I had breakfast yesterday with Steve Roach, one of Wall Street’s most respected economists. Steve is now the chairman of Morgan Stanley Asia and a professor at Yale.
In addition to getting Steve’s latest take on the global economy (gloomy), I learned that he is married to my second grade teacher, whom I remember fondly.
On to Steve’s thoughts about the economy …
BLODGET: Thanks for doing this, Steve. Great to see you. So where are we in the world economy these days?
ROACH: Japanese-like outcomes in the developed world, from Japan in its third lost decade to stagnation in the U.S. to recession in Europe. And I say Japanese-like because these are not temporary slowdowns. They are going to be lasting because of the damage done during these massive credit, property — and in the case of Europe — currency and interest rate bubbles for Southern European economies.
BLODGET: Is there anything that can be done to change this or is it just a matter of time?
ROACH: It is going to take really aggressive structural policies aimed at changing behaviour rather than the big bazooka of monetary and fiscal stimulus, which the authorities have embraced as an answer to a crisis. I think what we found in ’08 and ’09 is that aggressive monetary and fiscal stimulus can stop the crisis but it can’t spark a sustainable recovery. There’s no traction when you’re in a ‘liquidity trap’ when interest rates are too low and debt loads are too high to get real actors in the economy to respond.
BLODGET: And when you draw the Japan comparison, do you really think it’s 20-plus years for the U.S.?
ROACH: I don’t know, I honestly don’t know. But one of the great courses I’m teaching at Yale is called “The Lessons of Japan.” You spend five weeks studying what happened in Japan and developing metrics to calibrate the excesses pre-bubble, the mistakes made post-bubble, and then we look at that template relative to other countries in the developed and developing world and there’s a lot of striking similarities. Especially insofar as the U.S. and Europe let these bubbles and policy blunders distort the real side of their economy. It would be one thing if these were just financial or market-driven excesses. But they’re not.
BLODGET: One of the things that is different about the United States compared to Japan is that the United States’ population is still growing quite rapidly. Does that change things? Do we pull out faster as a result of that?
ROACH: I hope so. I mean I hope that our culture is one of greater resilience that enables us to do the necessary things. But our political process is so dysfunctional that it’s really hard to agree on the type of policy agenda that could have a lasting impact. The comparison I like to make is in Japan, the excesses in the late ’80s and then the problems in the ’90s and 2000s were in the corporate sector. A huge capex bubble went from like 15% to 22% of GDP and then just round-tripped back to 15%. It left a lot of bankrupt, insolvent or ‘zombie’ companies alive on artificial life support by these government directed funding policies. In the U.S., the problem is not the same. It’s consumers. Overly indebted, short of savings, high unemployment. We levered up in an asset bubble to take consumption to levels that we’ve never seen. Consumption pre-bubble in the U.S. was 66% of GDP. Now it’s 71%, 72%.
BLODGET: And does that go back to 66%?
ROACH: I think it does, yes. But in the meantime, in the last four years, consumer growth, in real terms, after taxes — or just consumer growth in real terms, forget the taxes — has averaged 0.4%, compared with a trend of about 3%. So, we’re focused on paying down debt and rebuilding savings. Consumers have zombie-like behaviour in the United States. I don’t think it’s going to go for two decades but it could go for another 3 to 5 years.
BLODGET: The Japanese stock market peaked in 1989 or 1990 at 40,000, and now, 20+ years later, we’re at less than a quarter of that. What’s the prognosis for the U.S. stock market?
ROACH: It’s not as bad as Japan because again the real excesses in Japan were in the companies that really ultimately had no earnings capacity. Our companies focused on productivity and still have the earnings capacity. The big question for us is do the rewards go from capital to labour. That’s the big debate of our time.
BLODGET: And do you think that they will? That does seem to be the big debate of our time. [Wages as a per cent of GDP are at an all-time low, while corporate profit margins are near all-time highs.]
ROACH: I think it’s going to be tough. I don’t think that government policy is the best way to get it there. Redistribution by tax policy, I think, will backfire. The emphasis has to be on re-skilling and education to equip workers to justify higher productivity-based returns. Just taking from one and giving to the other without validating it through relative productivity performance, it ain’t going to work.
BLODGET: So that sounds like investment, which costs money. What do you think about the U.S. debt situation at this point?
ROACH: It’s not great. It’s not great if you look at debt trajectories. An interesting chart that I and others have developed, if you look at Japan’s debt to GDP ratio, it was roughly around 40% of GDP when the bubbles burst. Now it’s 230%. Pre-bubble, we were about 35% and now we’re on our way, depending on how you measure it, to either 60 or 90%. So we’re not at Japanese levels. We subsidise the debt overhang by keeping interest rates low so that debt service is minimal. But how can we keep interest rates low and duck the bullet on the debt overhang?
BLODGET: People have been predicting collapse in Japan for 20 years now, because of the debt overhang and obviously the famous book, Rogoff and Reinhart, saying that debt at 90% of GDP is the magic number. Does the debt load really matter? Some people say it doesn’t matter, just look at Japan.
ROACH: It definitely matters. I mean, the trick to all of these flash points is that we don’t know when they really spark a major adjustment. Economists are good at pointing out tensions, but in terms of timing the correction, not great. What we know about Japan in retrospect is they are huge savers — at one point the biggest savers in the world. So they could fund their debt overhang internally. We’re not big savers. But we can issue debt in our own currency, which gives us what some have called “the exorbitant privilege” for a while. But you have to ask yourself how long can we stay in the good graces of our foreign creditors, especially if we’re aggressive in our trade policies against China.
BLODGET: What about Europe? Has the problem been fixed?
ROACH: I don’t think the currency’s going to blow up. But I think there’s still a huge battle over fiscal, political consolidation, giving up sovereign, national governments. And I think the debate will shift quickly from stopping the crisis — the ECB has expanded its balance sheet dramatically and is about to do more of that and that has been helpful in stabilizing the debt markets — but I think the debate will shift to how to deal with the recession. Europe is in a recession right now. So, as I said earlier, you can use policy to stop a crisis, but can you really use it to foster recovery when you have done as much damage as you have?
BLODGET: After 2008-2009, everyone’s primed to expect the next crisis. There are constantly predictions that it will be in the next six months — and then that time period just keeps rolling forward. Do you think it’s likely that the “tensions,” as you put it, end in a crisis in the next couple of years? Or is it more likely that it’s like Japan, where it’s just an endless workout period?
ROACH: I don’t know. I really don’t. I will tell you this. If you look at a timeline of major crises over the last couple of decades, starting in the early ’80s with the Latin debt crisis, going through the savings and loan crisis, Mexico, your favourite dotcom bust, subprime, sovereign debt, if you add them up, we’ve had 11 crises in the last 30 years, roughly one every three years. Those are not great odds. We always work hard to do a lot of backward-looking fixes. Here we are with Dodd-Frank post sub-prime. We will make sure that a subprime crisis never happens again. But it probably would never happen again anyway. So have we really figured out how to avoid crises? I think the odds suggest there will be another crisis, especially with excess liquidity and reckless fiscal policies in place. I just don’t know exactly where it will be and when.
Thanks to BI’s Ben Walsh for transcribing this interview.