Bubbles: the fallacy of composition and the fallacy of our times
Category: Thought for the day
Nouriel Roubini, the economist who called the crisis of 2008 more accurately than anyone, has warned we are building one “mother of a bubble.” Truth is, there are some pretty basic principles that are overlooked time and time again.
For a country to grow in a sustainable way it really needs to achieve one thing. It needs to produce more. And for that to occur, it needs either more workers or for existing workers to work smarter. For the global economy to grow, however, something else is required: demand needs to grow too. If growth in productivity outstrips growth in demand, we get unemployment. If it’s the other way round, we get inflation.
Take the equation demand equals supply, there is an important point that gets overlooked. For supply to rise, so must demand. But how can this happen? For demand to rise, so must supply. But which comes first? It is a bit like the chicken and the egg question. So imagine that – thanks to an innovation – all companies across the world can produce more for less input. Global production rises, but demand can only rise if wages and dividends increase in tandem. But wages and dividends cannot increase unless producers first sell the extra goods they have produced, but they can’t do this unless wages and dividends have risen. Do you see the dilemma? That is why I have this suspicion that there simply must be debt if there is to be global growth. You can’t have growth without either debt, or some magical increase in the money supply. But debt can lead to the formation of bubbles, and the creation of money can lead to hyper-inflation. The fact is that in a growing macro- economy there is a permanent risk of a credit bubble or hyperinflation.
Some may criticise the above model and come up with examples of growth occurring even if the conditions I have described were not in existence. But these critics are not seeing the big picture. They are victims of the fallacy of composition. The fallacy of composition relates to this idea that we often fail to appreciate that individual behaviour, which may actually be perfectly logical – even prudent – can have very negative consequences if applied by all. One country may be able to grow on the back of rising production and static demand, but the global economy can’t.
Now let’s look at this idea that we are building one mother of an asset bubble. I covered Roubini’s comments in yesterday’s Bull and bear, See: Has the mother of all asset bubbles really begun?
Central banks via QE are deliberately trying to force up asset prices. They hope that by doing this, companies and individuals will feel richer and will thus spend more. But if asset prices are rising for what to me seem like quite artificial reasons, does this not mean that they are in danger of reaching levels that are simply unsustainable. Perhaps interest rates will rise because of global forces over which not even central banks have any control. At that point we may see an horrendous crash in asset prices.
Sometimes it seems to me that central banks are creating one almighty Ponzi scheme. They are trying to create growth by artificially inflating asset prices, and that surely must end in tears.
That may be right, but the fallacy of composition strikes here too. Remember, money has to go somewhere. If it doesn’t go into bonds, maybe the only serious place left for it is equities. Central banks, by operating such loose monetary policy, are trying to persuade markets to sell bonds and buy other assets. Remember when stocks crashed in 2000, money flooded into bonds, and leverage became more popular. Perhaps the only way you can have a fall in all asset prices is if the money supply contracts.
There is a missing ingredient, however. We can have falling asset prices and a rising money supply if at the same time we see a growth in the number of assets. For example, it is possible to see falling house prices and a rise in borrowing, if the stock of property also increases. And that surely is what we want. We don’t really want asset prices to rise at all. We just want to see the creation of more assets – that’s real assets by the way, backed by solid things such as property, equipment, knowhow or inventory.
We want to see more wealth being created. If QE can achieve that, then it is no Ponzi scheme. Alas, right now, I see precious little evidence that it is achieving that.
These views and comments are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees