Stephen Roach (New York)
Oct 09, 2006
SourceConvictions are deep that a $46-trillion world economy has acquired a new Teflon-like resilience. On the surface, recent events appear to bear that out: Despite unprecedented outbreaks of terrorism, mounting geopolitical instability, soaring oil prices, and the bursting of a major equity bubble, the global economy has hardly skipped a beat. In fact, by the IMF’s metrics, world GDP growth appears to have surged at a 4.9% average annual rate over the 2003-06 period -- the strongest four-year global growth spurt since the early 1970s. And most forecasters, including those at the IMF, are banking on a similar outcome for 2007. Is this resilience a new organic feature of an increasingly globalized world, or has it come at a much greater cost than widely appreciated?
I am firmly in the latter camp -- that the world may have paid a very steep price for its newfound resilience. That price, in my opinion, is very much associated with the second-order effects of excess liquidity -- namely, a profusion of asset bubbles, record disparities between current account deficits and surpluses, and a mounting protectionist backlash. In a myopic rush to celebrate the immediate dividends of faster economic growth, the costs of what it has taken to achieve that outcome have all but been ignored. As long as global growth remains strong and the liquidity cycle remains accommodative, I suspect those costs will continue to be finessed. But when the tide goes out and the global growth engine slows for any one of a number of reasons, an increasingly integrated global economy and its tightly interdependent financial markets could well have to come to grips with these costs head on. That remains the biggest potential pitfall of 2007, in my view.
The excesses of the global liquidity cycle explain much of the new cushioning role world financial markets have played in warding off major shocks during the past several years. While we see visible manifestations of excess liquidity everywhere -- asset bubbles, historically low spreads on risky assets, and unusually low volatility in major equity and bond markets -- we are lacking in good metrics to measure it. For a forecaster, that makes it tough to render a judgment as to when -- and under what conditions -- the liquidity cycle goes from being a tailwind to a headwind insofar as its impacts on world financial markets and the global economy are concerned. The explosive growth of non-traditional sources of liquidity -- especially derivatives -- seriously complicates the measurement problem. BIS data put the notional value of global over-the-counter derivatives markets at US$285 trillion in December 2005 -- up more than 40% from volumes just two years earlier and more than six times the nominal level of world GDP. The notion of being awash in liquidity takes on a very different meaning in this context.
Derivatives, or not, I have a very simple view of what drives the global liquidity cycle -- central banks. That’s not because of their control over the commercial banking system. Indeed, because of the rapid growth of cash capital markets and derivatives, the banking sector has lost market share steadily in the intermediation of total credit. According to IMF statistics, the combined capitalization of global equity markets plus the outstanding value of debt securities totaled US$96 trillion in 2005 -- fully 73% larger than the assets of the world’s commercial banks. With loan-to-asset ratios typically in the 60% range, that would put cash positions in global equities and bonds at nearly three times the volume of worldwide bank lending. Despite the banking sector’s relatively declining slice of total credit intermediation, I still believe that central banks are key in anchoring the markets through their impacts on inflation and inflationary expectations. Their creation of high-powered money -- and the price they set for overnight funding -- remain the defining characteristics of the global liquidity spigot.
My favorite gauge of the quantity dimension of liquidity is the so-called “Marshallian K” -- the difference between growth in the money supply and nominal GDP. In essence, this measures the surplus of money that is not absorbed by the real economy. Joachim Fels has constructed such a measure for the “G-5-plus” group of industrial countries -- the US, Japan, the 12-country euro area, Canada, and the UK. This measure is based on “narrow money” (i.e., M-1) -- the monetary aggregate that still has the tightest linkage to central bank policy adjustments. The trend in this version of the global Marshallian K is now ticking below the “zero threshold” for the first time since 2000 -- consistent with earlier turns in the liquidity cycle that have been associated either with recessions (1991 and 2000-01) or abrupt adjustments in financial markets (1994).
Stephen Li Jen has made an analogous estimate of the price dimension of the global liquidity cycle -- calculating a weighted average of real, or inflation-adjusted, overnight policy rates for the G-10 economies. His latest estimate places the real G-10 policy rate at 2.8% -- well above the 1% reading of mid-2004 but still short of the longer-term average of 3.2% realized over the 1991 to 2000 period. Significantly, the change in real policy rates is every bit as great as that which occurred in the mid-1990s and in 2000 but the current level of the inflation-adjusted cost of overnight money remains far below past peak rates in the 4-5% zone. Combining these estimates of both the quantity and price dimensions, there can be little doubt that the global liquidity cycle has turned; however, it is equally apparent that the über-accommodation of 2001-03 has not been followed by a major tightening. Instead, with inflation remaining generally well-behaved, central banks have been more comfortable with steering the liquidity cycle back toward the so-called neutrality zone -- embracing the concept of policy normalization that fits the Goldilocks-type script of the fabled soft landing.
