I have no idea where oil prices are headed, but I would offer a couple of observations before you crack out the champagne. First, soaring oil prices did absolutely no damage on the upside to either the American consumer or the global economy. Nominal oil prices essentially doubled from 2003 to 2005, while real consumption growth in the United States accelerated from 2.7% over the 2001-03 period to 3.7% over the 2004-05 interval; meanwhile, world economic growth averaged 4.9% over the past four years -- the strongest burst of global growth since the early 1970s. The ex post rationale for this seemingly paradoxical outcome is that it matters whether surging oil prices are an outgrowth of supply or demand. In the past couple of years, the price spikes are now viewed as an endogenous implication of robust demand -- so, of course, they didn’t hurt. Now, however, the hope is that falling oil prices will boost economic growth because the decline is coming from improved conditions on the supply side of the energy equation. In other words, the oil price has changed stripes -- what didn’t hurt will now help.

Convictions are deep that a $46-trillion world economy has acquired a new Teflon-like resilience. On the surface, recent events appear to bear that out: Despite unprecedented outbreaks of terrorism, mounting geopolitical instability, soaring oil prices, and the bursting of a major equity bubble, the global economy has hardly skipped a beat. In fact, by the IMF’s metrics, world GDP growth appears to have surged at a 4.9% average annual rate over the 2003-06 period -- the strongest four-year global growth spurt since the early 1970s. And most forecasters, including those at the IMF, are banking on a similar outcome for 2007. Is this resilience a new organic feature of an increasingly globalized world, or has it come at a much greater cost than widely appreciated?

As I travel the world, I sense something big is brewing in the mix of industrial world economic activity. Four years ago, there were whispers of revival in Japan. They came mainly from the business sector, where a massive restructuring was gathering momentum. Anecdotal at first, these reports turned out to be an accurate portent of a stunning turnaround to come in the Japanese economy. Today, there are similar whispers in Germany. I have been to Germany twice in the past three weeks, and in meetings with a wide range of German business managers, the verdict was nearly unanimous — a powerful restructuring is now bearing fruit. Like the case in Japan a few years earlier, this could well be the start of a reawakening in the world’s third-largest economy.[...]

I have always thought that a German turnaround would hinge on the productivity story. From this perspective, there are grounds for encouragement on three fronts — the labor market, IT spending, and corporate restructuring. Yes, Germany still has one of the world’s highest-cost labor forces, with hourly compensation in manufacturing of $32.53 in 2004 — nearly double the $18 average for the industrial world, according to the US Bureau of Labor Statistics. And, of course, the fixed costs associated with the hiring and firing of German workers remain prohibitive. The good news is that Corporate Germany has responded to this cost disadvantage by moving to an increasingly flexible work force. Germany’s so-called “flexi-workers” — part-time and contract temps — now make up over 40% of the country’s total labor force; that’s up over 10 percentage points from the flexi share of a decade earlier. Meanwhile, once powerful German labor unions have lost their swagger, and the shortened workweek has increasingly fallen by the wayside. Yes, Germany still has a very rigid, high-cost labor market — but less rigid and less costly than was the case just a few years ago.[...]

The cyclical bear case for commodities has three legs to its stool -- the Chinese producer, the US housing market, and the asset allocation call. The China factor is, by far, the most important element on the demand side of the commodity equation. Over the 2002-05 period, China’s share of the total growth in global consumption of industrial materials was off the charts: 48% for aluminum, 51% for copper, 110% for lead, 87% for nickel, 54% for steel, 86% for tin, 113% for zinc, and 30% for crude oil (see Chapter 5 of the IMF’s September 2006 World Economic Outlook as well as my 2 June dispatch, “A Commodity-Lite China”). China’s powerful growth dynamic is both rapid in the aggregate and skewed heavily toward exports and fixed investment -- a sectoral mix that favors commodity-intensive activities such as urbanization, infrastructure, industrialization, and residential construction. As long as this growth dynamic remains intact, China’s demand for commodities would appear to be insatiable. That is what is now changing.

There are three key elements of a rebalancing policy agenda: First, US authorities must act to temper the consumption excesses of an asset-dependent economy. Tax policy should be used to alter the tradeoff between consumption and saving. Some form of a consumption tax -- either a national sales tax or a VAT -- would make good sense in the current climate; not only would it encourage saving but it would also broaden the tax base and lower the budget deficit -- thereby boosting national saving and reducing the US current account deficit. The US must also run a tighter monetary policy aimed at curtailing the expansion the excess liquidity that has long fed its multi-bubble syndrome.

