Asia Pacific
Goodbye, Mr. Greenspan
Jan 03, 2006

Andy Xie (Hong Kong)

Alan Greenspan’s accommodation of the US trade deficit has driven globalization: Globalization is deflationary, as the developing economies that earn income from global trade devote a disproportionate share to wealth accumulation.  The rising US trade deficit or declining savings rate has allowed these economies to achieve strong growth despite their savings bias.  Manufacturing-led Asia has benefited most from this process.

The era of stimulus is ending: The large US trade deficit and the low US bond yield are signaling the end of the stimulus era.  Alan Greenspan has essentially run a Keynesian stimulus program for the global economy in the past decade.  A flat yield curve at a low level of bond yield makes further monetary stimulus hard to achieve, in our view.

Export-led Asia may experience low growth in the next decade: Export-led Asia — China in particular — has grown rapidly on strong US demand.  If the US has exhausted its stimulus power, Asia could expect slower growth in the decade ahead.

Summary and Conclusions

The quadrupling of US imports during Alan Greenspan’s 18-year reign summarizes his global impact.  This increase in US import demand has underwritten globalization, led by the integration of developing economies with the US.  In that regard, his policy has affected manufacturing-led Asia most.

Rising trade deficits have accounted for 38% of US import growth during the Greenspan era.  One could argue that the rising US trade deficit has been the driver for globalization, and in particular financial globalization.  Why does the US trade deficit keep rising, and why is it so well funded?  The sustainability of globalization depends on the answers to these questions, in my view.

Mr. Greenspan’s ability to sustain investor confidence and his accommodative monetary policy towards asset demand are the answers to the above questions, I believe.  The global economy suffered a huge deflationary shock when the Berlin Wall fell.  The planned economies that accounted for half of the global population (China, India and the Soviet bloc) abandoned economic planning and looked to trade as the driver for economic development.

These former planned economies had to accumulate capital quickly to join the global economy, as their assets from the planning era could not add much value.  The fall of the Berlin Wall was equivalent to a big outward shift of the global supply curve.  The deflationary shock would have led to a prolonged global recession without an offset inflationary force.

Mr. Greenspan was instrumental in propping up optimism, which led to rising risk appetite and demand for risk assets.  He accommodated such demand by tolerating a rapidly rising demand for money from asset markets.  Rising asset prices in the US led to unusually strong consumption.  This inflationary force has offset the deflationary force from globalization.

The high level of wealth and institutional credibility of the US have allowed it to play such a critical role in giving birth to globalization.  The credibility of the US Treasury as the modern equivalent of gold for wealth hoarding is the instrument for sustaining the funding of the US trade deficit.

Mr. Greenspan has been the right person at the right time in right place to play such an important role.  If there were a midwife to the current era of globalization, it would be him.

The epidural for suppressing the birth pain of globalization is the vast global property bubble, thanks to financial globalization.  Mr. Bernanke, successor to Mr. Greenspan, will have to handle its aftermath carefully to prevent a backlash against globalization when the bubble bursts, as I believe it will.

The Midas Touch

On Monday, October 19, 1987, everyone in the US was talking about the 500-point drop of the Dow Jones index on the previous Friday.  Some economists were recalling memories of 1929.  Mr. Greenspan, the new Fed Chairman, came out, made a brief statement and cut interest rates.  Everyone stopped worrying.  The economy kept going without a hitch.  Despite the stock market crash in 2000, the Dow Jones index has increased by 533% since 1987.

At the time, I could not figure out what Mr. Greenspan was saying.  I thought that my economics were not good enough to understand the Chairman’s musings.  Over time, I realized that nobody could.  That is his magic: he leaves so much to the imagination.  Financial markets could work out the best scenario and Mr. Greenspan would just follow.  It has been the greatest show on earth.

Mr. Greenspan can send investors into frenzy, especially when he mentions productivity.  The low inflation environment is the key to his ability to move the market.  Low inflation can mean weak demand or room to grow.  It depends on your perspective.  He has played the role of chief psychiatrist for financial investors and has nudged the market in an optimistic direction.

The ‘Ice’

Mr. Greenspan has ruled the supply of dollars in an unusual era.  Two years after he became the Fed Chairman, the Berlin Wall fell.  Economic planning — the economic system under which half of the world’s population lived — was discredited.  Countries abandoned economic planning and rushed into the global economy.

