Morgan Stanley’s chief global economist adds his voice to the growing choir of doomsayers, predicting heartbreak for employees and consumers throughout the high-cost, developed world. His thesis is simple: growth in the world economy has come not from soaring wages but from bubbalicious home prices, soaring corporate profits, American consumerism and low-cost third-world labour. As jobs continue to stream offshore and the markets pray for a “soft landing”, recession may be the only tune this chorus is willing to sing…
Global Growth Paradox
by Stephen S. Roach
The global labour arbitrage tilts returns to labour away from the high-wage industrial world toward the low-wage developing world.
After fixating on an inflation scare over the past four months, financial markets have turned their attention back to the growth debate. And with good reason: Energy prices are now receding and a modest upside breakout to core wage and price pressures seems to have been contained. Meanwhile, cyclical risks are building on the downside of the global economy — underscoring the risks of a surprising deceleration in world economic growth in 2007 after the strongest four-year run since the early 1970s. The inherent asymmetries of globalization and the persistent global imbalances they have spawned could exacerbate the downshift.
The coming global slowdown is likely to be made in America. After a decade of leading the demand side of the global economy, consolidation is in the cards for the US consumer. The wealth dynamic imparted by a long frothy housing market is now beginning to recede. That will expose personal consumption to the tough fundamentals of stagnant real wages, subpar employment growth, record debt loads, and negative saving rates. The excesses of asset appreciation — first equities, then property — masked these persistent problems. As the housing bubble now bursts, over-extended US consumers have no place to hide. A decade of excess consumption — with growth in real consumer demand exceeding growth in real disposable personal income by an average of 0.5 percentage point per year since 1995 — is likely to be unwound. As I argued recently, this should have important implications for the rest of the world, which is lacking a consumption engine of its own (see my 28 August essay, â€œAnother Post-Bubble Shakeoutâ€).
The key in all of this is a seemingly chronic shortfall of income generation in the developed world — long the major driver of consumer demand. While there can be no mistaking the vigor of growth in world GDP over the past four years — a 4.8% average increase on an IMF purchasing power-parity basis — the benefits of this boom have not accrued to labor. This is illustrated by the downtrend in the real compensation share of national income for the â€œG-7 plusâ€ — the US, the Euro-zone, Japan, the United Kingdom, and Canada. By this metric, real compensation fell to 53.7% of gross national income for the G-7 plus in early 2006, fully 2.3 percentage points below peak rates hit in early 2002 just prior to the onset of the current upsurge in world economic growth. For the rich countries of the developed world, labor has been on the outside looking in during the strongest period of global growth in 35 years.
That poses an obvious and important question — a boom for whom? Two likely candidates come to mind — returns to capital in the developed world (i.e., corporate profits) and rewards to labor in the developing world. Both possibilities are outgrowths of globalization — the most powerful macro force at work today. Insofar as the developed world is concerned, it is all about the global labor arbitrage — a development that has turned one of the key building blocks of traditional macro theory inside out. Economics tells us that workers are ultimately paid in accordance with their marginal productivity contribution. That has not been the case in the US, where productivity gains averaged 3.3% per annum over the 2002-05 interval — more than double the anemic 1.4% trend in real hourly compensation over the same period. Itâ€™s one thing for labor income to be under pressure in slow-productivity economies like Europe and Japan. Itâ€™s another matter altogether for labor income shares to fall in a high-productivity-growth economy like the United States.
Therein lies the paradox of global growth: The global labour arbitrage tilts returns to labour away from high-wage developing world. At the same time, globalization leads to intensified competitive pressures and a mega-productivity push in the high-cost developed world. This results in downward pressure on both real compensation and employment in the rich countries — crimping labor income generation, the sustenance of consumer purchasing power. For a decade, the United States was able to sidestep this headwind by drawing heavily on the wealth creation of its asset-based economy. As the US housing bubble now bursts, that option has been effectively foreclosed. At a minimum, that means US consumption should return to its labor-income-based underpinnings. But it could be a good deal worse than that. If American consumers elect to rebuild long-depleted income-based saving balances, consumption growth might be pushed below income growth for a protracted period of time.
