Fallacies of composition

posted in: Economics | 6

On this morning’s BBC Radio Four “Today” programme, a generally unimpressive interviewee from HSBC said that “you don’t solve a debt problem by borrowing more” or something to that effect. He also used that dreary cliche about kicking the can down the road, an American expression which lost its power to impress many months ago. Leaving aside the question of whether HSBC is the first place you would go for an expert view on the bond market, this statement is both true and false.

In the long run, a country with too much debt must find a way to reduce its debt to GDP ratio. Obviously. But this is not a helpful piece of advice to Greece or other indebted countries. I don’t mean in the trivial or pedantic sense that what matters is debt relative to GDP, so you can increase your debt level if you increase your GDP even faster. The sense in which it is not true is that if every country tries to cut its debt at once the collective result may be more debt and a lower GDP.

As many commentators have rediscovered in recent months, what is true for an individual Euro member country is not necessarily true for the whole Eurozone. More generally, German and other experts on the Euro crisis have been guilty of a fallacy of composition. This means falsely assuming that what is true of the parts is true for the whole. Concretely, since the Eurozone is more or less a closed economy (it has a roughly zero balance of payments with respect to the rest of the world, which is not the same thing but is near enough for this purpose) policy measures which are rational for individual open economies are potentially disastrous for the whole zone. This argument was nicely put by Wolfgang Munchau in his excellent weekly Financial Times column last week.

As is so often the case, the origin of this line of thinking in economics goes back to Keynes, who more or less invented macroeconomics. He gave the example of the paradox of thrift. If everyone in an economy tries to save more by cutting his or her spending, the result is that everyone’s income falls and overall saving is reduced not raised. This is because everyone’s income comes from someone else’s spending. So what is rational for one person is collectively irrational.

So German advice for all Eurozone nations to be like Germany and run a surplus is both unhelpful and to some extent rather stupid. It is possible in principle for the whole Eurozone to run a surplus with respect to the rest of the world economy but as this is one of the three largest economies in the world, it would downward pressure on global GDP and be very unwelcome to both the US and China, the other two large economies in the world. Either the German politicians understand this and are therefore dishonest or they don’t in which case they are criminally ignorant. I’m not sure which is the case.

This chart shows the balance of payments deficits and surpluses of the main Eurozone economies (expressed as a percentage of GDP). Since about 2001 Germany has been in surplus and the other countries in deficit. Overall they sum roughly to zero. It is not feasible for all the economies to copy Germany and the attempt would lead to an even deeper European recession. (Note that Germany also had a surplus until reunification imposed a massive cost on the economy through the 1990s.)

As for Greece, even though the government has done more than could have been expected in terms of restructuring and raising taxes, it finds itself losing the battle to hit its deficit to GDP target because GDP keeps shrinking. But the economy is contracting at least partly because of the attempt to shrink the government deficit. A relatively closed economy with few sources of export income beyond tourism, Greece is therefore more likely to achieve long term debt to GDP stability if it eases off its deficit reductions and allows the economy to recover. But this is politically infeasible given the understandable distrust by others of Greek governments. Greece is therefore condemned to more cuts, shrinking GDP and continued failure to hit its targets. In the near term it will get more debt from the Eurozone bailout process until the inevitable happens and it is allowed to default on at least half of its debt.

6 Responses

  1. Lesley

    Thanks for the analysis Simon.(a rather nice addition to the lecture note!)

    I find the point of seeing eurozone as a “closed economy” (apart from Germany I guess) a way to simplify what’s going on in Europe right now. But looks like most of the European leaders are not aware of that yet?

  2. Ian

    Doesn’t this essentially highlight the fallacy of the European monetary union? Was it not foreseeable that imbalances would arise and there would need to be a way to rebalance (i.e. change the relative value of currencies)?

    There are only three solutions that I see:
    – constant and growing transfer of wealth from rich to poor.
    – migration of populations from poor to rich.
    – divide, default and devalue.

    which do you advocate?

    It’s a nice Keynesian fantasy to believe that debt is a mathematical abstraction unlinked to the real world, but at some point no one wants to lend you any more money. At that point the arguments of ‘money multipliers’, positive feedback loops, and zero-sum games are irrelevant (just ask Zimbabwe).

  3. Antony Mueller

    Less worse than the regular Krugman pitch, but faulty nevertheless because it is just not true that “German and other experts” ask the rest of Europe to have current account surpluses as well. Taylor implies that economists other that Keynesians are dotty. Maybe it’s the other way round. Anyway, historically speaking, any advice that has come from the Keynesians over the past six decades on this and the other side of the Atlantic would have been ruinous if followed on the continent.

  4. andy

    If the key is reducing the GDP to debt ratio, there are two options provided your asset holdings are sufficient. Reduce debt or increase GDP. If you were sure more borrowing could increase GDP, would this not be the least painful route for your nation to take?

  5. Phaedrun

    Nothing you can’t pick up from an intro level Econ class. Same case across the Atlantic-half a million public jobs slashed which offsets gains in private employment. The reason-Republicans in Congress refusing to move from the theology of slashing deficits in the midst of anemic growth. Across the board,whether it’s the CDU in Germany,the GOP in the US or the Tories in England-the theology of contracting deficits has hurt growth, jobs and real people.
    So-why don’t we ponder a constitutional amendment that would lead to a stipulated Monti-esque takeover when politicians repeatedly fail to deliver? Such as giving technocrats a mandate to overtake some power or all for a time-frame till unemployment falls below a certain level? Remember the ravages of recessions before independent Central Banks? Why cant we just have people at the helm who know what they’re doing? Their terms can be constitutionally limited to ensure they don’t make a power grab.

  6. Ray Lopez

    A famous mathematician named Gobel showed every argument has an a priori weakest link. So examine yours please: “But the economy is contracting at least partly because of the attempt to shrink the government deficit” Nice covering language “at least partly”.

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