The capital stock that they had accumulated during the planning era was not useful for capturing market share in the global economy.  They now had to accumulate capital stock appropriate for participating in the global economy as quickly as possible.  The integration of the ex-planned economies, therefore, was equivalent to a positive shock in labor supply and savings or a deflationary shock.

China was the most important player in that transition.  It was already experimenting with the market for development and accelerated the transition to a market economy after 1991.  Hong Kong and Taiwan transplanted their factories to China.  China acquired this revenue machine overnight and was able to increase capital stock quickly.

India also shifted towards the market in the early 1990s.  It cut import tariffs and licensing requirements to encourage competition.  Its economy accelerated afterwards.  The remittances of Indians resident overseas also played a vital role in funding the country’s capital accumulation.

The ex-Soviet bloc economies went further and privatized their capital stocks quickly.  Joining the EU allowed them to integrate their labor markets with the high wage labor markets in the West, with even better results than manufacturing exports could achieve for China.

Through various channels, the former planned economies managed to integrate their labor markets with those in established rich economies to boost income.  This income has gone disproportionately into investment to increase earnings power further.

The bursting of Japan’s property bubble was another huge deflationary shock to the global economy, mainly through increasing its surplus savings, reinforcing the positive savings shock from the ex-planned economies.

My former colleague Barton Biggs called the deflationary forces ‘ice’ and the inflationary forces ‘fire’.  Without policy-inspired inflationary force or ‘fire’ to offset the ‘ice’, the global economy would have stagnated.

The ‘Fire’

With benefit of hindsight, the ‘fire’ has been consumption in the Anglo-Saxon (mainly US) economies, as manifested in their large trade deficits or excess demand.  Rising asset prices, first in stocks and then properties, have inspired the Anglo-Saxon excess demand.  Mr. Greenspan has played a critical role in inspiring this source of excess demand.

The Anglo-Saxon economies went through structural reforms simultaneously in the early 1980s, decreasing the role of government, deregulating to increase economic flexibility, and opening up to global competition.  These reforms made these economies the best performing on the one hand and the easiest to stimulate on the other.  Anglo-Saxon consumer confidence has been the highest in the world.

Mr. Greenspan has played a critical role in translating the high consumer confidence in the US into demand.  Rising asset prices, in first stocks and then properties, have given US consumers the means to manifest their high confidence in the future by consuming more than they earn today.  Greenspan’s role in this story is his ability to inspire and sustain investors’ confidence about the future.

The Fine Balance between ‘Ice’ and ‘Fire’

The fine balance between the inflationary force from rising asset prices and the deflationary force from globalization has been Mr. Greenspan’s story.  I am not suggesting that he deliberately nurtured asset bubbles to sustain the US consumption growth.  Rather, his uncanny ability to inspire investor confidence led the US and the global economy down this alley.

The steady and gradual decline in the US bond yield reflects Mr. Greenspan’s success.  The declining bond yield justifies rising asset prices.  The P/E ratio for the S&P 500 averaged 23 during his era, compared with 14 in the three decades before.  Recently, the rental yield in the US has dropped below 5%, compared with the historical norm of 7%.  The rising asset prices have spurred strong demand growth that I believe validates optimism about the future.

The virtuous cycle of rising asset prices and strong growth is running into two headwinds.  First, the US bond yield is now so low that a further decline is likely to inspire fear of deflation rather than optimism towards price stability.  Hence, a loose monetary policy that keeps liquidity high and bond yields low may be counterproductive.  Second, the US trade deficit has become so large that the excess US demand may inspire fear of a dollar collapse rather than optimism towards US demand growth.

Mr. Greenspan has a Midas touch, which may be the key to his success.  However, he could also be the luckiest man alive.  When the deflationary force from globalization began, the US economy had a lot of stimulus power in reserve.  The high bond yield, low P/E ratio and low trade deficit were all there to be squeezed to stimulate demand.  He may have squeezed dry all the potential stimulus potential in the US economy.

One byproduct of the trade deficit is financial globalization.  US financial institutions have become dominant in this process as the key function of financial globalization is recycling the savings surplus outside the US to fund its deficit.  Even though I frequently berate loose monetary policy, rampant speculation and bubbles everywhere, I am quite conscious that I owe my job to the same forces behind such phenomena.

The Legacy

Economics is not science.  One cannot make experiments to prove or disprove an economic theory.  Empirical studies in economics are fraught with causality ambiguities.  Yet the stakes are exceptionally high when it comes to economic policy making.  What distinguishes Mr. Greenspan from other central bankers is his pragmatic approach.  The world will be debating his legacy for decades to come.  I will throw in my two cents here.

Accommodating globalization, I believe, will be seen as Mr. Greenspan’s greatest achievement.  An open market economy could not have triumphed without a robust global economy.  When the former planned economies switched to become market economies, they might not have been able to persist without better growth to support the new model.

What Mr. Greenspan has effected through creating the US trade deficit is essentially a global Keynesian stimulus program.  While the US has suffered from a rising trade deficit during the process, the US economy has boomed and financing for the US trade deficit has been painless.  The reason is that globalization has led to a productivity bonanza, mainly though bringing the idle labor force of the developing countries into the global economy — and there is enough to go around.

If globalization were not reversible (which I believe it is), Mr. Greenspan would be seen as one of the greatest men of the past two decades.  Globalization and technology are the two greatest forces shaping the world today, and Mr. Greenspan has played a more important role than anyone else in ushering in the new world.

His huge stimulus after the tech burst will be his most controversial legacy, in my view.  It was responsible for the global property bubble.  The problem was that it was not needed.  There was no risk of a global financial crisis. The US economy could weather a few years of slow growth to digest the excesses of the tech bubble.  It would have been a perfect soft landing for his monetary policy.  Instead, the stimulus has led to a 50% increase in the US trade deficit and an investment bubble in China. 

One redeeming feature of the global property bubble is that it recapitalized most emerging economies through high commodity prices.  The risk of another emerging market crisis in the new global downturn has diminished dramatically.

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United States
Critical Macro Investment Themes for 2006
Jan 03, 2006

Richard Berner (New York)

For three years, my annual thematic forecasting ritual has profiled the tug of war between a secular world of single-digit returns and my cyclical view that rising inflation and strong growth would push yields higher (for example, see “Critical Macro Investment Themes for 2005,” Investment Perspectives, January 6, 2005).  At least as it relates to risk-free yields, it is straightforward to catalogue some deeply-entrenched and powerful secular forces holding them down, including 25 years of disinflationary monetary policy, globalization, and the enduring legacy of the bubble years that has fostered a mean-reversion mentality among both investors and corporate managers.

Yet for three years in a row, I’ve joined the consensus in looking for a cyclical rise in long-term yields, one that would take 10-year Treasury yields to 5% or more, and for three years the secular forces have proved me wrong.  Now it’s time to mark my views to market and, more importantly, decide whether the cyclical forces are simply too feeble to matter for yields or whether in 2006 we honey-starved bond bears will finally be rewarded for our stubbornness.

While humbled, I’m not capitulating.  As I see it, the cyclical forces are finally likely to regain the upper hand in 2006.  Indeed, I think five related macro themes will likely dominate the investment landscape this year, and on balance they add up to higher yields: US ‘core’ inflation will resume its upward crawl, productivity will undershoot its trend, corporate and personal saving will swap places, home prices will rust rather than bust as housing activity declines, and term premiums and volatility will rise.

In contrast, judging by the yield curve and Eurodollar futures, investors seem increasingly to believe that yields may have peaked and that the Fed under Ben Bernanke will be easing monetary policy in 2006.  Thus, market participants who have thrown in the towel on rising yields seem largely unprepared even for the mildly bearish outcome that I envision. 

Rising Core Inflation

Perhaps my most critical and now out-of-consensus call is that core inflation (measured by the CPI) will rise to about 2½% over the four quarters of 2006 from today’s 2.1%.  The rise, as I see it, will reflect both cyclical fundamentals and the unwinding of statistical quirks that have suppressed it in 2005.  Compared with historical changes in inflation over the business cycle, that’s an exceptionally tame rise, and if inflation peaks at that rate, it would represent great longer-term news for both market participants and the Fed.  But for 2006, it reflects a gradual shift from forces that have held inflation back to those boosting it, and, in the context of healthy economic growth, would come as a bearish surprise. 

