The Bear of Wall St
Morgan Stanley Asia chairman Stephen Roach talks to Vikram Khanna about the global financial crisis and where it's headed.
FOR several years now, Stephen Roach, Morgan Stanley's chairman for Asia, has been flashing the orange light on the state of the US economy. In press articles, research reports, speeches and interviews, he's been hammering home his gloomy message: the US consumer is overstretched, the stock and property markets are in bubble territory, the US current account deficit is out of control and this party can't keep going on.
The party did, however, go on far longer than he predicted. As stocks and property values kept rising, Mr Roach, a former economist at the US Federal Reserve, earned himself a reputation as 'the perennial bear'. Market optimists would murmur 'there he goes again' everytime he spoke.
But then, around August last year, the bubble burst, the markets went into a tailspin, culminating in a financial meltdown and a near collapse of the Western world's banking system. It was an outcome that surprised even the great bear himself.
'In the last 35 years of my working life, I've been through five recessions and about 12 crises,' says Mr Roach, sitting across from me in a conference room at Morgan Stanley's Church Street office. 'This one is by far the worst.'
'But the question now is not to look back - other than to try to understand how we got here - but to look to where we're headed.'
While the worst may be over in terms of the financial contagion, there's lots more trouble to come in terms of the repercussions on the real side of the US and global economy, he says, and that will feed back into financial markets and financial institutions. 'So it's possible that we will have more episodes of distress bordering on panic.'
Two-stage process
The feedback loop from the financial crisis to the real economy will be a two-stage process, according to Mr Roach, starting with the United States. 'The US over the last 10 years has become a bubble-dependent economy,' he says. 'First equities, and then property and credit. It has grown well beyond its means as the current account deficit indicates, and has funded that growth by extracting purchasing power from overvalued property. And the extraction process has been fuelled by a credit bubble. So now, both the bubbles have burst and the economy is correcting.'
'The contraction is concentrated on consumers. We saw a very sharp decline in personal consumption in the third quarter of this year. And that's very unusual because personal consumption is something that hasn't declined in 17 years.'
Mr Roach points out that the second stage of the feedback loop to the real economy lies in the linkages between the American consumer and export-dependent economies around the world, especially in Asia. 'Developing Asia is slowing pretty much across the region and those adjustments have only just begun. And that's because America's moving into a multi-year consumption adjustment, and there's no other consumer out there to fill the void.'
He pulls out a chart which shows that if you stack up the consumption of China, Japan and India, the total still comes to barely two-thirds of US personal consumption in 2007.
'Developing Asia's exports relative to GDP have never been higher,' he says. 'So the region gets hit - it's just simple math.'
And how deep will America's recession be? Mr Roach reckons that it will be deeper than the recession of the early 1980s, which saw peak-to-trough declines of 2.5 to 3 percentage points of GDP.
'We've had a 14-year period in the US where consumption has grown by 4 per cent a year on average in real terms,' he says. 'It's the biggest consumption binge in recorded history. In the next three to four years, the average growth in consumption demand will be one to 2 per cent.
That means US GDP growth will average about 1.5 per cent over that period, given that consumption is about two-thirds of the economy. That's a huge slowdown. By way of reference, in Japan's lost decade during the 1990s, its growth rate was about one per cent. So this is not going to be a whole lot different.'
Mr Roach has been criticised for drawing parallels between what happened in Japan and what's happening now in the US.
He acknowledges that the two economies are very different. 'But there are a few things in common,' he adds. 'Both had huge bubbles bursting. And both had horrible monetary policies.'
'We have made major mistakes at the Fed in the last 10 years,' he points out. 'Two in particular. One was condoning asset bubbles under the false premise that we can always clean up the mess afterwards. Well, look at the mess today - not a good paradigm there. Second, we completely dropped the ball on the regulatory front. We let ideology drive our willingness to intervene in the development of those very complex financial instruments and structures. We failed to make the distinction between financial innovation, which would have been good, and financial engineering, which turned out to be bad. We just assumed that anything complex is an example of American ingenuity.'
'But these financial weapons of mass destruction, as Warren Buffet and Larry Summers have called them, almost brought our system to its knees.'
As for who's to blame, Mr Roach has this to say: 'Everybody's jumping down Wall Street's throat saying we were the problem. Sure, we deserve our share of the blame. But let's not forget one thing. We put central bankers on this planet to be the cops, to blow the whistle when things go wrong. And blinded by ideology and politics, they just went along for the ride.'
What of the future? In particular, to what extent can policies help cushion the coming downturn? That depends, says Mr Roach. 'Last spring, the US Congress enacted tax rebates. Americans were spent out, with no savings and record debt and it was an attempt to keep the magic alive. So the answer to economic hardship was to tell Americans, go buy another flat-screen plasma TV. That's the wrong policy.'
