February 26, 2007
By Stephen S. Roach | New York
A new level of complacency has set in. It’s not just a financial-market thing -- extremely tight spreads on risky assets and sharply reduced volatility in major equity and bond markets. It’s also an outgrowth of the increasingly cavalier attitude of policy makers. That’s true not only of central banks but also -- and this is a major concern of mine -- by the global authorities charged with managing the world financial architecture. Meanwhile, by flirting with the perils of protectionism, politicians are ignoring some of the most painfully important lessons from history. After four fat years, convictions are deep that nothing can derail a Teflon-like global economy. That’s the time to worry the most.
I am especially concerned about a new lax attitude that has crept into the mindset of the so-called stewards of globalization -- namely, the IMF and the broad collection of G-7 finance ministers. Last spring, in an uncharacteristically bullish lapse, I became more optimistic on the global economy than I had been in a long time (see my 1 May 2006 essay, “World on the Mend”). I was especially encouraged that the Wise Men had finally woken up to the perils of ever-mounting global imbalances -- namely, the widening disparity between America’s gaping current account deficit and large and growing surpluses in China, Japan, Germany, and the major oil producers. With great fanfare at the April 2006 G-7 and IMF meetings, institutional support was thrown behind a new framework of multilateral surveillance and consultation -- in my view, materially raising the odds of an orderly, or benign, rebalancing of an unbalanced world.
Unfortunately, the multilateral approach is now rapidly losing momentum. The first joint consultations between the US, Europe, Japan, China, and Saudi Arabia were held last summer, and there was a noticeable lack of “deliverables” following this effort. IMF Managing Director Rodrigo de Rato’s mid-November 2006 report on the “work program” of the Fund’s executive board was a further disappointment, relegating the problems of global imbalances to just one paragraph of a 49-paragraph document. And in the past few months, many of the individual participants at the various G-7 finance ministries and central banks have admitted privately to a lack of progress and conviction in the multilateral approach. With the global economy and world financial markets turning in yet another good year, suddenly, the urgency to act is now seen as less critical by the stewards of globalization. Complacency has claimed an important victim -- thereby undermining the major rationale for my bullish change of heart on the global prognosis.
Meanwhile, central banks -- basking in the warm glow of success on the inflation-targeting front -- are pouring more and more fuel on the global risk binge. America’s Federal Reserve seems to settling for a long winter’s nap -- likely to keep monetary policy on hold through at least the end of this year, according to our US team. While the Fed has expressed repeated concerns about last year’s minor upside breakout of inflation, it has also been quick to stress the coming deceleration on the price front. We could well be in the midst of a period like that which prevailed in the early 1990s, when the US central bank left the federal funds rate unchanged at 3% for a 17-month stretch from September 1992 to February 1994. Unfortunately, that experiment did not end well for the financial markets, as one of the Fed first “normalization campaigns” led to the worst year in modern bond market history.
An inflation-targeting Bank of Japan seems to be of a similar mindset. That’s mainly because of the distinct possibility of a minor deflationary relapse, with year-over-year comparisons in the CPI likely to move from being fractionally positive (+0.1% in January) to slightly negative by March. Moreover, with the economy still judged to be on shaky foundations -- especially the ever-cautious Japanese consumer -- political pressure on the BOJ to refrain from any policy action has been intense. After having succumbed to that pressure in January, Governor Toshihiko Fukui appears to have expended great political capital in orchestrating the BOJ’s second baby step away from its anti-deflationary ZIRP campaign. In the end, a one-party Japan has little tolerance for central bank independence -- especially in light of a still very fragile state of affairs on the inflation front. I suspect, as does our Japan team, that the mid-February policy adjustment will be the last move of the BOJ for a long time.
That leaves the European Central Bank as the only one of the three major central banks that is likely to make any type of a policy adjustment in 2007. Elga Bartsch, our resident ECB watcher, puts the upside at 50 basis points of rate hikes. This suggests that European monetary authorities -- the most dogmatic of the inflation targeters in central banking circles -- believe they are now only two policy moves away from their own normalization objectives in a still low-inflation world. This view, of course, is predicated on the belief that the European economy continues to surprise on the upside. Should that view be drawn into question for any reason -- hardly a trivial possibility in light of the recent increase in the German VAT tax, the lagged impacts of euro appreciation, and the ripple effects of Italian fiscal consolidation -- the risks to the ECB policy path could quickly tip to the downside.