Currently, in my view, the forces holding inflation back are largely secular: For more than two decades, monetary policy had worked asymmetrically to achieve price stability, primarily by steadily reducing inflation expectations.  “Opportunistic disinflation” described policy through much of that period, and its impact has endured.  Deregulation, globalization, and new technologies have broken barriers to the flow of goods, services, and factors of production, increasing competition and efficiency.  Those forces appeared to gather steam in the early years of this decade as newly-enabled outsourcing platforms promoted fears of deflation.  As I see it, however, the cyclical excesses of the 1990s were equally responsible: Overbuilding unmasked by the recession produced record slack in both the industrial and service economies and, combined with massive operating leverage, crushed profit margins and returns on invested capital.

That was then.  Reversing that process, in my view, are three sets of cyclical forces that will show up more visibly in 2006.  First, despite 325 basis points of Fed tightening, several years of a highly reflationary monetary policy stance have raised inflation expectations.  Moreover, the collapse in returns and margins promoted capital discipline and thus a sharp increase in operating rates in recovery.  That capex discipline was a key ingredient in the rebirth of pricing power for many industries, as both the change and the level of operating rates influence pricing power at the micro level and inflation in macro terms.  Most recently, tighter labor markets have begun to promote an acceleration in wages. 

Incoming data suggest that these fundamentals are working to promote higher core inflation: Longer-term inflation expectations at 3.1% in late December have stayed slightly but firmly above their average of the past seven years.  Industrial operating rates have recovered more than 700 basis points from their lows, are now on a par with historical norms, and, courtesy of slow capacity growth and faster gains in output, will likely move well above those norms during 2006.  Likewise, a broader measure of economic slack — the so-called “output gap” — has narrowed by more than 200 bp to about 1% currently, and above-trend growth would narrow it further.  Firmer labor markets have begun to promote faster gains in pay; measured by average hourly earnings, the 3.7% annualized gain over the past six months is a three-year high.  Last but not least, the unwinding of statistical distortions that lately depressed two components of housing inflation — owner’s equivalent rent and hotel room rates (together accounting for one-third of the core CPI) — may add 0.2% to that price gauge this year.

Productivity Undershoot

However, faster pay hikes would not trigger inflation concerns as long as productivity gains are strong.  Thus, my call for a coming productivity undershoot is a second key theme that bucks the consensus.  There’s no mistaking the surprisingly solid gains in productivity over this expansion, averaging an annualized 3.3% through the third quarter of 2005 and the strongest since the productivity boom of the 1960s.  Given that performance, forecasting a deceleration from above-trend gains in productivity to increases that are slightly below trend could be labeled a high-risk or even foolish prognosis. 

Yet as I see it, while productivity’s secular trend likely will remain favorable, the sources of recent productivity gains are largely cyclical and thus likely to fade.  In my view, the annual trend in nonfarm business productivity has improved to between 2½% and 2¾% as a result of the technology breakthroughs of the 1990s and of managing businesses better.  But a third, cyclical factor pushed productivity still higher in this expansion, namely Corporate America’s swing from over-hiring in the 1990s to under-hiring in the past four years.  The hiring discipline that emerged to purge the hiring excesses of the 1990s has suppressed job gains in a variety of industries, and some may not come back.  Yet in my opinion, as CFOs have repositioned their businesses for growth, and underhiring over the past three years has created pent-up demand for employment, both hours and employment will accelerate, and productivity gains likely will slow to about 2% as job growth catches up with the economy. 

The Coming Saving Swap

The emergence of strong job gains will in my opinion fuel a third critical theme for 2006: A swap from corporate to personal income that will flatten profit margins, contribute to healthy growth in consumer spending, and foster a pickup in personal saving.  Until now, consumers strapped for income and squeezed by higher energy quotes have abandoned thrift and dipped into housing wealth to defend their lifestyles.  In sharp contrast, their employers have raked in profits but haven’t invested or hired as in the past, leaving the corporate “financing gap” at or close to zero for the past three years. 

