Policymakers have a hard time making sense of the fallacy of composition. We all, of course, now know about the paradox of thrift from our readings of the Great Depression where an excess of private virtue (greater private savings, debt prepayments) led to public doom (fall in effective demand, collapse in broad money supply). More recently we saw another kind of fallacy of composition at work. Our interconnected financial system stood on the verge of disintegration when the rational response for any single financial institution was to cut back on counterparty exposure, but when every other institution wanted to do the same thing it threatened to produce a wholesale collapse. The US Fed’s hub-and-spoke system of liquidity support – and equivalent measures by other central banks as well – was belatedly designed to thwart the market’s self-destructive tendency to freeze credit.
Now there is another fallacy of composition that is slowly coming into view. Yet policymakers in their customary myopic way are either not aware of the problem, or if they are their response lacks coherence. This time again what seems to be a rational policy choice for many individual economies will, if adopted, lead to an adverse outcome for the global economy. That in turn would produce a self-defeating result for the economy whose policymakers were supposedly behaving prudently and rationally.
Yet this is what the authorities in the emerging economies are doing with their very public expressions of worry about asset bubbles. The Chinese have been a particularly nervous lot, though the Brazilians have not been much better. No one doubts that China has delivered impressive growth in the last few quarters, yet their policymakers are unsure on whether this growth will coexist with stability in financial and property markets. The steps they have taken – increasing the reserve requirement for commercial banks, raising the yield on government bills, and using moral suasion to restrain bank credit – have sent volatility rippling through the global markets.
The zeal with which the advanced industrialized economies are now talking about withdrawing fiscal stimulus (in the case of the US and the UK) or reversing structural budgetary deficits (in the case of some European economies) against a background of weak growth is closely related to talk coming out of places like China, Brazil and Russia that serious imbalances are starting to develop in their own economies and something needs to be done about that. The markets are insisting on immediate action on the first if the second is to happen. Western governments, cowed into craven submission, have no choice but to comply.
This is how it works. As my recently published book, SuperCycles, (McGraw-Hill) explains the severity of the financial crisis in both the US and Europe means that the household sectors in both regions will remain impaired for a very long time. The fiscal authorities must necessarily assume the burden of holding up aggregate demand in these economies. But the financial markets would prefer that final demand rotate away from the crisis-hit regions and move to the unburdened economies of the world, i.e., the big emerging markets (EM) who they would like to see become the flywheel for global demand. The only reason such high budget deficits in the developed world have been tolerated for so long by the market vigilantes is that they were always meant to be a temporary solution to a fall in demand. Governments in the developed world cannot do the bailing out if they are to be bailed out themselves.
However, if policymakers in the emerging economies push back – by resisting the nominal appreciation of their currencies as Brazil has tried to do, or reining in domestic demand to choke off inflation or asset froth as China has attempted – then the balancing mechanism breaks down. Inflation and asset bubbles in the emerging economies are therefore integral to global rebalancing. It is the price we must pay for stabilization of the global economy. Only India among the BRICS appears to show some degree of disregard for internal imbalances – and the financial markets would love it if every major emerging market behaved the same way.
It is no coincidence then that worries about the need for fiscal consolidation in Greece, Portugal, Spain and now even the UK are rising as signs abound that the emerging economies want turbocharged growth but not the imbalances that come with it. The real worry should be directed at the Chinese and the Brazilians who may not realize till too late that by restraining their own economies they are forcing a retrenching of demand everywhere else and this would be bad for all, including themselves.