'Now there's a consensus forming in the US Congress that we're going to need another stimulus package right after the election. And if that package is the same recipe of trying to keep the consumption binge up, we're in trouble. This is our problem. We spend too much, we save too little, we run massive current account deficits. We can't go down that road any more.'
'So this will be a real test for the new president, even before he's sworn in. The question is, what kind of fiscal policy will he support? If he supports a policy aimed at sustaining excess consumption, he would fail his first leadership test. If, on the other hand, he supports a policy that is pro-saving, pro-infrastructure, that injects money into the economy and provides some income support for those feeling the pain most acutely, then we've got a chance.'
And what approach should Asian countries adopt in dealing with this crisis? Mr Roach has supported expansionary policies to boost domestic demand. But there is a prior step, he says.
'You need to be mindful of the risks that were painfully prevalent here 10 years ago. We all know that Asia's fundamentals are much better today. But this is a very lethal global contagion. It can attack a country, it can attack a group of countries. It can attack an asset class, it can attack a group of asset classes.'
'The Korean won is under a lot of pressure. Will that be confined just to Korea? Or could it spread throughout the region? Korea has many characteristics that set it apart from many other countries. It has a current account deficit and is a debt-intensive economy. So you would hope that the markets would not generalise this to the region as a whole.'
'But look, that's logic. When you have contagion in such a crisis, logic gets thrown out. Investors shoot first and ask questions later.'
What then should the region do? 'It needs to develop a game plan for a coordinated policy response,' he says. 'If you have a crisis and stand together in numbers and act with collective resolve, you have a much better chance of tempering very powerful market forces.'
Speaking of collective resolve, there have been calls for a global economic summit and indeed, US President George W Bush has invited the leaders of 20 countries to a meeting in New York in mid-November to address the crisis.
'A summit would be a good thing,' says Mr Roach. 'We've gone too long down the road of globalisation to not have a global architecture to govern the system. I don't think the IMF or the World Bank are up to the task.'
As for what architecture would be appropriate for the world economy, Mr Roach thinks global fiscal and monetary tools are the need of the hour. 'You also need global regulatory oversight, and a system of well-designed early-warning indicators of global crises. But the most important thing you need is enforcement mechanisms: a system of rewards and penalties that can change behaviour. That's where it could get stuck. Because that would require individual nation states to abdicate some of their own enforcement, and countries just don't want to do that.'
Difficult ride
Meanwhile, Mr Roach believes investors are in for a difficult ride. 'For the average investor with a shorter-term horizon and limited resources than a Warren Buffet, this is a tough climate to put money to work,' he says. 'We don't know if we're through the worst. The psychology of equity markets has really been brutally disrupted. While it looks like the worst of the financial contagion is behind us, it's going to take a much longer time for the markets to heal up after what we've been through in the last month.'
'Obviously there are stocks that have been beaten down to below their intrinsic value and on anything other than an end-of-the-world scenario, they look attractive. But there are other stocks where earnings expectations are still too optimistic. So I would remain cautious.'
Despite the fact that the best bull runs start during recessions, he prefers to remain tilted to the bearish side. 'Normal recessions present investors with great opportunities, but the question is, is this a normal recession? I think it's deeper. Even if it were a deeper recession with a good healthy recovery, this would be a good buying opportunity. But the risk is, this is a deeper recession with disappointing and anaemic recovery prospects. And buying stocks when you don't have any visibility on recovery, that's a big risk.'
There are policy risks too. In one form or another, the US and European governments and central banks have pumped well over a trillion dollars into their economies. For the moment, this is helping to offset the withdrawal of private credit. But once private credit gets going again, central banks, in particular, will have to face up to the prospect of soaring inflation. 'They must then start withdrawing liquidity,' says Mr Roach. 'We can't run a system where we make emergency injections of liquidity permanent.'
'This will be the challenge for (Fed chairman) Ben Bernanke. If he is a clone of Alan Greenspan, he will be unwilling or unable to withdraw the stimulus, and will have to deal with serious problems down the road. But if he is cut from a different cloth, he'll do it and the system will go off life-support and figure out how to adapt. It's called tough love,' he adds, with a wry smile.
But in starting to raise rates in what could still be a recession, wouldn't Mr Bernanke get screamed at?
'That's just too bad,' says Mr Roach. 'In theory we have independent central bankers who are not supposed to care if people scream at them. Greenspan cared a lot when anybody so much as raised a finger. But his predecessor, Paul Volcker, couldn't care less.
'You think it was easy for Volcker to attack the double-digit inflation of the late 1970s? Believe me, I was working at the Fed at that time, and it wasn't easy at all. There were howls of protest all over the country. There was a blockade around the Fed's office building in Washington. But Volcker never flinched.
