, and why it is a brave forecaster who would offer a 2004 projection with any degree of confidence right now (still, as the saying goes, fools do rush in......). And this week, there reminding us of the truth which proves so hard to swallow is Stephen Roach, who points out that in his book shock analysis has two critical dimensions — the magnitude and duration of the shock itself, and the pre-shock condition of the affected economy. The first dimension is totally unknown at present (for the innocent abroad, we are taking about oil here, how high can it go and how long can it stay there?), the second one , as he keeps reminding us (and well, you already knew this part), looks none to healthy.

There are times when it pays to be overly-simplistic on the global macro call. This is one of those times. Three key points are most obvious to me insofar as the cyclical prognosis for the world economy is concerned: First, in a US-centric world, the global call is basically a call on the US economy. Second, the US is in the midst of a classic oil shock. And, third, that shock has occurred at a point of maximum vulnerability — when a US-centric industrial world had slowed to a virtual standstill. The conclusion is inescapable: The recession warning model that I have long advocated is now flashing a serious alert for the US and for the US-centric global economy. A stalling economy lacks the cyclical immunities that cushion it from an unexpected blow. A stalling economy that has been hit by a shock is a recipe for recession. Unfortunately, it’s that simple.

It’s educated guesswork as to where oil prices are headed. It’s a painful reality check to see where they have come from. Crude oil (WTI spot) prices have now pierced the $37 threshold — fully 89% above the level prevailing in January 2002. Moreover, as of the close of February 27, oil prices have now equaled the highs of $37.20 hit on September 20, 2000, that played an important role in triggering the recession of 2001. With oil inventories low, disruptions in Venezuela lingering, and war looming, the risk is that oil prices will move higher before they begin their fairly typical post-shock mean reversion. But those risks lie in a murky and uncertain future. At this point in time, the facts speak for themselves — an oil shock has already occurred.
Source: Morgan Stanley Global Economic Forum

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