This underscores perhaps the trickiest aspect of the liquidity call -- the stock versus the flow. The move from excess monetary accommodation to policy neutrality certainly constricts the flow of global liquidity. But given the extremes of monetary ease that were adopted in the post-bubble deflationary scare of 2001-03, the subsequent reductions in the flow of global liquidity have yet to bring the stock down into a more restrictive position. Shifts in the price dimension of the liquidity cycle described above render a similar verdict -- overnight money is more costly than it used to be but hardly onerous in the absolute sense. In my opinion, given the excesses of liquidity that built up in the first three years of the present decade -- both in terms of quantity and price -- the cycle has not turned enough to alter the financial market landscape. This is quite consistent with the broad consensus of investors who I speak with around of the world -- most of whom remain awestruck over the ample liquidity still available to support a broad array of financial assets. In other words, the flow may now be a negative but the stock is still a huge positive.
If that continues to be the case, then many of the seemingly anomalous results currently evident in financial markets are likely to persist. By this, I mean a persistence of unusually low spreads in risky assets -- such as emerging market debt and high-yield corporate securities. I am also referring to rock-bottom levels of volatility in major equity and bond markets. The asset-liability mismatch only compounds this phenomenon, as a still ample stock of liquidity continues to be drawn into higher-return risky assets. The high priests of each of these risky asset classes all have very persuasive arguments as to why the fundamentals have changed -- in effect, why the current assessment of risk is far more benign than in the past. Call me a cynic, but I don’t buy the theory of “riskless coincidence” -- that the fundamental underpinnings have simultaneously improved for all risky assets at precisely the same point in time. If there’s ever been a visible manifestation of the excesses of the stock of global liquidity -- despite an adverse shift in the flow -- this is it. Like it or not, the excesses of global liquidity have created a profusion of “this time it’s different” stories. I might be persuaded that one or two of them are intriguing -- it’s the profusion that kills me.
The same, of course, is true about the bubbles in the bigger asset classes -- first equities and now property. As those assets went to excess, we heard similar stories about new and powerful fundamentals -- dotcom-enabled productivity transformations in the case of equities and demographically-driven demand for shelter in the case of residential property. Each of these stories is, of course, based on a plausible kernel of truth. The problem is that the arguments eventually were taken to excess by the same liquidity-driven amplification mechanisms that Robert Shiller stresses have been a hallmark of financial bubbles of the past. As was the case with post-equity-bubble adjustments, as the US property bubble now bursts, those same amplification mechanisms are likely to be reversed -- with potentially important implications for asset-dependent American consumers, a US-centric global economy, and world financial markets.
The greatest risk, in my view, is that we have focused too much on the visible manifestation of excess liquidity and not enough on the second-order effects. Here, I am referring to the American consumer’s shift from income- to asset-based saving -- and the resulting depletion of national saving that has given rise to massive US current account and trade deficits. In a climate of persistently subpar job growth and near stagnation in real wages, these external imbalances have also sparked worrisome political tensions -- namely, a Washington-led outbreak of China bashing. The excesses of the global liquidity cycle are not just about surging demand for financial assets and/or the risks of inflation. They lie at the heart of a much broader set of tensions that are bearing down on the world economy. The good news is that the stewards of globalization --namely the IMF and G-7 finance ministers -- are now mindful of these risks. The bad news is that they don’t have any power over the monetary and fiscal authorities who can actually make things happen.
All this underscores the perils of an exquisite moral hazard dilemma. Central banks have created a monster -- not just liquidity-driven excesses in financial markets but also major cross-border imbalances in the global economy and mounting political tensions associated with those imbalances. Nor do I believe that the instability of this disequilibrium can be resolved through a mere normalization of monetary policies. Ultimately, a more meaningful shift to policy restraint will probably be required. At the same time, by waiting this long to face up to the excesses of the global liquidity cycle, the systemic risks embedded in world financial markets and the global economy have only gotten worse. A monetary tightening that goes too far risks a collapse in this proverbial house of cards. Yes, the world economy has been very resilient over the past five years -- but at a real cost. Increasingly, the celebrants of global resilience are dancing on the head of a pin.