by
Scott B. MacDonald and Keith W. Rabin
NEW
YORK (KWR) The usual set of strikes in France, the possibility
that reform of Japan's postal bank will be diluted, and
apprehension that the Bush administration will not make
much headway on reducing the sea of red ink on the federal
fiscal ledger all point to one thing – a certain
warped convergence between the world’s major economies.
In a very simple sense, U.S., European, Japanese and
even the Chinese economies need each other – to
maintain a status quo that allows them to put off politically
painful and hardnosed economic reforms. The current system
of mutual support – the flow of funds from Asian
and European investors into the United States in the
form of Treasury and corporate bonds and, in return,
the active stance of U.S. consumers in buying imported
goods with that borrowed money, keeps Japanese, Germany
and French companies pumping out products, making profits
and workers employed. At some point the music in this
dance must come to an end and the band paid. Yet, this
day of reckoning could well be postponed for several
more years. While this will make the inevitable meltdown
all the more harsh -- until the carousel ride stops,
the party goes on.
The sad thing is all the players recognize the problems. For the United
States, it is a combination of large fiscal and current account deficits,
a top-heavy reliance on the consumer, an alarming depletion of personal
savings, a pressing need for tort reform, and serious issues concerning
social security. For Japan, its is the government’s massive build-up
of debt to about 150 percent of GDP, the need for further structural reforms
such as postal system privatization, a continuing reliance on the export
sector, and a rapidly aging population.
For the Europeans, in particular the continental giants of France, Germany
and Italy, critical reforms are required in terms of labor markets, pension
systems and competition laws. Current efforts remain inadequate. Failure
to reform has resulted in anemic economic growth, higher-than-expected
government spending and deficits and, in some cases, a failure to meet
EU Growth and Stability Pact targets. Europe also has to consider similar,
though not as extreme, demographic trends as Japan.
China has also bought into this system. It is in the process of a massive
economic transformation. For it’s leadership to be successful, it
must have strong economic growth and some ability to distribute its national
wealth. To achieve this goal, China needs markets for its goods and the
ability to source industrial inputs such coal, copper and oil. China also
requires some degree of stability in international currency markets, hence
its glacier-like approach to allowing its currency to float. If Europe,
the United States and Japan were to embark upon needed reforms, economic
growth in those countries could slow. If that were to happen, the current
great Chinese leap forward which started in 1978 could sputter. Any major
slowdown could result in social unrest, perhaps even upheaval.
What all of this means is that the United States, Europe, Japan and China
are locked into their current patterns of economic growth. The nagging
issues of high unemployment, looming pension and social security crises,
and untidy fiscal accounts are likely to continue. As for China, do not
look for any floating of the currency in 2005 and for growth only to modify
down to 8 percent in 2005 from last years, 9.6 percent. China will achieve
a soft landing, but is likely to be longer and bumpier than many expect.
What keeps this system in place is that no one really wants to see it collapse.
Change will be painful for everyone, so it remains easier to push the day
of reckoning further into the future, beyond current political terms. The
U.S. current account deficit will continue to be a problem, with no one
wanting to make the adjustments – in terms of allowing the Euro or
Yen to appreciate too much to threaten growth. We have already seen a recent
round of squabbling between Europe and Asia over who will assume the burden
of another round of dollar weakening. In 2004 it fell more on Europe; now
the Europeans want to see the Asians pick up some of the adjustment burdens.
Japan was quick to indicate it might intervene in international currency
markets, especially if the dollar/yen ratio drifts toward the 100 mark.
The results of failing to act on economic problems in the world’s
largest economies is likely to be one of ongoing budget and current account
deficits in the United States, marked by periodic weakening in the U.S.
dollar. Japanese economic growth, while positive, is likely to remain below
its potential, and the nation will struggle to deal with the public sector
debt it has taken on. As for Europe, the pressures on pension and social
services are likely to mount, as there will be fewer people to support
an aging population. And Europe’s large economies will face strong
pressures to move businesses further East to countries like the Ukraine,
with well educated populations, but far lower wages and social costs.
The ultimate result of this system is a long, range-bound era of moderate
to weak economic growth, eroded by a lack of the changes badly required
to address population shifts and the necessary economic transition. At
some point, something may give – a plunge in the dollar that does
not stop, an unexpected currency move by China, or a major financial meltdown
caused by mistakes with derivatives. Such a meltdown could be far worse
than anything seen in recent history due to the accumulation of debt and
structural inefficiencies – sadly all of which could have been corrected
at an earlier period.
From an investment standpoint, however, the key question is whether we
will see things unwind in a slow economic crumble or a precipitous drop
off the cliff. The former would suggest the Fed is likely to continue or
even reverse its “measured pace” posture. Under that scenario,
current trends such as rising commodity prices, an out-performance of emerging
over developed markets and even perhaps the “bubble-like” appreciation
of U.S. real estate markets may continue for sometime. A drop off the cliff,
however – and many extremely smart investors have patiently waited
and underperformed over several years believing this to be inevitable – would
have ominous implications.
While entirely possible – and even justified based on the underlying
fundamentals – it is hard to see how anyone would benefit from an
abrupt systemic shock and major economic dislocation. This does not mean
it will not happen, and things could certainly get out of hand. Massive
liquidity, however, and the complementary though admittedly dysfunctional
relationship highlighted above, does indicate that a more gradual adjustment
is entirely possible. While this does not eliminate the potential for manic,
volatile swings as we seek to determine whether inflation or deflation
will gain the upper hand. It does, however, argue against a doomsday “imminent
depression” in the immediate future. These alternatives have very
different implications for both fixed income and equity investors.