Stephen Roach had a nice article today called The Handover Fallacy.
Point by point Roach dismisses the idea that there is going to be a smooth transition from US consumer spending to spending elsewhere that will drive the world economy forward. I do not buy that idea and neither does Roach. Let’s tune in.
Fallacy #1 – The Capex Handover
The capex handover is at the top of everyone’s list these days. That’s especially the case with respect to the US economy. There is a presumption that consumer fatigue is about to give way to support from the business sector. Awash in record cash flow and profitability, the wherewithal of Corporate America to spend on new plant, software, and equipment has never been greater. And so, there is hope that the baton of economic leadership is likely to be passed from consumption to capex — a seamless transition that could well lead to another upside surprise for US economic growth.
The anemic pace of consumer demand in the final period of 2005 was even weaker than that recorded in the aftermath of 9/11 and, in fact, was the second weakest quarter of consumption growth of the past decade. If this is, in fact, the beginning of the end for the wealth-dependent American consumer — hardly idle conjecture as the housing sector now starts to roll over — hopes for a capex handover may be dashed.
Given that consumer spending is 70% of GDP, exactly why should businesses be expanding production if consumer spending slows? It idea is as silly as it is pervasive. Instead we are likely to see share buybacks, IPOs, mergers and acquisitions, leveraged buyouts, and spinoffs in a foolish attempt to drive prices higher. This is similar to what happened in Spring of 2000 and it is happening again. Stock buybacks and acquisitions at these prices, while staring at an inverted yield curve and likely recession is silly. Yet history is repeating.
Fallacy #2 – China, Japan, and Europe demand will replace US demand.
Don’t count on it — the arithmetic of this particular handover is daunting. US consumption totaled $8.7 trillion in 2005 — about 25% greater than European consumption (at market exchange rates), 3.3 times the level of Japanese consumer demand, 8-9 times the size of Chinese consumption (depending on data revisions), and fully 20 times the size of overall consumer spending in India. That means it would be a tall order for any one of these economies to compensate for a shortfall in US consumer demand. The bottom line is that an imminent slowing of the American consumer probably spells a weakening of global consumption and world GDP growth.
Mish: It is nearly impossible to tell anyone aware of “The China Story” that China’s demand is all that matters. Yet much of that demand from China is to produce goods for the US. There is no doubt that China is the growth story, but there is also no doubt that China is not yet fully prepared for a smooth baton handoff. Based on negative savings rates and a likely sustained drop in home prices, US consumer spending fueled by cash out refis and home equity lines of credit is about to fall dramatically. There is no way China can pick up the slack. Furthermore the UK consumer seems to be in the same boat as the US consumer. That makes the downside risk all the more precarious. On the basis of demographics, Europe and Japan are simply not going to pick up the slack either. Long term China remains the story, short term don’t be so sure.
Fallacy #3 – A handover from an asset to an income driven US economy will save the day
It’s a neat theory, but it won’t work as long as America’s private sector labor income generation remains decidedly subpar. In my view it would take a reversal of the global labor arbitrage — and a related unwinding of many of the powerful forces of globalization that are driving it — to kick-start America’s internal income-generating capacity. Barring an unlikely outbreak of protectionism, the odds of a shift away from globalization are low. That suggests that the pressures on US labor income growth are likely to remain intense for years to come.
I have been asked time and time again: “What will it take for you to change your deflationary outlook?” My answer has not once changed changed: “Rising US wages and significant US job expansion”. I see little likelihood of this happening anytime soon. Furthermore, unlike Roach, I disagree that protectionism will do anything but make matters worse. Surely Roach is aware of the problems caused by the Smoot Hawley Tariffs in the 1930’s. Protectionism is bound to throw more people out of work than any supposed benefit from increased wages.
Fallacy #4 – There will be a smooth transition from the Greenspan Fed to a Bernanke FED
The Maestro turns over his baton to Ben Bernanke this week. Many argue that forward-looking financial markets have already discounted any risks associated with this historic event. With unusually tight credit spreads and low equity volatility pointing to an absence of risk in the price of risky assets, I find that assessment hard to buy. But I also think it misses the basic point of what this changing of the guard at the world’s most important central bank is all about. When he leaves his office on 31 January, Alan Greenspan will take his books, his papers, and his pictures off the wall. But the most important thing he will take with him will be the nearly 18 1/2 years of confidence that he has earned in the financial markets. Ben Bernanke walks in the next day as a very smart and talented man — but with a clean slate on the confidence front. As I have noted previously, financial markets have an uncanny knack of quickly testing a new Fed chairman (See my 7 October 2005 dispatch, “Transition Curse”). This is not a handover to take lightly either.
The problems facing Bernanke are simply impossible to resolve. Greenspan is leaving Bernanke with a housing bubble, a junk bond bubble, an enormous baby boomer time bomb, a Congress intent on cutting taxes and overspending, staggering budget deficits, staggering balance of trade issues, and growing threats of protectionism. Bernanke’s writings prove he does not have a clue about the real cause of the great depression even though he is facing the greatest global economic set of problems since 1928. Bernanke has to face a Congress and president unlikely to bow to his every thought like they did Greenspan. Finally and most importantly, Bernanke unlike Greenspan does not have an internet boom or a housing boom to bail out his mistakes.
There is no “handover” to be had.
Mike Shedlock / Mish/