STEPHEN ROACH, CHAIRMAN, MORGAN STANLEY ASIA
Interview by Don Durfee

Stephen Roach isn’t one to apply a sweet coating to bitter economic truths. The chairman of Morgan Stanley Asia—previously the investment bank’s long-time chief economist—predicted “economic Armageddon” in 2004, arguing that big U.S. deficits and growing asset bubbles would inflict serious pain on the global economy. Now that the U.S. slowdown has arrived, Roach says that the recession in the United States will be far more serious than most expect. Roach spoke to CFO Asia about the likely impact on Asia.

You have argued that the current U.S. slowdown will be longer and deeper than many believe. Why?

The case for a short and mild recession is a real stretch, given the breadth of the sectors that are involved in the post-bubble adjustment. The problem for the United States is that the real economy has become increasingly dependent on the asset and credit bubbles that are now bursting. American consumers have been spending well in excess of their underlying income generation, with that excess critically dependent on ever-rising home prices and on cheap credit. Now the underpinnings of the asset- and credit-dependent consumer have been drawn into serious question. The income side is also under pressure because of rising unemployment, which is likely to continue through the balance of this year and early 2009.

So the American consumer can only consolidate. Consumption last year was 72 percent of real GDP. You add a housing sector that peaked at about 6 percent in 2006, and you have 78 percent of the U.S. economy under pressure. That’s six times the size of the capital spending sector that pushed the U.S. into recession seven years ago. You’ve got a much larger scope for adjustment.

You’ve been very critical of the U.S. Fed’s role.

The view at the Federal Reserve has been that it should not be rendering judgments on the state of asset markets—that the central bank has the tools and the capability to clean up the mess after asset markets correct. The serious mess that we’re in right now is prima facie evidence that this view is incorrect.

The Federal Reserve, like any well-intended authority, goes astray sometimes. It went seriously astray in the 1970s, when I was there [as an economist on the research staff], in failing to understand and deal with raging inflation. And it went very seriously astray in the last ten years by failing to deal with a profusion of asset bubbles and their impact on the real economy.

As a result, I think the mandate of the Fed is going to be recast by Congress—to whom the Fed is accountable—to include paying much greater attention to potential instability in asset markets.

What effect will the U.S. slowdown have on Asia? The impact seems mild so far.

It’s been mild so far because the U.S. has only been in recession for three or four months, at the most. China’s growth rate could slow from 11.5 percent to maybe somewhere in the 8-9 percent zone for a while. That’s actually a welcome result for China since the country is overheating and needs some cooling off. But other economies will be hit harder—certainly slower growth in Korea, Taiwan, and some of the ASEAN economies, which are among the most export-dependent in Asia. Also Japan, the world’s second largest economy, could tip back into recession—it doesn’t have the cushion that China has going into this downturn. It will be problematic for the rest of the world if the number one and number two biggest economies are in recession.

Other than a slowdown in the West, what risks confront China’s economy?

China’s got imbalances of its own to deal with, the most important being the deficiency of private consumption. But I think it will deal effectively with its imbalances, though maybe not at the pace that the West wants. One of the most exciting stories in the world over the next three to five years is the emergence of the Chinese consumer. It’s going to be a huge transforming event for China, for the region, and for the world.

China does have a serious inflation problem. I derive no comfort from the fact that people ascribe this to exogenous forces like food and energy. Just as it was in the early ‘70s in the U.S., dismissing so-called exogenous inflationary shocks is a recipe for making a policy mistake.

The other concern I have is the growing possibility of anti-China protectionist policies enacted in Washington.

Do you think U.S. politicians will be even harder on China than they’ve been?

I do. In the last three years we’ve had 45 separate pieces of anti-China legislation introduced in Congress. The good news is that none passed. But last year, two of them did pass major Senate committees by overwhelming bipartisan majorities. The risk is that one of these bills gets signed into law. When the new Congress comes to town, it will presumably have larger margins of control for the Democrats. And more likely than not, there will be a new Democratic president [in 2009] who’s been aggressively campaigning against trade, against globalization, and against China. Add to that a rising unemployment rate, and the political pressures for a dangerous protectionist “fix” will mount.

What lessons are Asia’s policy makers drawing from the subprime crisis?

They’re understandably wary about embracing U.S.-style financial market innovation and capitalism. This crisis is going to send a real chill through the regulatory and reform process that’s pushing for instruments such as derivatives and securitized loans. The theory has always been that these add liquidity—that they’re shock absorbers for the system. The current environment is challenging a lot of those presumptions.