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The evidence is too overwhelming to dismiss as happenstance.  Here we are in the midst of the strongest four-year spurt of global growth since the early 1970s and there has been no meaningful acceleration of inflation.  Unemployment rates are dropping and there has been no appreciable pickup in real wages in the developed world.  In the United States, where productivity growth has been surging and the unemployment rate is nearing what many judge to be the full-employment threshold, real wage stagnation is all the more puzzling.  Economics teaches us that workers ultimately are paid their just reward insofar as their marginal productivity contribution is concerned.  That is no longer the case in America.  Moreover, the world’s major central banks have tightened (the Fed and the ECB) or are contemplating doing so (the Bank of Japan), and there has been no increase in longer-term interest rates.  At the same time, unprecedented disparities between the world’s current account surpluses and deficits have not resulted in a dramatic currency realignment.  I could go on and on, but suffice it to say, the macro we once knew has been turned on its head. 

Globalization is the main culprit, in my view.  As global trade hits new records each year — it is currently closing in on the 30% threshold as a share of world GDP — it has driven an unmistakable wedge into conventional macro relationships.  BIS research has carefully documented the sharply diminished correlations between labor costs and inflation for a broad sample of industrial countries over the past decade; similar findings are evident with respect to reduced elasticites between import prices and core inflation (see Chapter II of the 75th Annual Report of the Bank of International Settlements, June 2005).  I don’t think it’s a coincidence that the break in these key macro rules coincides with the onset of a sharp acceleration in the pace of globalization.  The sharply increased cross-border flow of goods and the potential for a like trend in services have spawned powerful cross-border arbitrages in labor, capital, and saving.  The low-cost, high-saving developing world has had a profound impact by altering the implicit price structure of these scare resources.  Quiescent inflation, real wage stagnation, and the great interest rate conundrum could well be outgrowths of this arbitrage.

Why now?  After all, globalization has been around for a long time, and the old macro worked reasonably well in the first 50 years after World War II.  The main reason is the Internet — the most disruptive technology in modern history.  Quite simply, the Internet changes the rules of engagement of globalization.  In tradable goods, it revolutionizes the logistics of price discovery and supply-chain management, allowing global producers to keep squeezing costs and pricing — irrespective of resource utilization rates in their home countries.  Moreover, in once sheltered services industries, the Internet now connects knowledge workers around the world to desktops anywhere — in effect, converting an increasingly large segment of nontradables into tradables. 

A key aspect of this IT-enabled strain of globalization is its speed.  The Internet only came into existence about ten years ago, and yet the user population exceeded 1 billion people in late 2005, with penetration ratios rising to around 60% in the developed world, according to Mary Meeker.  Never before has a major technology reached so many in such a short period of time.  Students of technology will tell you that’s the norm — that each succeeding wave of technological transformation is accompanied by increasingly rapid rates of dissemination.  That was true of railroads, motor vehicles, air conditioning, radio, and TV.  The Internet follows that pattern but with an important twist — it rewrites the rules of cross-border connectivity between developing and developed countries and it takes that connectivity very quickly into the once sacrosanct realm of services.  For those reasons, alone, the potential macro impacts of the interplay between globalization and the Internet cannot be minimized. 

Yet the journey has only just begun.  Not surprisingly, the first wave of the current strain of globalization has been concentrated in the assembly and exchange of manufactured, or tradable, goods.  Over the past 15 years, the volume of worldwide trade in goods has increased by ten percentage points of world GDP — from about 15% of global GDP to a record of nearly 25% today, according to the IMF.  By contrast, the globalization of services has lagged.  Currently, world trade in services accounts for just 6% of global GDP.  While that’s up from the 4% share prevailing in 1990, it represents only about one-fourth the portion accounted for by tradable manufactured products.  A gap of this magnitude should not be so surprising — it reflects traditional patterns of commerce, which are skewed heavily toward the physical exchange of goods.  The IT-enabled exchange of knowledge is a relatively recent phenomenon. 

I fully expect services to be the next frontier of IT-enabled globalization.  In the developed world, services remain the dominant form of economic activity.  According to the World Trade Organization (WTO), the value added of the services sector currently accounts for about two-thirds of overall world GDP.  On that basis, alone, there is plenty of upside to the current 6% share of world GDP going to cross-border services trade.  However, given the intrinsic character of services — especially the intangibles that cannot be lifted, or even touched — there are obvious limits to their tradability.  The haircut, the string quartet, religious worship, housekeeping, and a broad array of other personal services still require on-site consumption. 

However, for many professional and commercial services, the Internet has dramatically changed both the availability and accessibility of global options.  That’s especially true of professional knowledge workers such as software programmers, engineers, designers, doctors, other medical professionals, lawyers, accountants, actuaries, financial analysts, and many business consultants.  IT-enabled connectivity now brings the output of remote, or offshore, knowledge workers live to desktops literally anywhere in the developed world.  While coming off a low base, such white-collar offshoring is now among the world’s most rapidly growing segments of economic activity.  Over time, I fully expect it to become an increasingly powerful force in driving global trade.  The same can be said of commercial services — namely, transportation, travel, communications, construction, insurance, and other financial services.  According to the WTO, trade in commercial services has doubled since 1990 to a level that currently accounts for about 20% of total world trade in goods and services, combined.  As the world shrinks, there is nothing but upside for trade in commercial services.

In my view, the shifting mix of rapidly expanding trade from the rich to the poor is the icing on the cake insofar as the need for an open macro is concerned.  According to IMF statistics, trade volumes in the developing world are likely to have expanded at a 9.4% average annual rate over the 1997 to 2006 period — nearly double the 5.6% pace in the developed world over the same period.  This divergence stands in sharp contrast with trends over the prior decade, when gains were close to parity in both the developing (6.9% per year) and developed (6.7%) world.  Needless to say, the rapidly growing Chinese trade juggernaut — with exports expanding at a 25% clip over the past six years, has played a critical — but by no means exclusive — role in driving this trade dynamic.  In economics, it is change at the margin that always determines the incremental pricing decision.  And that’s the bottom line for the open macro of globalization: The increasingly dominant role played by the low-cost developing world in driving the rapid growth of global trade in recent years could well be the decisive force shaping the global arbitrage of costs and prices. 

Yet policy makers and investors seem stuck in the antiquated, closed-economy constructs of the past.  In his first congressional appearance as Fed Chairman, Ben Bernanke stressed the timeworn linkage between US inflation risk and slack — or the lack thereof — in domestic labor and product markets.  He, of course, is not alone in leaning on this point.  Such short-term Phillips-Curve reasoning remains very much the raison d’être of modern-day macro.  But this relationship no longer holds in today’s increasingly globalized economy — and it hasn’t been working for nearly a decade, as pointed out in the BIS research noted above.  I don’t think that is a coincidence — nor do I think this anomaly is about to fade.  If anything, given the upside potential of IT-enabled trade in global services, I think the cross-border arbitrage could well intensify in the years ahead. 

Policy makers need to heed the lessons of the past several years very carefully.  Fiscal and monetary authorities, alike, should consider the implications of their domestic policy actions in the context of open models — rather than just relying on the closed models of yesteryear.  Policy stimulus may no longer lead to accelerating inflation in a world awash in excess supply that is constantly arbitraging away excess costs and pricing.  Instead, the impacts of such stimulus may show up in the global liquidity cycle and asset markets.  The global saving arbitrage has the potential to compound this phenomenon — especially as the world’s biggest deficit (America’s) is funded increasingly by externally-dependent developing economies such as China. 

As long as inflation remains at bay, the rules of old macro suggest little reason to worry.  Yet that may well prove to be the biggest risk of all in today’s unbalanced world.  Open macro, which focuses attention on asset bubbles and the excesses of asset-dependent economies, suggests that this is no time for complacency.