Both saving gaps are poised to change, in my view, potentially implying higher real interest rates.  The key reason: A shift in income to consumers from companies is about to unfold, as both hiring and wage growth quicken and profit margins flatten.  With gains in wealth slowing, consumers likely will begin to save more out of current income.  And as profit margins level off and capital spending continues to grow briskly, companies will begin to tap external funding to finance investment. 

The swings in these two saving-investment balances, together with the change in government and current-account deficits, will help shape the direction of real interest rates.  Most market participants believe that any rebound in personal saving would signal consumer retrenchment.  But I think changes in the saving-investment balance could come amid stronger growth: As I see it, the risk is that a swing in income to consumers from companies will fuel faster overall growth and upward pressure on interest rates (for details, see “Will the Coming Saving Swap Bring Higher Real Rates?” Investment Perspectives, December 15, 2005). 

Rust Not Bust

Many market participants view my fourth theme as the most important issue for 2006.  They believe that rising housing wealth and the associated pace of home equity extraction has been the key driver of consumer spending.  Correspondingly, they fear that a bursting housing bubble will have dire consequences for the consumer in particular and economic activity in general.  I respectfully disagree on both counts:  As my colleague David Greenlaw and I see it, housing activity will decline gradually and home prices will decelerate without crippling the consumer (see “Housing Wealth and Consumer Spending” and “Home Sweet Home,” Global Economic Forum, October 7, 2005 and December 15, 2005).

That some housing markets are frothy is now obvious to even the most casual observer.  Yet, casual observation of the metrics often cited as proof of a housing bubble can be misleading.  Price indexes themselves, the investor share of sales, housing turnover, and the terms of mortgage lending all suggest froth but not a bubble.  What’s the difference?  Some markets are frothy and show classic signs of speculative activity, especially the buying of homes for investment purposes in the apparent belief that the recent trend in appreciation will continue.  But in many other markets — even in some large markets where home price appreciation has run at twice the national average — those signs are absent.  In our view nationwide housing ‘valuations’ have risen significantly — but from undervalued levels five years ago (see “Housing Bubble Metrics,” Global Economic Forum, May 27, 2005).

We think that home prices will rust, not bust and housing activity will gradually fade.  Several factors will promote the slowing: Measures of housing affordability stand at 14-year lows thanks to the runup in prices, and pent-up demand has ebbed.  Favorable demographic trends are starting to fade: The immigration boom has cooled since 9/11, and the growth in households of prime home-buying age has slowed.  Home sales are turning down from nosebleed levels, and inventories of unsold homes have risen to 9-year highs.  But it would take soaring interest rates or declining employment to produce a bust. 

Nonetheless, there are significant risks in current mortgage lending practices that have magnified the housing boom.  The use of "payment option" adjustable-rate mortgages and of so-called “piggyback” loans — those offered along with first liens to boost leverage but avoid paying mortgage insurance — in many high-cost areas has risen to 50%.  Borrowers who are already stretching on the first lien are more likely to have large second liens, and borrowers in high-cost areas are using option ARMs to stretch affordability.  These data suggest that the tails of the distribution for lenders’ mortgage portfolios are getting fatter, and that the risks for lenders are rising.  As a result, regulators last week proposed more stringent guidelines for loan terms, underwriting criteria, and for portfolio and risk management practices for such nontraditional mortgage loan products, which may further constrain demand.

Uncertainty Rising = Higher Term Premiums?

The final theme is also bond unfriendly.  I believe that “term premiums” — the compensation for moving out the risk-free yield curve — and volatility are both poised to rise back toward their longer-term norms as uncertainty about the US economic and monetary policy outlook increases.  A look at 9-year forward 1-year rates, which have declined far more than have nominal yields, suggests that compression in the term premium accounts for a significant part of the decline in long-term yields over the past year and a half.  Correspondingly, I think a rise in term premiums will boost long-term yields and help to re-steepen the yield curve over the coming year. 

To be sure, two other key factors have suppressed yields.  First, Fed tightening and low inflation have convinced market participants that inflation won’t surge.  Second, global investors searching for yield have profitably financed longer-maturity dollar positions in yen or even euros.  Concurrently, those central banks who want to limit the appreciation in their currencies have passively accumulated dollar reserves on favorable terms for the US.  But the decline in term premiums has been the dominant factor in reducing longer-term yields and is the one most likely to change this year.