There’s nothing wrong with this picture from a strict inflation-targeting perspective. But that’s just the point, in my view. At low levels of inflation -- and persistent risks of deflation in Japan -- inflation targeting produces an exceptionally low level of nominal interest rates. That, in turn, continues to fuel the great liquidity binge that underpins an extraordinary degree of risk taking still evident in world financial markets. Central banks have circled the wagons in taking an agnostic position on this state of affairs. As a former senior central banker put it to me indignantly the other day, “Who are we to judge the state of markets?” That’s indicative of what I believe is a very narrow perspective of the role and purpose of central banking. Most importantly, it relegates financial stability to a secondary consideration at precisely the time when financial globalization and innovation could be inherently destabilizing.
The orthodox view of modern-day central banking is premised on the belief that hitting the narrow target of CPI-based price stability is sufficient to address anything else that might come along. Never mind that this approach has produced a most unfortunate string of asset bubbles -- first equities, now property, and next those that may well be bubbling up to the surface in the form of a tightly correlated compression of spreads on a host of risky assets (i.e., emerging market debt and high-yield corporate credit). Never mind the explosion of worldwide derivatives, whose notional value has now reached some $440 trillion (OTC and listed, combined) -- over nine times the size of the global economy. Central bankers will tell you that the liquidity and risk-distribution benefits of derivatives far outweigh the lack of transparency and limited information they have on the incidence and concentration of counter-party risk. Never mind the power of the carry trade, which has been given a new lease on life by the politically-compromised Bank of Japan. Never mind the potential “canary in the coal mine” that may well be evident in America’s sub-prime mortgage market. All in all, increasingly complacent central banks are telling us that these concerns are not actionable issues for monetary policy. That could well be a blunder of tragic proportions.
A similar complacency is evident on the political front. As the pendulum of economic power in the developed world has swung from labor to capital, the pendulum of political power is now swinging from the right to the left -- not just in the US but also in France, Germany, Italy, Spain, Japan, and Australia (see my 8 January 2007 dispatch, “Power Shift”). As pro-labor politicians now move into action, trade protectionism is increasingly getting the nod as a legitimate policy response. Nowhere is this more evident than in Washington D.C. I have spent a good deal of time in the US capitol the past couple of weeks and sense that Congress’s anti-China sentiment is most assuredly intensifying. The new Democratically-controlled Congress is not in a rush -- its momentum on trade policy, in general, and China, in particular, is methodical yet increasingly contentious. I have taken the other side in the debate at several forums in Washington -- but to little or no avail. This takes complacency to an even more worrisome level. US politicians feel completely justified in ignoring some of the most painful lessons of history. And, ironically, the broad consensus of investors feels equally justified in ignoring the possibility of a protectionist outcome. Such an inconsistency is yet another example of a world in denial.
I’ve been relatively constructive on the global outlook over the past 10 months. The call didn’t work out all that badly -- the world economy turned in another great year and, after a brief bout of risk-aversion last May, the markets did fine as well. That was then. New and worrisome political forces are coming into play at precisely the time when the stewards of globalization have gone back into hibernation. Meanwhile, central banks are refusing to take away the proverbial punchbowl when the party is getting better and better -- instead, egging on the risk-takers when risky assets are priced for all but the absence of risk.
Enough is enough -- from where I sit, it no longer makes sense to maintain an optimistic prognosis of the world. This is more of a structural call than a cyclical view. I remain agnostic on the near-term outlook, and certainly concede that the Goldilocks-type mindset currently prevailing could put more froth into the markets. But complacency is building to dangerous levels — always one of the greatest pitfalls for financial markets. And yet that’s precisely the risk today, as investors, policymakers, and politicians all seem to have dropped their guard at the same point in time. The odds have shifted back toward a more bearish endgame. I have a gnawing feeling we’ll look back on the current period with great regret.