United States
All About Income
Feb 21, 2006

Richard Berner (New York)

Consumers went on a spending spree over the past three months; I estimate that real outlays jumped at close to a 10% annual rate in the November-January span, the fastest 3-month clip since the spring of 1987.  That surge occurred despite rising debt and interest rates, a negative saving rate, and apparently slowing home price gains.  It’s hardly an understatement to say that the pace is unsustainable; at a minimum, warm weather doubtless boosted sales in January at February’s expense.  And the apparent challenges to the consumer — honey for the bears on the economy — seem to be growing daily.  Despite those hurdles and the likely February payback, in my view, consumers won’t likely retrench.  Here’s why.

The key factor, as I see it, is that strongly rising job and income growth are likely to sustain consumer spending and concurrently permit consumers to begin a slow recovery in saving.  Among the ingredients for the income acceleration: Companies likely will fill pent-up hiring demand, wage gains probably will quicken further as labor markets firm, and rising interest rates and dividend payouts will boost nonwage income.  And if energy quotes merely stabilize, real incomes will soar. 

Before looking ahead in detail, however, it’s important to set the recent spending surge in perspective.  There’s no mistaking the fact that abnormally unstable weather and sharp swings in energy prices accounted for a good bit of the volatility in consumer spending over the past several months.  An energy price spike that began with a hot summer and went skyward in the wake of the summer hurricanes hammered consumer discretionary income (and thus spending) between June and September.  By one metric, the energy price spike cost consumers $107 billion at an annual rate in nominal purchasing power over that period.  Not surprisingly, with a short lag, that price surge and the dislocations from the hurricanes promoted a temporary 5.4% annualized plunge in real spending in the three months ending in October. 

But between September and December, the plunge in energy quotes restored $60 billion of that lost purchasing power.  So some — but not all — of the sharp spending spree in November and December (up 11.6% annualized) simply represented a recovery from the previous sharp declines as energy prices tumbled and economic activity slowly recovered in the Gulf Coast region.  What’s more, a record warm January — fully 8 degrees above the norm — doubtless spurred unusually large gains in retail sales and also in housing activity that in turn added to the apparent lift in consumer spending.  My colleague Steve Roach is right that the heat wave probably exaggerated sharp gains in outlays for spring clothing, furniture, and restaurant meals (see his “Seasonally Mal-Adjusted,” Global Economic Forum, February 17, 2006).  Poor seasonal adjustment may also have exaggerated the effects on spending of the growing use of gift cards that may have shifted spending from December to January, especially at general merchandise stores.  A payback is coming for both factors in February.  Of course, the warm weather also depressed utility outlays, so the January gains in overall spending likely amounted to half the November/December average monthly pace.  The upshot, as I’ve noted previously, is that weather- and energy-induced volatility in income and spending make it hard to discern the underlying trends (see “Rebound: Is it Real or Just the Weather?” Global Economic Forum, February 3, 2006).

Importantly, however, one positive effect of January’s warm weather on consumer discretionary incomes will be more lasting: It substantially reduced heating demands for both natural gas and distillates.  As a result, natural gas and petroleum product inventories are abnormally high.  For example, working gas in storage was 2,266 Bcf as of Friday, February 10, 2006, 44% above the 5-year average for this time of year.  Thus, notwithstanding colder weather in Europe, wholesale prices, especially for natural gas but also for gasoline, have tumbled.  Natural gas futures plunged 36% since the end of December, and wholesale gasoline quotes are off 18%.  While rising unrest in Nigeria has lifted crude and product quotes over the past week, and gasoline prices will rise again this summer, barring an outbreak of subzero weather, the dip in energy quotes will represent a lasting benefit for consumers’ purchasing power. 

Most important of all, however, nominal — and thus real — income growth has begun to accelerate sharply.  Facing stronger business conditions and having been extraordinarily disciplined about hiring in this expansion, Corporate America and small businesses are both filling pent-up demand for hiring.  As a result, a key measure of labor inputs — hours worked for nonsupervisory workers — rose by 2.6% from a year ago, close to the fastest pace in the current expansion.  Moreover, firming labor markets have boosted average hourly earnings; they rose by 3.3% over the same period, to a 3-year high. 