At issue is how much of the term premium compression is permanent and how much is temporary.  By promoting price stability, by damping macroeconomic volatility, and by increasing what officials call the “transparency” of their communication to the public, I think that the Fed has contributed to the permanent decline in the term premium (see “Risk Premiums and the Fed,” Global Economic Forum, July 25, 2005).  More scientifically, our rate strategy team confirms quantitatively and convincingly that Fed words and tactics in the current tightening cycle have been the primary factor behind an additional decline in the premium that may or may not last (see Graig Fantuzzi and Nilsson Kocher “Resolving the Conundrum,” November 14, 2005).  The Fed’s language clearly telegraphed the pace of monetary tightening, and with ambiguity over pace gone, investors could profitably reach for yield. 

Those temporary factors compressing term premiums may be ending.  Now that monetary policy is completely dependent on the inflation and growth outlook, and thus is inherently less certain, term premiums and long-term yields are likely to rise.  Indeed, there is an ironic twist in the yield curve debate.  Many fear that the flattening in the US yield curve is an ominous portent of much slower US and thus global growth or even recession.  They point to the tendency of the Fed to overdo tightening, the yield curve’s business-cycle forecasting prowess, the asset-driven nature of the US consumer, and evidence of a housing slowdown (see “Debating the Yield Curve,” Global Economic Forum, November 23, 2005).  But if a declining term premium — rather than the weighted sum of expected future changes in short-term interest rates — has recently contributed both to lower long-term yields and to a flatter yield curve, both imply faster, not slower future growth, exactly the opposite of the traditional interpretation.  And if the term premium has declined permanently for whatever reason, making the current structure of interest rates more stimulative than otherwise, then the Fed will have to raise short-term rates by more than otherwise to achieve its goals (see “Yield Curve Angst,” Investment Perspectives, November 23, 2005). 

Humility needed

Despite my confidence about the validity of each of these themes, three straight years of being wrong about yields has made me humble about the risks to this call.  Among them: Secular disinflationary forces may overwhelm the cyclical factors boosting inflation; notably, trend productivity growth could be higher than I reckon.  Faster job gains and strong productivity growth may also coexist, yielding robust growth with low inflation.   Significant slippage in the growth of home prices could imply collateral damage for consumer spending.  The shift of saving-investment imbalances that I think will promote higher real yields may be deferred.  These would be bullish for bonds and risky assets.

But investors would do well to be mindful of risks in the other direction.  A weaker dollar and the elimination of slack in the economy could combine to push inflation up more rapidly.  I think the surprise may be that the economy and the consumer will do well even as housing activity and growth in home prices weaken.  And three years of crying wolf about yields has bred market complacency about upside risks to interest rates.

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Global
The Lessons of 2005
Jan 03, 2006

Stephen Roach (New York)

“To unlearn is to learn.”

-- Wipro poster, Bangalore, India

Slogans like this are plastered all over the walls of Wipro’s sleek campus in Bangalore.  They personify the culture of one of India’s most dynamic companies -- a culture that challenges a talented pool of nearly 46,000 knowledge workers to break out of their comfort zone in tackling the systems problems of tomorrow.  We in the macro business face the same task as we ponder the economic and financial-market outlook.  But it’s all too easy just to wipe the slate clean and start anew at the beginning of each year.  In our case, the unlearning is not without consequences: It requires us to look inward -- learning from the inevitable mistakes as well as from those rare and fleeting successes that come with the macro territory.  In that spirit, I present the Lessons of 2005.

Stability.  A year ago, we were all convinced that global imbalances mattered.  America’s current account deficit was in uncharted territory, having pierced the seemingly ominous 5.5% threshold as a share of GDP in late 2004.  In keeping with the time-honored venting of the pressures stemming from external imbalances, the dollar was nearing the third anniversary of what had been an orderly, but significant, 16% decline (in real terms) on a broad trade-weighted basis.  The consensus of financial market participants was looking for a further decline in the US currency as a key element of the rebalancing of an unbalanced world.  Even the Federal Reserve sounded the alarm in late 2004 about a likely diversification by foreign investors out of dollar-denominated assets.  The debate was over the character of the coming landing -- hard or soft.  I went so far as to invoke the principles of elementary physics: The longer rebalancing is put off, I argued, the greater the chance of a destabilizing endgame for a lopsided, US-centric global economy.

