America's inflated asset prices must fall



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America's inflated asset prices must fall By Stephen Roach
Mon Jan 7, 1:05 PM ET



The US has been the main culprit behind the destabilising global
imbalances of recent years. America's massive current account deficit
absorbs about 75 per cent of the world's surplus saving. Most believe
that a weaker US dollar is the best cure for these imbalances. Yet a
broad measure of the US dollar has dropped 23 per cent since February
2002 in real terms, with only minimal impact on America's gaping
external imbalance. Dollar bears argue that more currency depreciation
is needed. Protectionists insist that China - which has the largest
bilateral trade imbalance with the US - should bear a disproportionate
share of the next downleg in the US dollar.

There is good reason to doubt this view. America's current account
deficit is due more to bubbles in asset prices than to a misaligned
dollar. A resolution will require more of a correction in asset prices
than a further depreciation of the dollar. At the core of the problem
is one of the most insidious characteristics of an asset-dependent
economy - a chronic shortfall in domestic saving. With America's net
national saving averaging a mere 1.4 per cent of national income over
the past five years, the US has had to import surplus saving from
abroad to keep growing. That means it must run massive current account
and trade deficits to attract the foreign capital.

America's aversion toward saving did not appear out of thin air. Waves
of asset appreciation - first equities and, more recently, residential
property - convinced citizens that a new era was at hand. Reinforced
by a monstrous bubble of cheap credit, there was little perceived need
to save the old-fashioned way - out of income. Assets became the
preferred vehicle of choice.

With one bubble begetting another, America's imbalances rose to epic
proportions. Despite generally subpar income generation, private
consumption soared to a record 72 per cent of real gross domestic
product in 2007. Household debt hit a record 133 per cent of
disposable personal income. And income-based measures of personal
saving moved back into negative territory in late 2007.

None of these trends is sustainable. It is only a question of when
they give way and what it takes to spark a long overdue rebalancing. A
sharp decline in asset prices is necessary to rebalance the US
economy. It is the only realistic hope to shift the mix of saving away
from asset appreciation back to that supported by income generation.
That could entail as much as a 20-30 per cent decline in overall US
housing prices and a related deflating of the bubble of cheap and easy
credit.

Those trends now appear to be under way. Reflecting an outsize
imbalance between supply and demand for new homes, residential
property prices fell 6 per cent in the year ending October 2007 for 20
major metropolitan areas in the US, according to the S&P Case-Shiller
Index. Most likely, this foretells a broader downturn in nationwide
home prices in 2008 that could continue into 2009. Meanwhile, courtesy
of the subprime crisis, the credit bubble has popped - ending the cut-
rate funding that fuelled the housing bubble.

As home prices move into a protracted period of decline, consumers
will finally recognise the perils of bubble-distorted saving
strategies. Financially battered households will respond by rebuilding
income-based saving balances. That means the consumption share of
gross domestic product will fall and the US economy will most likely
tumble into recession.

America's shift back to income-supported saving will be a pivotal
development for the rest of the world. As consumption slows and
household saving rises in the US, the need to import surplus saving
from abroad will diminish. Demand for foreign capital will recede -
leading to a reduction of both the US current-account and trade
deficits. The global economy will emerge bruised, but much better
balanced.

Washington policymakers and politicians need to stand back and let
this adjustment play out. Yet the US body politic is panicking in
response - underwriting massive liquidity injections that produce
another asset bubble and proposing fiscal pump-priming that would
depress domestic saving even further. Such actions can only compound
the problems that got America into this mess in the first place.

China-bashers in the US Congress also need to stand down. America does
not have a China problem - it has a multilateral trade deficit with
over 40 countries. The China bilateral imbalance may be the biggest
contributor to the overall US trade imbalance but, in large part, this
is a result of supply-chain decisions by US multinationals.

By focusing incorrectly on the dollar and putting pressure on the
Chinese currency, Congress would only shift China's portion of the US
trade deficit elsewhere - most likely to a higher-cost producer. That
would be the same as a tax hike on American workers. If the US returns
to income-based saving in the aftermath of the bursting of housing and
credit bubbles, its multilateral trade deficit will narrow and the
Chinese bilateral imbalance will shrink.

It is going to be a very painful process to break the addiction to
asset-led behaviour. No one wants recessions, asset deflation and
rising unemployment. But this has always been the potential endgame of
a bubble-prone US economy. The longer America puts off this reckoning,
the steeper the ultimate price of adjustment. Tough as it is, the only
sensible way out is to let markets lead the way. That is what the long
overdue bursting of America's asset and credit bubbles is all about.

The writer is chairman of Morgan Stanley Asia

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