For most of the last decade -- and especially over the past four years -- it has been a one-consumer world. But now as the over-extended American consumer weakens in a post-housing-bubble climate, the world growth dynamic could falter as a result. For that not to happen, the baton of global economic leadership has to be transferred quickly through the exquisitely well-timed handoff that many still seem to be counting on. For reasons I have long advocated, I don’t think another consumer is capable of stepping up and filling the void (see my 28 August essay). Nor do I believe that another sector in the US economy, such as business capital spending, will take up the slack. Too much of the incremental capex decision is heavily conditioned on the expected state of end-market demand. A likely slowing of US consumption is a distinct negative in that regard.

All in all, a post-housing bubble shakeout could entail a haircut of at least two percentage points off the overall US GDP growth rate -- 1.5 percentage points via the construction effect and another 0.5 percentage point from the wealth effect. The overall impact could even be larger if households elect to rebuild income-based saving balances -- hardly unusual in light of the looming retirement of some 77 million baby-boomers. The repercussions of multiplier effects through construction-related hiring shortfalls could also compound the problem. For a US economy that has been growing at a 3.2% average annual rate over the past three years, a two percentage point haircut does not guarantee a recession. But it certainly could end up being a close-enough call that might trigger a recession scare in financial markets. The hope, of course, is for the exquisitely well-timed handoff -- a seamless transition from asset-dependent consumption to other sectors, such as capex and net exports. I remain suspicious of such claims of built-in resilience. If the US consumer slows, the demand expectations that typically drive capital spending will also weaken. So, too, will the growth dynamic of America’s export-led trading partners -- thereby undermining support for US exports, as well. In short, for a wealth-dependent US economy, the bursting of another major asset bubble is likely to be a very big deal.

Inasmuch as China remains very much a “blended economy” -- a combination of a state- and market-directed system -- the verdict on its current tightening campaign is far from convincing. A shift in monetary policy achieves traction only when the banking system and financial markets are fully developed -- something that is still very much lacking in China today. At the same time, state-owned enterprises -- which continue to account for between 30-40% of the Chinese economy -- behave very differently than private and publicly owned businesses. The former are not motivated by market signals nor influenced by policy actions designed to impact markets. The persistent regionalization of the Chinese economy also complicates any macro tightening campaign, leaving a highly fragmented China largely insensitive to Beijing-directed cooling off measures. Recent punitive actions aimed at regional officials in Inner Mongolia pay lip service to this aspect of the problem but do little to challenge the runaway growth still concentrated in coastal China.

I do not think there is any doubt that the US housing cycle is now turning. The questions pertain more to scope, speed, duration, and depth of the coming adjustments. In an era of financial-market deregulation -- especially since deposit ceilings in mortgage lending institutions were eliminated by the early 1980s -- residential property cycles have taken on a life of their own. As a result, both the uplegs and the downlegs have lasted far longer than standard business cycles. The data flow has certainly shifted to the downside -- namely, mounting inventories of unsold homes, declining mortgage loan applications, rising financing costs, and anecdotal reports from builders and realtors.

I continue to believe that the global economy is now in better shape than financial markets. The stewards of globalization have finally woken up to the perils of ever-mounting global imbalances -- the major macro issue that has concerned me for nearly four years. But the policy requirements of rebalancing are not without risks --especially since they entail a withdrawal of excess liquidity. In my view, the risk aversion trade that began in early May should be seen as a venting of the tension between global rebalancing and a potential shift in the liquidity cycle. Financial markets may not have seen the end of this adjustment...

...it is possible that emerging market securities have benefited largely from the combination of excess global liquidity and an increasingly urgent search for yield by fund managers. If that’s the case, and the liquidity cycle now turns, a sustained correction could well be in the offing...

I think there is an important implication of the Fed’s hair-trigger response to an arguable inflation scare: After years of excess accommodation, the US central bank may be trying to reclaim the "tough-guy" image that a credible monetary authority needs. And there is good reason to believe this sentiment is global in scope. Recent monetary tightenings by the ECB and by central banks in India, Korea, Turkey, South Africa, and even Iceland all speak to a similar disciplined mindset. And these actions all have comparable implications for the global liquidity cycle and world financial markets -- reducing the flow of high-octane fuel that has fed the multiple asset bubble syndrome of the past seven years.

If India is to services as China is to manufacturing, what role does that leave for the high-cost developed world? Down the road, if India also succeeds in pushing into manufacturing while China makes successful forays into services, the same question becomes all the more threatening to the world’s major industrial economies. Protectionism is the biggest risk in all this. IT-enabled globalization is pushing economic development into manufacturing and services at a breakneck pace. Moreover, IT-enabled connectivity has increasingly transformed once non-tradable services into tradables -- and has moved rapidly up the value chain and occupational hierarchy in doing so. The result is a mounting sense of economic insecurity in the developed world that has become a lightning rod for political action that, unfortunately, has unleashed an increasingly worrisome protectionist backlash.