'So, we're now at a leadership moment,' he says. 'A leadership moment for politics and a leadership moment for central banking. You don't get too many of those.'
FOR several years now, Stephen Roach, Morgan Stanley's chairman for Asia, has been flashing the orange light on the state of the US economy. In press articles, research reports, speeches and interviews, he's been hammering home his gloomy message: the US consumer is overstretched, the stock and property markets are in bubble territory, the US current account deficit is out of control and this party can't keep going on.
The party did, however, go on far longer than he predicted. As stocks and property values kept rising, Mr Roach, a former economist at the US Federal Reserve, earned himself a reputation as 'the perennial bear'. Market optimists would murmur 'there he goes again' everytime he spoke.
But then, around August last year, the bubble burst, the markets went into a tailspin, culminating in a financial meltdown and a near collapse of the Western world's banking system. It was an outcome that surprised even the great bear himself.
'In the last 35 years of my working life, I've been through five recessions and about 12 crises,' says Mr Roach, sitting across from me in a conference room at Morgan Stanley's Church Street office. 'This one is by far the worst.'
'But the question now is not to look back - other than to try to understand how we got here - but to look to where we're headed.'
While the worst may be over in terms of the financial contagion, there's lots more trouble to come in terms of the repercussions on the real side of the US and global economy, he says, and that will feed back into financial markets and financial institutions. 'So it's possible that we will have more episodes of distress bordering on panic.'
Two-stage process
The feedback loop from the financial crisis to the real economy will be a two-stage process, according to Mr Roach, starting with the United States. 'The US over the last 10 years has become a bubble-dependent economy,' he says. 'First equities, and then property and credit. It has grown well beyond its means as the current account deficit indicates, and has funded that growth by extracting purchasing power from overvalued property. And the extraction process has been fuelled by a credit bubble. So now, both the bubbles have burst and the economy is correcting.'
'The contraction is concentrated on consumers. We saw a very sharp decline in personal consumption in the third quarter of this year. And that's very unusual because personal consumption is something that hasn't declined in 17 years.'
Mr Roach points out that the second stage of the feedback loop to the real economy lies in the linkages between the American consumer and export-dependent economies around the world, especially in Asia. 'Developing Asia is slowing pretty much across the region and those adjustments have only just begun. And that's because America's moving into a multi-year consumption adjustment, and there's no other consumer out there to fill the void.'
He pulls out a chart which shows that if you stack up the consumption of China, Japan and India, the total still comes to barely two-thirds of US personal consumption in 2007.
'Developing Asia's exports relative to GDP have never been higher,' he says. 'So the region gets hit - it's just simple math.'
And how deep will America's recession be? Mr Roach reckons that it will be deeper than the recession of the early 1980s, which saw peak-to-trough declines of 2.5 to 3 percentage points of GDP.
'We've had a 14-year period in the US where consumption has grown by 4 per cent a year on average in real terms,' he says. 'It's the biggest consumption binge in recorded history. In the next three to four years, the average growth in consumption demand will be one to 2 per cent.
That means US GDP growth will average about 1.5 per cent over that period, given that consumption is about two-thirds of the economy. That's a huge slowdown. By way of reference, in Japan's lost decade during the 1990s, its growth rate was about one per cent. So this is not going to be a whole lot different.'
Mr Roach has been criticised for drawing parallels between what happened in Japan and what's happening now in the US.
He acknowledges that the two economies are very different. 'But there are a few things in common,' he adds. 'Both had huge bubbles bursting. And both had horrible monetary policies.'
'We have made major mistakes at the Fed in the last 10 years,' he points out. 'Two in particular. One was condoning asset bubbles under the false premise that we can always clean up the mess afterwards. Well, look at the mess today - not a good paradigm there. Second, we completely dropped the ball on the regulatory front. We let ideology drive our willingness to intervene in the development of those very complex financial instruments and structures. We failed to make the distinction between financial innovation, which would have been good, and financial engineering, which turned out to be bad. We just assumed that anything complex is an example of American ingenuity.'
'But these financial weapons of mass destruction, as Warren Buffet and Larry Summers have called them, almost brought our system to its knees.'
As for who's to blame, Mr Roach has this to say: 'Everybody's jumping down Wall Street's throat saying we were the problem. Sure, we deserve our share of the blame. But let's not forget one thing. We put central bankers on this planet to be the cops, to blow the whistle when things go wrong. And blinded by ideology and politics, they just went along for the ride.'
What of the future? In particular, to what extent can policies help cushion the coming downturn? That depends, says Mr Roach. 'Last spring, the US Congress enacted tax rebates. Americans were spent out, with no savings and record debt and it was an attempt to keep the magic alive. So the answer to economic hardship was to tell Americans, go buy another flat-screen plasma TV. That's the wrong policy.'
