|September 22, 2002/New York TIMES
The Costs of Bursting Bubbles
By STEPHEN S. ROACH
LONDON - A year after terrorism dealt a seemingly lethal blow to America,
talk of resilience and economic recovery is in the air. The nation's
inflation-adjusted gross domestic product has risen for four consecutive
quarters following a mild downturn in the first nine months of 2001. While
the estimated 3.2 percent growth rate over the past year is subdued when
compared with the more vigorous rebounds of the past, the hope is that it's
a down payment on bigger and better things to come.
But while Sept. 11 was a defining event for America, it was not a defining
event for the economy or the financial markets. That role belongs to the
stock market bubble of the late 1990's that finally popped in March 2000.
There was far more to the excesses of the 1990's, however, than an asset
bubble. The bubble expanded high enough, and for long enough, to have
infected the behavior of consumers and businesses alike.
The equity bubble helped to create other bubbles - most notably in the
housing market and in consumer spending. Their continued existence poses a
serious threat to lasting expansion - and yet, puncturing them raises the
grave risk of deflation. This suggests the economy will prove as challenging
to America's political leadership as any other issue in the year ahead.
There is good reason to believe that both the property and consumer bubbles
will burst in the not-so-distant future. If they do, there is a realistic
possibility that the United States, like Japan in the 1990's, will suffer a
series of recessionary relapses over the next several years. Yet denial
remains deep, just as it was when the Nasdaq composite index was lurching
toward 5,000. Few want to believe that this economic expansion may be built
on such a shaky foundation.
The evidence in support of a housing bubble is compelling. The 27 percent
increase in inflation-adjusted American house prices since 1997 represents
the sharpest five-year increase since 1945. This surge is about three times
the increase in real housing rents over this period. (The divergence of home
prices and rents, which usually move in tandem, is one measure of the
speculative element of the housing market.) As their property values rise,
hard-pressed consumers have been quick to extract purchasing power from
their homes, taking advantage of low interest rates to refinance their
property and use the savings to buy cars, furniture, appliances and other
luxury goods. Thus the ever-expanding property bubble has become central to
the culture of excess that is now driving the United States economy.
The consumer-spending bubble will undoubtedly be the last to pop. Short of
savings and long on debt, an aging American population must begin to come to
grips with the looming realities of retirement. Yet it must now do so in an
era of defined contribution pension plans whose performance has been
battered by a devastating bear market in equities. We all know that
Americans are addicted to shopping. Yet we also know that, if they want to
retire with any kind of financial security, they must increase their savings
and rein in their spending.
What might cause the consumer-spending bubble to burst? It's hard to say,
although several realistic possibilities come to mind - a spike in oil
prices, a surge of white-collar layoffs or a collapse of the property
bubble. Any one of those developments could send a wake-up call to the
American consumer, thereby denying the United States and the broader global
economy its main source of support.
But it gets worse. The saga of the post-bubble United States economy doesn't
stop with the bursting of the housing and consumer bubbles. Since these
events are likely to occur when inflation is already running at a very low
rate, they could push the United States into a period of outright deflation
- a decline in the nation's overall level of prices for goods and services.
This is a rare and worrisome condition for most economies. The impact of
deflation would be most acute for wage earners and debtors. To stay
profitable, companies would have to cut jobs or wages, eventually inhibiting
consumer purchasing power. And the fixed obligations of indebtedness would
have to be paid back in deflated dollars, squeezing overextended borrowers
all the more.
America is already on the brink of deflation. Our broadest price gauge, the
G.D.P. price index, recorded just a 1 percent annualized increase in the
second quarter of 2002. That's the lowest inflation rate in 48 years. Prices
of goods and structures - covering nearly half the economy - are already
contracting at an annual rate of 0.6 percent. Only in services, where price
statistics are notoriously unreliable, are prices still rising.
The hows and whys of America's deflationary perils will long be debated. Two
sources seem most likely. First, the bubble-induced boom of business capital
spending led to an overhang of new information technologies and other forms
of capital equipment in the late 1990's. The result was excess supply, a
textbook recipe for lower prices.
Also at work are the unmistakable effects of globalization. The modern-day
American economy now has a record exposure to global competition. In the
second quarter of 2002, America imported a third as many goods as it
produced, well in excess of the 20 percent ratio prevailing at the onset of
the last recovery in the early 1990's. Significantly, more and more of these
goods are coming from highly competitive Asian producers who have much lower
cost structures than their American counterparts.
Moreover, with the exception of Korea, every major Asian economy is now in
the throes of its own deflation. Consequently, courtesy of ever-expanding
trade relations with Asia, America is now buying more and more from
countries like China and Japan that are already in deflation. The growing
share of these increasingly cheap foreign goods helps drive down prices of
products made at home, thereby deepening deflationary pressures.
History tells us that when major asset bubbles burst, deflation is often the
result. That was true of the United States in the 1930's and Japan in the
1990's. Most are quick to claim that America is not Japan - that its more
flexible, dynamic economy stands in sharp contrast to Japan's economic
inertia. But the United States is already a lot closer to the deflationary
edge than most concede - and it could go further.
Deflationary risks can never be taken lightly in a post-bubble economy. Yet
that's precisely what American investors and policy makers now seem to be
doing. If the housing and consumer bubbles pop, then the risk of outright
deflation will only increase. It's time to stop pretending this can't happen
in the United States.
Stephen S. Roach is chief economist and director of global economics at