The dollar, of course, rose rather than fell -- confirming the old adage that financial markets are designed to humiliate the largest number of people as often as possible.  On a broad trade-weighted basis, the greenback rebounded by about 4% over the 12 months of 2005, with especially sharp gains against the yen (15%) and the euro (14%).  Rather than ending the year down 20% from its early 2002 peak as the consensus expected, the dollar’s cumulative decline over nearly four years now amounts to a paltry 13% -- a seemingly modest adjustment for an economy with such a massive external imbalance.  To compound the humiliation, the currency surprise flew in the face of a dramatic worsening of America’s current account deficit, which averaged 6.4% of US GDP in the first three quarters of 2005.  The ex post rationalization of this move was a shift in interest rate differentials driven by a Fed that methodically tightened monetary policy in each of the eight policy meetings of 2005.  With the benefit of hindsight, that seemed to be all that mattered for highly-liquid, yield-hungry foreign investors.  Yet, at the same time, there can be no mistaking the policy-induced buying of dollar-denominated assets by Chinese monetary authorities.  No matter who did the buying, the outcome was clear: US Treasury TICS data revealed that $1.1 trillion of foreign capital flowed into long-term US securities in the 12 months ending October 2005 -- more than enough to fund a record US current account deficit that was running at about a $780 billion annual rate over that period.  So much for elementary physics.  The first lesson of 2005: In a super liquidity cycle, capital flows remain an important stability cushion for an otherwise unbalanced global economy. 

Durability.  History tells us that the duration of economic expansions is critically dependent on the inflation cycle.  With modern-day central banking focused on price stability, the willingness of central banks to lean against incipient pressures on the price front invariably spells upside risks to interest rates that sow the seeds of a classic cyclical endgame.  The world’s three most powerful central banks are currently at different stages of this time-honored ritual.  America’s Federal Reserve has led the way with an interest rate normalization campaign that has taken its policy rate up 325 basis points over the past 18 months.  The European Central Bank has just embarked on a similar endeavor, and there are even hints that the Bank of Japan may be about to enter the fray with a termination of its quantitative easing campaign in early 2006.

Policy normalization need not, however, pose major cyclical risk.  That’s especially the case if inflation stays low, as it did in 2005.  While our latest estimates suggest the industrial world CPI rose just 2.4% in 2005 -- 0.7 percentage point faster than our forecast of a year ago -- the overshoot was solely a by-product of a 45% surge in oil prices.  Outside of the energy complex, there was virtually no spillover into most gauges of core inflation; the US core CPI, for example, slipped to a 2.1% y-o-y rate in November 2005 -- actually down a bit from the 2.3% pace at the start of the year.  In my view, the good news on inflation was very much an outgrowth of the increasingly powerful forces of globalization, which have altered the linkages between core inflation and many of its traditional determinants -- namely, labor costs, currency fluctuations, import prices, and domestic output gaps.  If underlying inflation continues to remain low, there may be no need for central banks to push monetary policy into the cycle-ending restrictive zone.  The second lesson of 2005: Globalization’s disinflationary bias seems to be prolonging the current business cycle expansion.

Resilience.  The world economy took its share of body blows in 2005, but emerged relatively unscathed.  Natural disasters were off the charts -- Asia’s late-2004 tsunami and America’s Hurricane Katrina were cases in point.  War (Iraq) and terrorism (London) were ongoing sources of instability.  And, of course, there was the energy shock of 2005, which in many respects was very much on a par with the oil-related jolts of the 1970s and the early 1990s -- all of which were associated with recessionary adjustments in the global economy. 

