Seven Questions: A Much-Needed Correction

China Photos/Getty Images NewsJust a blip? Chinas turbulent stock market bears watching.

FOREIGN POLICY: Observers have suggested a number of different reasons for last weeks stock market stumble. What do you think was the main cause?

Stephen Roach: The correction in the Chinese stock market was a very important development. There were new doubts that surfaced with respect to the outlook for the U.S. economy. Those were the two dominant factors. There were other causes: the yen carry trade, or investors simply being caught complacent on a number of risky assets. Those were all facets. But the fundamental story from my point of view was a real one. This was not a trading accident, and it was made in China and America.

FP: Given that the Chinese stock market is still mostly state controlled, and not very well linked to the rest of the world, why was it able to spark such trouble?

SR: The Chinese stock market had doubled from August through late February. It was emblematic of a huge surge occurring in emerging-market equities and debt. The correction that arose in Chinawhether it was state directed or notforetells what could be a meaningful, but desirable, slowdown in the Chinese economy. Premier Wen Jiabao echoed this message when he made his opening statement to the National Peoples Congress in Beijing on Monday, warning of a slowdown to 8 percent, which is still very strong, from the 10.7 percent gains from last year.

FP: What lessons should policymakers take away from what happened?

SR: [Prior to last week], we had seen a dangerous build-up of complacency around the world by investors, by policymakers, and by politicians. And markets were pretty much ripping on their own. The trading action that I thought was most disconcerting was in what has traditionally been the riskiest of assets: high-yield corporate credit in the United States or in Europe, emerging-market debt, and emerging-market equities, where spreads in debt markets had gotten down to levels wed last seen in the late 1990s.

Policymakers, by targeting inflation in the narrow sense, whether its the consumer price index (CPI) or some type of consumption deflator, were ignoring an important responsibility in managing risk and financial market stability. Its very important for central banks, in particular, to have a broad perspective on their mandate, and not ignore the excesses that can build from time to time in asset markets.

FP: Do you think that policymakers have learned these lessons, though?

SR: No, I dont, and that discourages me. The orthodox approach to running a monetary policy now is that if you are successful in achieving price stability in the narrow senseagain, by a CPI or consumer deflatorthen any and all problems that may arise outside of inflation targeting will take care of themselves. And Im very critical of central banks for doing that. At low levels of narrow inflation, running monetary policy with extremely low nominal interest rates sets the stage for one asset bubble after another. And the record in the last 10 years is terrible. Weve had an equity bubble, a property bubble, a bubble in subprime mortgage debt, bubbles in emerging-market debt and high-yield corporate debt. This is an outgrowth of central banks that are acting irresponsibly in the context of their broader financial stability mandates.

FP: Your viewpoint is pretty bearish relative to those of other observers and commentators. What is it, either from your experience or your insights, that leads you to a more pessimistic conclusion than others?

SR: Well, Ive been examined by leading physicians and geneticists, and so far they havent determined anything terribly abnormal in my physical makeup. But I am very suspicious of the view that market fundamentals are sound. The standard response [to last weeks drop] is to say that this was just a market eventits a blip, the fundamentals are sound, and nothing has impacted the underlying strength of the global economy. In many respects, those statements are made by political figures or policymakers who have strong political leanings, or by sell-side analysts who want markets to just rebound and resume their sharp upward assent.

In China, I do see some legitimate reasons for a marked slowdown. In the United States, this post-housing bubble shakeout is going to end up being a lot more serious than most people think. When we woke up last Tuesday, not only did we get news of a huge drop in the Chinese stock market, but earlier in the day in the United States we also got a hugely disappointing report on capital goods orders. It was the fourth disappointment in the last five months. This was one of the sectors that was supposed to be resilient and underscore the case that the U.S. economy had this amazing knack for walling off problems. As the capital expenditures outlook darkens, that [belief] will be drawn into serious question. The one sector thats hanging in there is the consumer, and my guess is thatll be the next shoe to drop. But right now thats a guess, and so far it looks like Im wrong.

FP: Were there any big winners from last weeks shake-up?

SR: I think China comes out as a winner in this. Theyve come to the realization that their current growth recipe is unsustainable. Its just loaded up with too many exports and too much fixed investment, and is really deficient in private consumption. So they have to rebalance their economy, and they have to take a hit on their growth rate to do it. But if taking a hit on the growth rate means slowing from 10.7 to 8 percent, sign me up. Its not bad news. If the Chinese stay the course and move to a somewhat slower growth path, provide support for private consumption, and start to deal with issues like their social safety net, the environment, and income distribution, then theyve sown the seeds of a very sustainable, long-lasting expansion. Thats terrific news for them. But if they back away here, then theyre back in the soup again.

FP: What do you think could be the spark for the next financial crisis?

SR: I have no idea. But the one thing that keeps me awake at night in terms of crisis-type developments would be an enactment of some sort of protectionist legislation, aimed at China, coming out of Washington. That would really raise the risk that the Chinese would not participate in some upcoming Treasury auctions to the extent that they have in the past, with big consequences for the dollar and long-term U.S. interest rates.