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The Endogenous Oil Shock

September 5, 2005

One of my favorite economists, Stephen Roach, of Morgan Stanley gives us an insight into what the latest economic shock may mean for the economy. Economic shocks often lead to a fairly predictable slowdown and recovery, but Roach argues that the Fed induced asset bubbles of the last few years may cause this current shock to prick "America's asset economy."

I hope Roach is wrong and that the imbalances in the economy work themselves out slowly rather than popping a bubble, but this makes for a thought provoking Outside the Box.

John Mauldin, Editor
Outside the Box

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The Endogenous Oil Shock

In the macro world, strikes, wars, and natural disasters have long been thought of as classic exogenous shocks -- those out-of-the-blue disruptions that jolt economies and markets. For stable economies, the impact of the exogenous shock is fairly predictable -- a temporary reduction in growth followed by the rebound of recovery. Such are the impacts that are likely to follow from the devastation of America's Hurricane Katrina. But the energy shock of 2005 may be of a very different breed. It could well be an endogenous shock -- an unfortunate outgrowth of excesses that have been building in the macro system for a long time.

The Federal Reserve has set the stage for this endogenous shock. As it has supported the US economy from bubble to bubble, it has fostered a climate of excess demand and excess liquidity. First equities in the late 1990s and now property -- the Fed has nurtured the steady transformation of an income-based US economy into an asset-dependent spending machine. Belatedly, Alan Greenspan has finally paid lip service to the mounting perils of the Asset Economy. In his recent swan song at Jackson Hole, the Fed chairman cautioned that "history has not dealt kindly" with investors (i.e., American consumers) who may have gone too far in "accepting lower compensation for risk" on their asset holdings (see "Reflections on Central Banking," August 26, 2005). Even couched in all the oblique caveats so typical of Fedspeak, this is quite a confession. The Father of the Asset Economy now fears he has created a monster.

Those fears are well founded, in my view. The tragedy is that the powers that be are only now just coming to this realization. Alas, there has long been ample evidence that America's asset-dependent spending mindset has gone too far. That's the message from unconscionably low saving rates -- now below "zero" for individuals (a record low of -0.6% in July) and at low single digits for the nation as a whole (on a net, after-depreciation, basis). That's also the message from a gaping US current-account deficit -- a record 6.4% of GDP in early 2005. Such excesses are further corroborated by an unprecedented debt binge by asset-dependent American consumers; not only has the household sector's outstanding debt risen by 20 percentage points of GDP over the past five years -- more than the cumulative increase over the preceding 20 years -- but debt-servicing expenses are near all-time highs in what is still a rock-bottom interest rate climate. And if there was any doubt over the bubble-like underpinnings of the Asset Economy, the latest report on nationwide home prices says it all -- a 13.4% y-o-y increase in 2Q05, the sharpest increase since mid-1979. Saving-short American consumers have gone deeper and deeper into debt in order to spend freely out of artificial purchasing power extracted from overvalued homes. All that paints a very compelling picture of an excess-demand-driven US economy.

The same is true of the case for excess liquidity. In America's deregulated financial market environment, liquidity-related impacts show up less in the various gauges of the money supply and credit flows and more in the form of movements in real interest rates. With the Fed maintaining a long period of unusually accommodative policy -- a negative real federal funds rate from late 2001 to late 2004 that has gone only barely positive since -- financial assets have been supported by a steady stream of "carry trades." This, in turn, has created excess demand for a wide range of fixed-income assets in recent years -- further depressing intermediate- and longer-term interest rates and thereby boosting property prices and wealth-dependent consumption.

It is the resulting excesses on the demand side of the US macro equation that have set the stage for an endogenous shock. That's very much the case with respect to the oil shock of 2005. Hurricane Katrina may well go down in history as the tipping point to another energy crisis. But it is important to keep in mind that oil prices had already pierced the $65 threshold before this devastating natural disaster occurred. The reason: an unusually tight balance between long constrained energy supply and surging energy demand, with the latter well supported by the spending excesses of the Asset Economy. In other words, had it not been for America's asset-induced spending binge, there probably would have been a greater margin between aggregate supply and demand that would have left prices of oil and other energy products on a very different trajectory. With the United States still accounting for fully 25% of worldwide oil demand -- more than three times the share of China -- the impacts of excess US consumption on global oil prices can hardly be minimized. The endogenous energy shock is very much an outgrowth of this phenomenon, in my view.

Nor should the oil shock be treated as an isolated occurrence. America's Asset Economy is perfectly capable of generating other endogenous shocks, as well. The two most worrisome possibilities -- a bursting of the property bubble and a current-account crisis. These are typically low-probability events. But for an Asset Economy that has gone to excess, those probabilities are higher today than would otherwise be the case. Of these two possibilities, a post-bubble shakeout in the US housing market is more worrisome. The government's just-released report on 2Q05 home prices underscores why. Not only is the nationwide rate of housing appreciation at a 26-year high, but fully 25 states plus the District of Columbia -- a grouping that probably accounts for at least 65% of the total market value of US residential property -- have experienced double-digit house price increases over the past year. At the same time, for 55 metropolitan areas, house price appreciation has been 20% or higher over the past year. As the housing bubble grows larger and covers more and more of the US, the perils of a post-bubble endgame for overly indebted American consumers grow larger by the day. Such are the perils of an Asset Economy that has long gone to excess.

The same would be the case with a US current account crisis. All it would take would be a desire on the part of America's foreign creditors to seek compensation for taking currency risk -- or an inclination on the part of foreign central banks to diversify their official foreign exchange reserve portfolios that are so heavily over-weighted dollar-denominated assets. Both of these possibilities are entirely feasible and not without important implications for the global economy. In either case, the back-up in US interest rates that would arise from such a response would reverberate into other asset markets, especially over-valued residential property. Here, as well, the shocks associated with such a scenario are very much an endogenous outgrowth of an Asset Economy that has gone to excess.

The oil shock of 2005 now poses an immediate threat to the US and global economy. The significance of that threat will only become apparent with the passage of time. In the end, it is always the duration of any shock that matters the most in shaping macro outcomes. But this oil shock did not exactly come out of thin air. It was, in effect, set up by chronic excesses on the demand side of the US macro equation. Such an outcome could have important implications for financial markets. Fed tightening could be brought to a premature conclusion, as US monetary authorities pause to assess the damage from Hurricane Katrina. In response, bonds could rally further and equities could sag under the weight of prospective shortfalls to corporate earnings.

Endogenous shocks are of a different breed than the more typical exogenous disturbance. They reflect systemic risks in economies that could well take a good deal of time to purge. That was always the biggest risk for America's Asset Economy.

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You can find Stephen Roach's current and archived commentary at http://www.morganstanley.com/GEFdata/digests/latest-digest.html

Your keeping a close eye on the economic effects of Katrina analyst,

John Mauldin

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