From Perma-Bear to Teddy Bear

Is the world really on the mend? That's what Stephen Roach would have his readers believe in his Monday commentary. Wall Street's most famous perma-bear over at Morgan Stanley, now sounds a lot like a Teddy Bear. What gives?

Having been a big fan of Mr. Roach's writing in recent years and referencing his work about once a month in the last year, this latest missive is, at first glance, quite a surprise.

The World on the Mend.

Hmmm...

This from the same man who referred to monetary policy under the Greenspan Fed as, "A policy blunder of monumental proportions" and to the Maestro himself as a "batonless" and a "serial bubble blower".

It almost sounds too good to be true - Wall Street's number one doomsayer now praising the same world economy about which he has been so critical for years.

Let's see what all the fuss is about.

It seems like eternity since I was last optimistic on the world economy. It was back in 1999 when I argued that “Global Healing” would allow the world to make a stunning comeback from the ravages of the worst financial crisis in 60 years. My enthusiasm was short-lived, however, as the cure led to the mother of all liquidity cycles, multiple asset bubbles, and an unprecedented build-up of global imbalances. While an unbalanced world has yet to shake its hangover from global healing, I must confess that I am now feeling better about the prognosis for the world economy for the first time in ages.

The reason: The world is finally taking its medicine -- or at least considering the possibility of doing so. Central banks are carefully adjusting the liquidity spigot -- taking advantage of the luxury of low inflation to move very slowly in doing so.
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Central banks remain leading actors in this drama. They almost blew it -- especially the monetary authorities in Japan and the US. By condoning asset bubbles and their concomitant distortions of debt cycles and increasingly asset-dependent real economies, both the BOJ and the Fed flirted with the most corrosive of macro diseases -- deflation. Japan actually succumbed to a mild, yet protracted, strain of this ailment, while the US had a close brush in 2003.
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While Japan finally seems to be exiting from its long slump, the jury is still out in America, as one bubble (equities) has morphed into another (housing).

Taking its medicine or considering the possibility of doing so? Not very convincing so far. Now would be a good time to remind readers that Mr. Roach is still an economist, and although he's of that rare breed that criticizes the world's most famous economists at the Federal Reserve, he is still an economist.

And, as has been pointed out many times in this space, economists are a tad naive about the real world. The liquidity spigot as represented by interest rates has obviously been dialed back slowly, but money has never been more available - easier to come by, just at a higher cost.

The interest rate moves have largely benefited those who hold dollars - the nation's creditors and traditional savers - and have left the impression that the banking system is once again acting responsibly, but lending standards, still largely based on Fannie Mae's bold innovations of a few years back (yes, back when they could actually file financial statements) - these lending standards have yet to be reigned in.

Moreover, Wall Street has not missed a step in coming up with ever more clever ways to create new money in the form of mortgage backed securities and new derivative products for any and all those seeking higher yield in a world where insipient inflation is causing the yield bar to be raised quickly.

We are in the midst of what could well be the mother of all liquidity cycles. Courtesy of an extraordinary monetary accommodation, financial markets have enjoyed open-ended support from central banks. This has been a key role reversal for the tough guys who are supposed to take away the “punch bowl” just when the party gets good. Given the power of this liquidity cycle -- evidenced not just by asset bubbles in major markets but also by an extraordinary compression of spreads on risky assets such as emerging-market debt and more traditional credit instruments -- a serious monetary tightening could prove devastating for financial markets and increasingly wealth-dependent economies. As long as inflation remains low, however, the authorities can set their sights on the more benign target of neutrality.

Sorry, but we're still not buying the premise that since the Fed Funds rate is about to go to five percent and core inflation is benign, that the Fed has done its job. It must be that inner-economist speaking here - Stephen was much more likeable a few years back when interest rates were one percent and he was yelling from rooftops that they should be immediately raised by 200 or 300 basis points, or the whole world was going to implode.

On China, now, there's something to be hopeful about - serious thought about unhitching their wagon from the greatest debtor nation the planet has ever seen.

I have just returned from my second trip to Asia in the past month, and I sense a major change in the region’s global perspective. That’s especially the case in China, where the need to stimulate internal consumption has gained great traction in policy circles (see my 24 April Special Economic Study, “China’s Rebalancing Challenge”). If China pulls this feat off, it would do so considerably earlier in its development than Japan, Korea, and other Asian economies. This only underscores China’s amazing capacity to leapfrog everything we know about economic development. Export-led Asia is finally coming to grips with the need to diversify its sources of growth. Given the likely consolidation of US consumer demand -- long the region’s most important customer -- that’s certainly a good thing. A rebalancing of the Asian growth model is a big plus for an unbalanced world.

As I put all these pieces together, I now believe that the odds are shifting away from a disruptive global rebalancing. That tempers my long-standing concerns over the possibility of a sharp decline in the US dollar and a major back-up in real long-term US interest rates that such a currency crisis might have triggered.

That whole "foreign lenders will demand higher interest rates" always seemed to be a canard. The Beijing Olympics are in the Summer of 2008 - maybe higher interest rates will be demanded in the fall of 2008, but the more the Chinese are understood (which, admittedly is not much), the less likely it appears that they would do anything to spoil their coming-out party.

Just think of the possibilities though in 2009, when Social Security turns from virtuous to vicious - when demographics and short-sighted accounting gimmickry begin to add to the budget deficit instead of making it appear smaller than cash flows would indicate.

In summary, the light appears to have changed from red to yellow.

No, I am not prepared to give an unbalanced world the green light. But it’s time to give credit where credit is due: First, to globalization for holding down inflation. Second, to central banks for collectively embarking on policy normalization campaigns. Third, to the stewards of globalization for facing up to the imperatives of architectural reform. And fourth, to Asia -- especially China -- for recognizing the unsustainability of export-led growth models. Notwithstanding the risks noted above -- all of which need to be taken very seriously -- I am delighted that the global economy finally seems to be taking its medicine. Let’s hope the cure works.

Giving a little credit shouldn't come too hard from someone who has been predicting the end of the world for a few years now with nary a whiff of confirmation of said outcome.

But it seems that only the easy part is now complete - normalizing interest rates. Living with higher interest rates is the hard part, and there is a long way to go on that account.

Is Mr. Roach's most recent commentary the ultimate contrary indicator? Everyone cross their fingers - we're about to find out.