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Stephen Roach is one of my favorite analysts

At work is yet another post-bubble adjustment in the world's largest economy
- this time, the bursting of America's massive property bubble.
The subprime fiasco is the tip of a much larger iceberg - an asset-dependent American consumer who has gone on the biggest spending binge in the modern history of the global economy.
Stephen S. Roach 2007-10-22

Seven years ago, the bursting of the dot-com bubble triggered a collapse in business capital spending that took the US and global economy into a mild recession. This time, post-bubble adjustments seem likely to hit US consumption, which at 72% of GDP, is more than five times the share the capital spending sector was seven years ago.
This is a much bigger problem - one that could have grave consequences for the US and the rest of the world.

There is far more to this story than a potential downturn in the global business cycle. Another post-bubble shakeout poses a serious challenge to the timeworn inflation-targeting approach of central banks.

The American consumer has been the dominant engine on the demand side of the global economy for the past 11 years.
With real consumption growth averaging nearly 4% over the 1996 to 2006 interval, US consumption expenditures currently total over $9.6 trillion, or 19% of world GDP (at market exchange rates).

Moreover, the bursting of the property bubble has left the consumer wealth effect in tatters. After peaking at 13.6% in mid-2005, nation-wide house price appreciation slowed precipitously to 3.2% in mid-2007. Given the outsize overhang of excess supply of unsold homes, I suspect that overall US home prices could actually decline in both 2008 and 2009 - an unprecedented development in the modern-day experience of the US economy.

A capitulation of the American consumer spells considerable difficulty for the global economy. This conclusion is, of course, very much at odds with notion of "global decoupling" - an increasingly popular belief that depicts a world economy that has finally weaned itself from the ups and downs of the US economy.

This constellation of forces could prove especially vexing for the US dollar.

Economic theory is very clear on the implications of such huge imbalances: Foreign lenders need to be compensated for sending scarce capital to any country with a deficit. The bigger the deficit, the greater the required compensation. The currency of the deficit nation usually bears the brunt of that compensation. It then follows that as long as the United States fails to address its saving problem, its large balance of payments deficit will persist and the dollar will keep dropping.

The only silver lining so far has been that these adjustments to the US currency have been orderly - declines in the broad dollar index averaging a little less than 4% per year since early 2002. Now, however, the possibility of a disorderly correction is rising - with potentially grave consequences for the American and global economy.
A key reason is the mounting risk of a recession in America.

Basking in the warm glow of a successful battle against inflation, central banks decided that easy money was the world's just reward.

America's IT-enabled productivity resurgence in the late 1990s was the siren song for the Greenspan-led Federal Reserve - convincing the US central bank that it need not stand in the way of either rapid economic growth or excess liquidity creation. In retrospect, that was the "original sin" of bubble-world - a Fed that condoned the equity bubble of the late 1990s and the asset-dependent US economy it spawned. That set in motion a chain of events that has allowed one bubble to beget another - from equities to housing to credit.

Aided and abetted by the explosion of new financial instruments - especially what is now over $440 trillion of derivatives worldwide - the world embraced a new culture of debt and leverage. Yield-hungry investors, fixated on the retirement imperatives of aging households, acted as if they had nothing to fear. Risk was not a concern in an era of open-ended monetary accommodation cushioned by a profusion of derivativesbased shock absorbers.

It is high time for monetary authorities to adopt new procedures - namely, taking the state of asset markets into explicit consideration when framing policy options. Like it or not, we now live in an asset-dependent world.

That doesn't mean central banks should target asset markets. It does mean, however, that they need to break their one dimensional fixation on CPI-based inflation and also pay careful consideration to the extremes of asset values.

This is not that difficult a task. When equity markets go to excess and distort asset-dependent economies as they did in the late 1990s, central banks should run tighter monetary policies than a narrow inflation target would dictate.

The current financial crisis is a wake-up call for modern-day central banking. The world can't afford to keep lurching from one bubble to another. The cost of neglect is an ever-mounting systemic risk that could pose a grave threat to an increasingly integrated global economy.

Full text of this outstanding article

The Economist points a finger at central bankers
What a delightful current issue of The Economist - a special pull-out section with the title
"Only Human - A special report on central banks and the world economy"
along with a number of other articles on the faults and foibles of central bankers.
Tim Iacono October 21, 2007