The shape of the US recovery
By Stephen Roach
FT.com site; May 15, 2001
The writer is chief economist and director of global economics at Morgan Stanley
It has been popular to play the alphabet game in predicting the shape of the coming recovery in the US and the global economy. My vote is for an American-style L.
This stands in sharp contrast to the Japanese L, which is now in its 11th year, with gross domestic product growth averaging about 1 per cent. The US strain would be somewhat stronger but considerably shorter - an average growth rate in the range of 1.5 per cent to 2 per cent, lasting about three years.
Not so bad, you may say. But this implies growth rates of less than half the 4.5 per cent average recorded between mid-1995 and mid-2000. It also points to a relatively subdued corporate earnings trajectory over the next three years, with profits growth probably averaging in the mid-single-digit range. That would be far short of the long-term earnings expectation in the mid-teens that is still being discounted by the stock market.
There are important differences between the US and Japan, which lie behind the distinction between these two strains of the dreaded L: their banking systems, political structures, labour markets and shareholder value culture, to name just a few.
Even so, there is one critical thing the two nations have in common: the popping of an equity bubble and the related purging of bubble-related excesses in their respective real economies.
In the US, the Nasdaq bubble was the culmination of an equity bubble that had been building for five years. Prior to the great bull run of the late 1990s, the US had experienced only two consecutive years of back-to-back gains in excess of 20 per cent. Yet the broader Wilshire 5000 index rose 25 per cent a year between 1995 and 1999. This unprecedented surge finally spilled over into the real economy. Businesses and consumers alike began to see the stock market as a permanent source of funding and saving. Little wonder that capital spending rose excessively or that the personal saving rate dipped into negative territory for the first time since 1933. All sense of traditional discipline was lost.
The L comes from the powerful and enduring interplay of cyclical and structural forces that is likely to be the defining feature of the post-bubble era. The cyclical piece of the equation stems largely from the wave of corporate cost-cutting now being unleashed as the earnings recession deepens. As always, cost-cutting focuses on the two main factors of production: capital and labour. Given the new mathematics of the new economy, cuts in business investment budgets will have to be concentrated in information technology - by far the biggest component. Indeed, the IT growth rate finally went negative in the first quarter of this year. The same can be said for the labour piece of cost-cutting; just as excess hiring was concentrated in white-collar ranks so these workers are likely to bear the brunt of downside redundancies.
That has only just begun. But there is an equally important structural dimension to the current adjustments. Courtesy of the ever-alluring equity bubble, the US has been living beyond its means for the past several years. The negative personal saving rate is just one manifestation of the phenomenon. Another example is a capital-spending share of nominal GDP that soared to a record 13.9 per cent in the third quarter of last year. Moreover, reflecting the lack of domestic funding for this investment binge, the US has had to run a record current account deficit to attract the foreign capital that was necessary to close the financing gap.
These excesses have led to systemic flaws in consumer and business balance sheets. Household debt ratios soared to new records as consumers transformed new-found wealth into spending. And, in their rush to install new e-based delivery platforms, old economy businesses duplicated existing cost structures. While such excesses were not a problem in the hyper-growth era of the late 1990s, they are a serious problem in today's slow-growth economy and will have to be rationalised.
Insofar as these structural and cyclical excesses took years to build, it seems highly unlikely they will be purged quickly. That will not stop the authorities from trying to jump-start the economy, as a panic-stricken Federal Reserve is now attempting to do. But given the unique strain of systemic imbalances and excesses that have built up in private sector balance sheets, the quick fix of monetary and fiscal stimulus is not likely to work this time.
Post-bubble shakeouts always seem to have two things in common: they last longer than expected and the authorities end up pushing on that proverbial string. This post-bubble era should be no exception, hence the American-style L.
In fact, the US economy has already settled into the L-shaped profile. GDP growth has averaged 1.7 per cent over the past three quarters. The inevitable dips and rebounds should not obscure the most important conclusion of all: the US is not likely to return to the go-go days of the late 1990s for quite some time.