There is an important footnote to this argument — the contention by many that Americaâ€™s labor income generating machine is now functioning quite normally again (see Dick Bernerâ€™s 21 February 2006 dispatch, â€œAll About Incomeâ€). The argument is simple: Irrespective of global forces, real wages are viewed as finally responding to falling domestic unemployment. That, in conjunction, with improved employment growth, should result in a meaningful upturn in worker compensation — by far, the largest component of personal income. Unfortunately, I donâ€™t think the facts bear this one out. Yes, there was a stunning upward revision to wage income just announced by US Commerce Department statisticians; some $98 billion was added to private sector wages and salaries in the first half of 2006 — although fully 85% of this revision was concentrated in just two months, January and February. But, even with the revision, after 56 months of the current economic recovery, inflation-adjusted private sector compensation — wages, salaries, and fringe benefits — are still tracking some $360 billion below comparable points in the average trajectory of the past four long-cycle expansions in the US. Moreover, based on the just-released August labor market survey, the combination of anemic wage gains, a declining workweek, and sluggish employment growth suggests that month 57 of this comparison is likely to be even weaker. Looking through the ebb and flow of monthly gyrations in the labor market, the case for a chronic shortfall of US labor income generation remains very much intact.
That underscores one key element of the global growth paradox — the uphill battle faced by consumers in the developed world. The headwinds of subpar labor income generation may fade from time to time or, as in the case of the US, be temporarily overcome by wealth effects from asset bubbles. But as long as globalization and the cross-border labor arbitrage remain intact, those are likely to be aberrations rather than the norm. The flip side of this development is the other beneficiary of the global labor arbitrage noted above — labor in the low-wage developing world. On the surface, the rising real wages of these workers appears to be a very consumer-friendly outcome. Unfortunately, the developing economies benefiting the most from this shift, such as China, are lacking the institutions like social security, private pensions, unemployment insurance, and medical benefits that nurture consumer cultures. All this points up what could well be one of the greatest ironies of globalization — a decidedly anti-consumption bias. Over time, this bias might dissipate as the cross-border labor arbitrage levels the global playing field of worker rewards and as the developing world makes progress in providing a safety net for insecure families. But these are long-term possibilities. That means for the foreseeable future, globalization is likely to remain highly asymmetrical — offering more opportunity and support for producers rather than consumers.
That raises one of the deepest questions of all — the sustainability of world economic growth in a weak global consumption climate. For most of the last decade — and especially over the past four years — it has been a one-consumer world. But now as the over-extended American consumer weakens in a post-housing-bubble climate, the world growth dynamic could falter as a result. For that not to happen, the baton of global economic leadership has to be transferred quickly through the exquisitely well-timed handoff that many still seem to be counting on. For reasons I have long advocated, I donâ€™t think another consumer is capable of stepping up and filling the void (see my 28 August essay cited above). Nor do I believe that another sector in the US economy, such as business capital spending, will take up the slack. Too much of the incremental capex decision is heavily conditioned on the expected state of end-market demand. A likely slowing of US consumption is a distinct negative in that regard.
Financial markets are playing the growth debate as a standard cyclical risk-assessment exercise. I donâ€™t think there is anything standard about the adjustments now under way. An unbalanced global economy is very much an outgrowth of an asymmetrical globalization. As the US-led demand side now weakens, downside adjustments to global growth expectations could be fast and furious. Bonds have rallied and equities have held their own in the belief that all this ends in a well-orchestrated soft landing. Yet lacking in consumption support, that optimistic endgame could be no more than wishful thinking. Moreover, in a slower growth climate, the squeeze on labor income can only raise the odds of a social and political backlash — giving even greater reason to worry about the protectionist wildcard. If the American consumer now fades, as I suspect, the pitfalls of the global growth paradox could pose serious problems in 2007.