By Stephen Roach
Aug 15, 2005
SourceAh, for the perspective of the summer break. For me, it came just in the nick of time. Not much has broken my way over the past few months. The soft patch turned out to be shorter and softer than I had thought, as the US-led global business cycle once again has demonstrated its time-honored resilience. This reflects what is by now an all-too-familiar theme: On the surface, the global economy seems to be doing just fine. Yet just beneath that seemingly tranquil surface, the imbalances and tensions are only getting worse.
The shock of the summer -- or for that matter of the year -- has been the unrelenting surge in oil prices. In real, or inflation-adjusted, terms WTI-based oil prices are now more than 25% above levels reached in the run-up to the first Gulf War in late 1990 and back to levels last seen in late 1982. In the past six months, alone, the increase has been close to 40% -- taking real oil prices up more than three-fold relative to levels prevailing at the trough of the last recession in late 2001. Yet even more stunning than the price run-up itself has been the apparent resilience of the global economy to this full-blown energy price shock. Standard rules of thumb tell us that every $10 increase in oil prices should knock about 0.4% off GDP growth during the following four quarters. But after the briefest of soft patches this spring, the world proceeded to zig rather than zag, as the business cycle miraculously sprang back to life. So much for the precision -- or even the relevance -- of our time-honored macro metrics! Those who felt that $50 oil would derail the global economy have been dead wrong. Why worry about $60 or even $70?
The reason to worry, in my view, is that the cost of this cyclical resilience in the face of an energy shock is not without serious consequences for an unbalanced world. In particular, it has pushed the asset-dependent American consumer to a new state of excess. At first blush, there seems to be little reason to worry -- according to our US team, personal consumption growth is tracking a 5.5% gain in the current quarter. But consider the costs of that stellar accomplishment -- a personal saving rate that has finally hit the “zero” threshold, debt ratios that continue to move into the stratosphere, and asset-led underpinnings of residential property markets that are now firmly in bubble territory. Courtesy of surging oil prices, these costs are now at the breaking point, in my view.
Consider the saving position of the American consumer. The flaws of this measure are well known -- especially the exclusion of saving traceable to capital gains on asset holdings. But shifts in the national-income-based personal saving rate do a perfectly adequate job in depicting disparate movements of labor-market-dominated income generation and personal spending. On that basis, there can be no mistaking the precarious position of today’s US consumer. In the face of an unprecedented shortfall of labor income -- with real compensation growth in the 44 months of the current expansion running $282 billion below the path of the typical cycle -- consumers have not even flinched. Reflecting a new asset-dependent spending mindset -- first arising out of the equity bubble of the late 1990s and more recently supported by the property bubble -- US households have been more than willing to draw their income-based saving rates down into unprecedented territory.
While this penchant for spending may make sense in normal periods, it is the height of recklessness in the face of an energy shock. In the two oil shocks of the 1970s, the personal saving rate averaged about 9.5%, whereas in the oil shock just prior to the Gulf War of early 1991, it was around 7%. That means that in each of those earlier instances, US consumers had a cushion of saving they could draw upon in order to maintain existing lifestyles. Today’s “zero” saving rate underscores the total absence of any such cushion. The only backstop available to support the spending excesses of American consumers is the saving that is now embedded in their over-valued homes. Yet with the housing bubble now in the danger zone, that’s not exactly a comfort zone.
There is another eerie parallel with earlier energy shocks that should not be taken lightly. Just prior to the two oil price spikes of the 1970s, discretionary spending by US households had also gone to excess. The GDP share of consumer durables and residential construction -- the latter being a proxy for the discretionary demand for shelter -- was running at peak levels of around 14.5%. In the aftermath of those two earlier energy shocks, discretionary spending collapsed -- with the combined share of consumer durables and homebuilding falling to 11.5% in the mid-1970s and 10.5% in the early 1980s. These were the most severe consumer-led recessions on record in the United States. In the current expansion, discretionary household spending has moved into a similar zone of excess. The combined share of consumer durables and residential construction has averaged 14.3% of GDP over the past year -- virtually identical to peak shares hit just before the two energy-shock-induced consumption collapses of the 1970s. In other words, just as the energy shocks of the 1970s hit US households at a point when their spending behavior had gone to excess, the same is the case in the present climate. Yet unlike those earlier periods, today’s asset-dependent, overly-indebted American consumer is lacking any semblance of a backstop of income-based saving to shore up the downside. It would be one thing if American consumers were committed to defending modest lifestyles. It is another thing altogether in today’s era of excess -- there is much more room and greater urgency for consolidation.
At the same time, a persistence of spending excesses by the income-short US consumer also underscore the potential pyrotechnics of a major current account adjustment -- yet another problem that was not evident during earlier energy shocks. The more consumers push income-based saving rates toward zero, the greater the depressant on national saving -- and the greater the need to import surplus saving from abroad in order to fund economic growth. And, of course, the only way for a saving-short economy to attract that foreign capital is to run massive current-account and trade deficits. June’s outsize US trade gap of nearly $59 billion -- the third largest monthly shortfall on record -- only underscores this bias. Nor was this a problem during earlier energy shocks. In the two oil-related disruptions of the 1970s, the US current account was basically in balance, whereas in the pre-Gulf War shock of late 1990 there was only a small deficit that was soon to turn into America’s last current-account surplus in 1991. Today’s nearly 6.5% US current-account deficit underscores America’s unprecedented external vulnerability in the midst of an energy shock. The more income-short American consumers keep on spending to defend their overly-indulgent lifestyles, the larger the US current-account and trade deficits are likely to be -- and the greater the possibility of an external funding problem that could result in a weaker dollar and/or wider cross-border spreads for US interest rates.
So far, only the dollar -- and possibly gold -- seem to be sniffing out this possibility. The renewed weakening of the US currency has been reinforced by recent improvements in the cyclical state of the Japanese economy that appear to be more than offsetting the potential ramifications of a stunning setback to postal reform. The bond market, by contrast, remains well bid -- rallying yet again in recent days even in the face of signs of increased cyclicality of the global business cycle. Two developments continue to underpin bonds, in my view -- persistent signs of subdued inflation and the ever-present potential of an energy-shock-induced shortfall to economic growth.
I don’t know where oil prices are going. But I do feel strongly that an important macro threshold has now been breached -- one that adds unmistakable tension to the world economy’s greatest imbalances. At the current level of oil prices, I suspect one of two things will happen -- either the over-extended American consumer will finally cave or the long-awaited US current account adjustment will finally unfold. Courtesy of a full-blown energy shock, the venting of global imbalances can no longer be deferred indefinitely. If consumers remain unflinching in the face of sky-high oil prices, a plunging saving rate will push an already outsize current account deficit to the flash point.
As always, duration matters. If oil prices fall back quickly and sharply, all will be forgotten and the consequences will be minimal. Unfortunately, that’s a bet the financial market consensus has been making for far too long. All this points to what could be the biggest macro call that any of us will have to make for a long time -- the capitulation of the unflinching American consumer. Needless to say, this would have profound implications for the rest of the global economy -- largely a US-centric world that is utterly lacking in support from autonomous domestic consumption.
Over the years, I’ve learned to be wary of betting against the American consumer. But the history of energy shocks argues to the contrary. Moreover, today’s saving-short, asset-dependent, overly-indebted consumer is far more vulnerable than in the past. After years of such warnings, investors, of course, have all but given up on that possibility. That’s precisely the time to worry the most.