'Now there's a consensus forming in the US Congress that we're going to need another stimulus package right after the election. And if that package is the same recipe of trying to keep the consumption binge up, we're in trouble. This is our problem. We spend too much, we save too little, we run massive current account deficits. We can't go down that road any more.'
'So this will be a real test for the new president, even before he's sworn in. The question is, what kind of fiscal policy will he support? If he supports a policy aimed at sustaining excess consumption, he would fail his first leadership test. If, on the other hand, he supports a policy that is pro-saving, pro-infrastructure, that injects money into the economy and provides some income support for those feeling the pain most acutely, then we've got a chance.'
And what approach should Asian countries adopt in dealing with this crisis? Mr Roach has supported expansionary policies to boost domestic demand. But there is a prior step, he says.
'You need to be mindful of the risks that were painfully prevalent here 10 years ago. We all know that Asia's fundamentals are much better today. But this is a very lethal global contagion. It can attack a country, it can attack a group of countries. It can attack an asset class, it can attack a group of asset classes.'
'The Korean won is under a lot of pressure. Will that be confined just to Korea? Or could it spread throughout the region? Korea has many characteristics that set it apart from many other countries. It has a current account deficit and is a debt-intensive economy. So you would hope that the markets would not generalise this to the region as a whole.'
'But look, that's logic. When you have contagion in such a crisis, logic gets thrown out. Investors shoot first and ask questions later.'
What then should the region do? 'It needs to develop a game plan for a coordinated policy response,' he says. 'If you have a crisis and stand together in numbers and act with collective resolve, you have a much better chance of tempering very powerful market forces.'
Speaking of collective resolve, there have been calls for a global economic summit and indeed, US President George W Bush has invited the leaders of 20 countries to a meeting in New York in mid-November to address the crisis.
'A summit would be a good thing,' says Mr Roach. 'We've gone too long down the road of globalisation to not have a global architecture to govern the system. I don't think the IMF or the World Bank are up to the task.'
As for what architecture would be appropriate for the world economy, Mr Roach thinks global fiscal and monetary tools are the need of the hour. 'You also need global regulatory oversight, and a system of well-designed early-warning indicators of global crises. But the most important thing you need is enforcement mechanisms: a system of rewards and penalties that can change behaviour. That's where it could get stuck. Because that would require individual nation states to abdicate some of their own enforcement, and countries just don't want to do that.'
Difficult ride
Meanwhile, Mr Roach believes investors are in for a difficult ride. 'For the average investor with a shorter-term horizon and limited resources than a Warren Buffet, this is a tough climate to put money to work,' he says. 'We don't know if we're through the worst. The psychology of equity markets has really been brutally disrupted. While it looks like the worst of the financial contagion is behind us, it's going to take a much longer time for the markets to heal up after what we've been through in the last month.'
'Obviously there are stocks that have been beaten down to below their intrinsic value and on anything other than an end-of-the-world scenario, they look attractive. But there are other stocks where earnings expectations are still too optimistic. So I would remain cautious.'
Despite the fact that the best bull runs start during recessions, he prefers to remain tilted to the bearish side. 'Normal recessions present investors with great opportunities, but the question is, is this a normal recession? I think it's deeper. Even if it were a deeper recession with a good healthy recovery, this would be a good buying opportunity. But the risk is, this is a deeper recession with disappointing and anaemic recovery prospects. And buying stocks when you don't have any visibility on recovery, that's a big risk.'
There are policy risks too. In one form or another, the US and European governments and central banks have pumped well over a trillion dollars into their economies. For the moment, this is helping to offset the withdrawal of private credit. But once private credit gets going again, central banks, in particular, will have to face up to the prospect of soaring inflation. 'They must then start withdrawing liquidity,' says Mr Roach. 'We can't run a system where we make emergency injections of liquidity permanent.'
'This will be the challenge for (Fed chairman) Ben Bernanke. If he is a clone of Alan Greenspan, he will be unwilling or unable to withdraw the stimulus, and will have to deal with serious problems down the road. But if he is cut from a different cloth, he'll do it and the system will go off life-support and figure out how to adapt. It's called tough love,' he adds, with a wry smile.
But in starting to raise rates in what could still be a recession, wouldn't Mr Bernanke get screamed at?
'That's just too bad,' says Mr Roach. 'In theory we have independent central bankers who are not supposed to care if people scream at them. Greenspan cared a lot when anybody so much as raised a finger. But his predecessor, Paul Volcker, couldn't care less.
'You think it was easy for Volcker to attack the double-digit inflation of the late 1970s? Believe me, I was working at the Fed at that time, and it wasn't easy at all. There were howls of protest all over the country. There was a blockade around the Fed's office building in Washington. But Volcker never flinched.
'So, we're now at a leadership moment,' he says. 'A leadership moment for politics and a leadership moment for central banking. You don't get too many of those.'
Comments