The US economy is exhibiting the signs that typify the aftermath of a severe financial crisis, with housing prices likely to fall yet further and no immediate sign of easing unemployment.
According to Kenneth Rogoff, Harvard University professor, investors can take comfort in seeing the US behave like most other countries have done following a financial crisis. "Because crises end," he told the AsianInvestor and FinanceAsia Asia-Pacific Debt Investment Forum in Hong Kong yesterday.
Rogoff and his colleague Carmen Reinhart last year published "This Time Is Different", their data-soaked analysis of 800 years of sovereign debts and defaults. The book is not only recognised as a breakthrough analysis of sovereign debt, but has also captured the public imagination; it has ranked as the number-four bestseller on Amazon.com for the past several days.
He says his outlook for America is for slow growth, noting the economy is suffering aftershocks from its subprime-centred earthquake, but is not headed for another recession. "The problems in the economy are why we're not growing at 7%," he says. Europe is in a similar position.
For the near term, the US benefits from steady capital inflows from Asia that makes it easy for it to refinance its debts. Rogoff says that, based on his recent conversations with central bankers in Asia, they are aware that their own financial markets are deepening. Someday, Asian capital will be able to remain invested in Asia.
"We're learning at this conference when that day may come," he says, adding that when this process begins, it will unfold quickly.
The development of many Asian capital markets has been deliberately hobbled out of a fear of allowing in hot money or surrendering government control to market forces. At some point, Asian countries' growth strategies won't work anymore, but there will remain a political need to meet demands for sustained growth. That is when liberalisation of financial markets will accelerate. If this is handled wisely, it can set the foundations for a new era of sustainable growth; if handled poorly, it can lead to a crash.
For now, Asia faces both external and internal risks, Rogoff says. The external one is that of trade protectionism in the US or Europe. The internal one is inflation, which is likely to worsen so long as the region continues to import America's loose monetary policies.
He also says that some voices in China are engaging in a kind of self-delusion; namely that the country is immune to the vagaries of the business cycle.
Rogoff is confident that over the next 40-50 years, China will become the world's pre-eminent economic power. But this does not mean China has defeated the business cycle, and in any given year there is a 10% chance it will experience a recession. The government has yet to admit to having experienced a recession, although there is circumstantial evidence that it did so in 1989.
The fact of Chinese growth doesn't obviate the country's own imbalances. Rogoff believes property prices in China are in a bubble. The authorities are wisely trying to tighten from a position of strength, rather than after a possible collapse. Even so, the export machine simply can't maintain its same rate of growth given the troubles in Western consumer markets, and infrastructure investment has limits too.
It's obvious that China must raise domestic consumption, but how it will do so and how it can maintain its global competitiveness is not clear. To date, Asian export nations have relied on competing in the global consumer market, which has proven a success. But boosting domestic demand requires a completely different set of choices and policy decisions. In China's case, this would include the need for anti-trust rules and enhancing the rule of law.
Rogoff is sanguine on the West's prospects, in the sense that he feels growth will be slow but there shouldn't be a return to recession (at least, assuming politicians don't make the worst of decisions).
But that doesn't mean there won't be defaults. On the contrary, Rogoff and Reinhart's research shows that countries with total levels of debt below 90% of GDP won't be affected by indebtedness, but everyone else will feel the pinch. For example, they will have to raise taxes to fill the gaps.
Sovereign indebtedness balloons after a financial crisis, but not everyone can afford it, and some of the smaller countries are going to default. "At some point the markets call your bluff," Rogoff notes.
He believes the eurozone's problems are manageable, but that one or two smaller sovereigns will eventually have to default or restructure. The European Union and the International Monetary Fund are right to defend Spain at the federal level, but states/provinces, municipalities and private debts need to be allowed to default. Even today, Greece -- with a fiscal situation about as dire as any in history -- could still pay its debts, but whether it has the political will to do so (by privatising assets, for example) has yet to be seen.
However, Rogoff expects the euro to survive, so long as it doesn't fall prey to high inflation -- the one outcome that Germans could not abide.
As for the US, he says fears about Uncle Sam inflating its way out of debt are overdone, mainly because the structure of American indebtedness would require more inflation than the Federal Reserve could engineer.
However, the government could use inflation as a tool, provided it first forces banks, pension funds and insurance companies to buy more government bonds. New regulation in Europe and the US is orientated in this direction, with new rules to increase capital reserves and liquidity by forcing institutions to hold more 'safe' government bonds.
Slow growth may not sound like a very exciting future for the US and Europe, but it could have been worse, says Rogoff. And there will be chances for them to return to stronger growth, so long as trade links remain open, productivity is given a chance to improve, and technological innovation remains healthy.