The Perils of Circular Thinking
Stephen Roach

 
We’re all guilty of it from time to time -- fudging an assumption in order to validate a conclusion.  But I am worried that this is starting to become the norm in the circular thinking that now pervades financial markets.  In particular, concerns over debt, current account imbalances, and oil have been dismissed all too quickly, in my view.  It’s as if the world has discovered a new means to cope with the once intractable.  Such was the folly of the New Paradigm when Nasdaq was cresting at 5000 in early 2000.  And such could well be the folly again in ignoring critical risks now bearing down on the global economy.
 
Take the matter of household indebtedness.  In a rousing defense of the overly-indebted American consumer, Fed Chairman Alan Greenspan recently concluded, “household finances appear to be in reasonably good shape” (see his October 19, 2004 speech, “The Mortgage Market and Consumer Debt,” before the American Community Bankers Annual Convention, Washington, D.C.).  He basically dismisses concerns over the unusually sharp run-up in mortgage indebtedness in recent years.  In doing that, Greenspan makes the critical assumption that such debt is fine as long as it is in reasonable alignment with the property values that collateralize such obligations.  But is this the correct assumption to make in weighing this key macro risk factor?
 
The evaluation of debt burdens by property-market conditions presupposes a permanence to underlying asset values -- a rather bold presumption for a US economy that just lived through the bursting of the biggest asset bubble in some 70 years.  In today’s climate, property bubble or not, there can be no mistaking the role that a low interest rate regime is playing in supporting an unsustainably rapid rate of nationwide house price appreciation -- a 25-year high of 8.8% Y-o-Y through mid 2004, according to the Office of Federal Housing Enterprise Oversight.  Were interest rates to rise, it seems perfectly reasonable, in my view, to expect a sharp downward adjustment in the elevated rate of house price inflation.  This does not necessarily mean that the level of home prices will fall.  But it does mean that, at a minimum, there will probably be a sharp reduction in the equity extraction from this asset class -- a development that could seriously crimp the discretionary purchasing power of the overly-extended American consumer.
 
In my view, dismissing debt perils by drawing comfort from asset markets is a classic example of circular thinking.  It ducks the key risk factor -- interest rates.  And it ducks the toughest question of all -- whether rates can stay low for a saving short US economy with massive current-account and budget deficits.  And it ducks the sheer magnitude of the debt overhang.  Alan Greenspan is outright dismissive of this aspect of the problem, drawing comfort in his recent speech from the observation, “For at least a half a century, household debt has been rising faster than income…”  Unfortunately, he fails to make the critical distinction between the secular shift to higher leverage and the unusually voracious appetite for debt over the past four years -- an expansion of household liabilities over the 2000-03 period that was, in fact, 65% faster than the cumulative growth of nominal GDP over the same interval.  Like it or not, America’s consumer debt bomb is ticking louder and louder in a climate where the artificial depressants to interest rates and debt service are on thinner and thinner ice.
 
The fallacy of circular reasoning also comes into play in dismissing the perils of America’s record external imbalance.   At 5.7% of GDP in 2Q04, America’s gaping current account deficit must be funded by capital inflows that need to average about $2.6 billion per business day.  With the current account deficit most likely headed into the 6.5% to 7% range within the next year, the daily financing requirement could easily approach $3.5 billion.  No problem goes the logic of circular thinking.  In this Brave New World, Asia -- America’s unshakable economic appendage -- will gladly step up and fund anything the US needs to keep on spending.  How realistic is this key assumption?
 
It’s a real stretch, in my view.  For starters, foreign investors see the handwriting on the wall -- a US that has lived beyond its means for far too long.  Fearful of the currency and interest rate risks that normally accompany a long-overdue current account adjustment, most channels of capital inflows into America have dried up.  For example, net foreign direct investment (inward less outward) into the US has swung from a surplus of $160 billion in 2000 to a deficit of -$134 billion in 2003.  Moreover, foreign buying of US equities slowed to an average of just $0.6 billion of US equities in the first seven months of 2004 -- sharply below the bubble-driven peak of $14.6 billion but also a significant shortfall from the $5.7 billion monthly average of the post-bubble period 2001-2003 (see my 27 September essay, Collision Course).  The stopgap funding has come mainly from foreign buying of US fixed income instruments, led by Asian central banks that are desperate to maintain dollar-based currency pegs.
 
The real question pertains to the stability of this external financing arrangement.  Three key risks could come into play, in my view.  The first is the possibility of protectionism.  If Asian currencies fail to adjust to a weaker dollar, the euro will bear the brunt of what could be a very severe impact; this could put already hard-pressed European politicians very much at odds with Asia.  Similarly, a persistently massive US trade deficit could put a post-election US Congress on a collision course with Asia.  Second, rapid accumulation of foreign exchange reserves runs the risk of heightened financial instability in Asia -- especially for countries like China, with relatively undeveloped debt markets that impair currency sterilization.  Third, Asia’s role as an export-led financier of American consumers raises fundamental questions about the endgame of Asian development -- in particular, the inevitable need to absorb surplus saving and stimulate domestic demand, especially private consumption.  It is the height of circular thinking, in my view, to dismiss these serious concerns and presume that America’s external financing is simply there for the asking.
 
Finally, consider the perils of another oil shock.  The common pushback I get on this one is that oil prices aren’t high in real terms -- that they, in fact, remain well below the highs of the late 1970s and early 1980s.  While technically correct, that point is all but irrelevant to macro impact analysis.  What matters most in assessing growth risks is the change in real prices -- not levels.  On that basis, there can be no mistaking the implications of today’s sharply higher oil prices.  At $50 on the nominal WTI, the real price of oil is about 65% above the average that prevailed over the 2000-03 time period -- a legitimate shock, by my reckoning.  Even in the face of this calculation, there are those who maintain this sharp increase doesn’t matter -- largely because it is a “perfectly natural” outgrowth of rising demand.  This is pure econo-babble, in my view.  Whether it’s supply or demand -- or some combination of the two -- sharply rising oil prices are a tax on oil consumers that saps discretionary purchasing power.  Yes, there is a transfer of wealth from oil consumers to producers, but history tells us this is not the zero-sum game of circular thinking.  Oil shocks are a distinct negative for the global growth outlook -- precisely why we lowered our global prognosis for 2005.
 
Macro is not hard science.  At its best, it is a framework that depicts adjustments from disequilibrium back to equilibrium.  Its strength lies in assessing the direction of change -- not in timing the shift with any great degree of precision.  Turning points are invariably a question of exogenous event risk rather than the internal workings of an economy or collection of economies.  In the end, however, macro is only as good as the assumptions that underpin the framework.  To the extent that many of today’s key macro tensions are being assumed away by the seductive power of circular thinking, the risks are high that both policy makers and financial markets could be blindsided.
 
©2004 Morgan Stanley