This energy shock was, of course, different -- dangerous words in the lexicon of financial markets but not without some legitimate justification in 2005.  For example, unlike earlier oil shocks, this one had an important assist from the demand side of the equation -- especially from the rapidly growing economies of China and India, both of which are relatively inefficient users of energy.  Moreover, the sharp run-up of energy prices in 2005 hit a world that has reduced its oil intensity (i.e., oil consumption per unit of global GDP) by nearly 40% from levels prevailing in the late 1970s.  The flip side of this oil shock came in the form of diminished demand for petro-dollars by Middle East oil producers; instead of recycling oil revenue windfalls into dollar-denominated assets, they were more focused on internal development options -- infrastructure, booming urban development in Dubai and Doha, and surging domestic equity markets.  But as the capital inflow data cited above suggests, the US hardly suffered in response.  The third lesson of 2005: As immunity to the recent energy shock suggests, even a lopsided, US-centric world economy seems to have uncovered new sources of macro resilience. 

Globalization.  On the surface, there seems to be no stopping the powerful forces of globalization.  World trade volumes seem likely to have risen by at least 7% in 2005 following a spectacular 10% surge in 2004 -- marking the strongest two years of back-to-back gains on record.  That’s not to say there weren’t some meaningful disappointments on the world trade front in 2005: Limited progress on the Doha round of trade liberalization was a case in point, as were mounting bilateral tensions between the US and China.  But barring an unlikely outbreak of protectionism, the trade-related assist to global growth seems very much intact. 

The problems with globalization are less about trade and more about the inherent asymmetries between the world’s producers and consumers.  Apart from America, which has taken its consumption-led growth dynamic to excess, the rest of the world -- developed and developing countries, alike -- has been overly reliant on external demand as the sustenance for economic growth.  This has been true of Europe and Japan, as well as the biggest experiment in the laboratory of globalization -- China.  Based on newly revised government statistics, our estimates suggest that the private consumption share of the Chinese economy fell to a record low of about 46% of GDP in 2005. 

In my view, the world was flirting with the sustainability of globalization’s asymmetries in 2005.  The US consumer has pushed the Asset Economy to its limit, and China has taken its investment and export-led growth model to an equally precarious threshold.  Meanwhile the global labor arbitrage that drives this cross-border integration is having profound impacts on employment and real wages in the developed world -- squeezing labor and generating potentially destabilizing political reactions.  So far, the backlash to globalization has been contained.  Whether that continues to be the case is very much an open question.  The fourth lesson of 2005: As long as the global trade cycle remains on the upswing, the world is willing to ignore some of the thorniest aspects of globalization.

Risk appetite.  Riskier assets continued to lead the charge in world financial markets in 2005.  That was true of investment-grade credit, high-yield corporates, and emerging market debt.  In local currency terms, emerging markets accounted for the top five equity performers in the world in 2005 -- Russia, Brazil, Korea, Taiwan, and India.  The jury is out on whether the outperformance of such “spread products” is traceable to a dramatic improvement in the underlying fundamentals of the asset class or to a super liquidity cycle that has squeezed the return out of relatively riskless instruments. 

The debate is especially contentious with respect to emerging markets.  The bull case is that the wrenching financial crisis of 1997-98 taught the developing world a painful and lasting lesson; by turning current-account deficits into surpluses, rebuilding foreign exchange reserves, reducing exposure to short-term capital inflows, and abandoning currency pegs, there is hope that the continuum of financial crises in the developing world has finally been broken.  The bear case is that the developing world has implemented a typical “fix” aimed at the last crisis; yet the next crisis will undoubtedly be different -- possibly coming in the form of an external demand shock, driven by a consolidation of the American consumer that would hit China and NAFTA-linked Mexico the hardest.  The fifth lesson of 2005: Risky assets should continue to outperform as long as global liquidity remains ample.  A corollary to this lesson:  Only when the tide goes out will it be possible to distinguish between newfound resilience and vulnerability in this asset class. 

There are important consequences of the lessons of 2005 that could well bear critically on the outlook for 2006.  Complacency over macro risks is at the top of my list.  Because the dollar rose instead of fell, concerns over global imbalances have all but vanished into thin air.  At the same time, the excesses of the global liquidity cycle may have provided a false sense of security as to the staying power of this unbalanced expansion.  History is littered with regrets of the overly complacent.  Sadly, those regrets always come too late.  I am the first to concede that 2005 was a tough year for those of us wedded to traditional macro.  Moreover, I would go further and admit that if an unbalanced world continues to stay its present course with impunity, the pressures for “unlearning” will undoubtedly intensify.  That’s when complacency poses the greatest danger of all.

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