The combination suggests that a proxy for private wage and salary income rose over the past year at a 3% real rate — a 6-year high.  While these measures are flawed and incomplete, if anything, they may understate pay gains, which are increasingly going to professional, technical and engineering workers (see “Will the Real Wage Measure Please Stand Up? Global Economic Forum, January 6, 2006).  Yet the official data for real private wage and salary income paint a different picture over the past year, with a deceleration in real wage and salary income to just 1%.  That’s because a surge in stock-option exercise activity temporarily and artificially boosted that metric in the last months of 2004, depressing the growth of private wage and salary income over 2005.  When that “base effect” drops out in the next several months, income will appear to catch up with the wage and salary proxy.  And faster job and pay gains and the prospect of stable energy quotes suggest an even brisker real income pace over 2006.  The improvement in state and local budgets also suggests more hiring and pay gains in the coming year.  

What’s more, other income sources are also growing strongly.  Rising interest rates and dividend payouts are boosting property-type income; adjusted for the one-time Microsoft dividend in December 2004, such income growth is already running at a 9-10% rate.  It’s worth noting that because such income is typically saved rather than spent, it has a profound effect on the personal saving rate.  Indeed, such compositional changes in income probably accounted for a third or more of the decline in the saving rate as measured in the National Income and Product Accounts since 1989.  Proprietors’ income, while erratic in the wake of the dislocations from the hurricanes, is rising at better than a 7% rate.  And both Social Security and Medicare transfers should rise strongly this year; the former boosted by the adjustment to last year’s inflation rate (a 4.1% increase per beneficiary effective on January 1, 2006), and the latter by the introduction of the Medicare Prescription Drug Benefit. 

The upshot: The 5.6% rise in real disposable income we expect over the four quarters of 2006 would be the strongest such gain since 1998, and would finance healthy gains in consumer spending and a rise in the personal saving rate from its current below-zero level to 1½%. 

Despite such prospective gains, many are concerned that the combination of rising debt and debt service and sinking gains in housing wealth and home equity extraction will more than offset the growing consumer wherewithal.  I disagree.  First, careful analysis of consumer debt service and financial obligations ratios reveals a healthier American consumer than commonly thought; appropriately-adjusted measures are actually well below their peaks of three years ago.  That throws some cold water on a slowdown story based on presumed household balance-sheet fragility (see “Financial Obligations: Misleading Metrics?” Global Economic Forum, January 27, 2006). 

In addition, for US consumers, real “core,” or after-tax wage and salary income is the most critical factor supporting consumer spending.  Indeed, as I see it, the influence of income on most categories of consumer spending is, dollar for dollar, anywhere from five to 50 times greater than is the influence of housing wealth or home equity extraction.   Correspondingly, if I’m right about the prospects for improving job growth and wage gains, the housing bust scenario that many investors fear is far fetched.  In my view and that of my colleague David Greenlaw, it would take soaring interest rates or declining employment to produce a bust (see “Housing Wealth and Consumer Spending” and “Home Sweet Home,” Global Economic Forum, October 7, 2005 and December 15, 2005).

For market participants, such income gains at this point may not come as much of a surprise.  After all, January’s surge in retail sales erased many investors’ fears of forthcoming consumer weakness; so much of this good consumer news is in the price.  Moreover, a significant February “payback” in spending such as we expect could temper market growth bulls.  But with the fundamentals turning more favorable for income, shorting the American consumer probably will be frustrating.

As always, risks abound.  In my view, a supply-driven energy price spike or a meaningful surge in inflation pose the biggest threats to this upbeat scenario.  The former would sap discretionary spending power.  The latter would promote a more significant tightening in monetary policy, which would be bad news for both housing and financial-market consumer net worth.  And sharply rising interest rates would raise the odds of a significant consumer ‘ARM squeeze’.

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