The Fallacy of the Fallacy of Composition
No unarmed profession has done as much harm as economists.
Recently, Yukio Hatoyama, the new Japanese Prime Minister, proved it again…revealing a budget deficit that must have made Paul Krugman drool. The Japanese government will spend 92.3 trillion yen next year, about 1 trillion dollars. Tax receipts will be enough to cover only half that amount, leaving the nation with the biggest shortfall since WWII.
It is obvious to everyone but an economist that spending twice as much as you earn is not a formula for real prosperity. And it is obvious to anyone but investors that buying Japanese debt is asking for a kick in the pants. But these are the same economists who mistook the bubble world of 2003-2007 for genuine prosperity and the same investors who bought dotcoms in ’99 and mortgage finance companies in ’07.
Mr. Hatoyama portrayed his spending spree in humanitarian terms. It was aimed at “saving people’s lives,” he offered. This is a big change, he explained; previous spending initiatives have been intended to channel rivers and create parking places. So bountiful were these public works projects that, in the ’90s, Japan poured more concrete than any country on earth, prompting one commentator to refer to Japan’s stimulus efforts as “state-sponsored vandalism.”
Effacing the landscape did little to bestir the economy. The concrete hardened, but the markets gave way. More wealth was lost than in any other country at any time in history. Commercial real estate dropped 87%. Banks lost $1 trillion as they wrote off bad loans in the property sector. Golf club membership prices dropped 95%. Stocks ebbed down for 20 years and then hit a new low in March of 2009. After 20 years of bear market, they were back to 1982 levels. In the real estate and stock markets alone, $15 trillion was wiped out, an amount equal to three times the GDP of the entire country. By way of comparison, during America’s Great Depression, between ’29 and ’33, only 1 times GDP was erased.
“Everyone was bankrupt,” concludes Nomura Securities’ chief economist, Richard Koo.
The trouble, according to most economists, was that what was good for individuals wasn’t good for the whole economy. As businesses and consumers paid down debt the money went into banks and didn’t come out again. How could it? No one wanted to borrow; they wanted to save. Sales fell. Then prices fell, prompting consumers to save even more. The more the private citizen repaired his finances; the more the finances of the nation fell apart. This is known in economics as the ‘fallacy of composition,’ which is to say, the whole is not the same as the parts. You may have all the parts of a cow in your freezer; but don’t expect it to moo.
Richard Koo believes Japanese economists pulled off a great triumph. Monetary policy didn’t work; consumers wouldn’t borrow and banks wouldn’t lend. But huge dollops of fiscal stimulus kept the wheels turning. The private sector cut spending; the public sector put it back. As a result, GDP never fell below its 1989 high…and unemployment never rose above 6%.
It’s too bad the world is not a simpler place. If it were, the fallacy of composition might make sense…prosperity might be as easy as maintaining positive GDP growth…and economists such as Koo and Krugman might be worth a damn.
But the fallacy of composition is a fallacy…at least as applied by modern economists. There comes a time when a man should sober up, even though the hangover is unpleasant. But while Japanese households were drinking strong coffee, Japan’s economists refused to allow GDP to fall; they put zombie companies on life support; and they kept the doors on the banks open. This not only prevented a new economy from arising, it cost money. As the citizens paid off debt, the government borrowed in their names. While households repaired their private balance sheets, government destroyed the balance sheet of the entire nation.
Now, after 20 years, the private sector has had time to pay down its debts. Corporate debt-to-GDP levels are back to 1956 levels. Japanese households have more net savings than any others in the world. But instead of tapering off its deficits, they grow larger and larger. Why? Because deficits no longer stimulate the economy; they ARE the economy. The Japanese tried to cure an alcoholic with heroin. Now, they’re addicted to it. Take away the stimulus now, says Koo, and the economy gets the shakes, tax revenues fall and deficits actually grow larger.
Asked ‘what is the most effective form of fiscal stimulus,’ Mr. Koo replied: “military spending…because it increases demand without increasing supply.”
Only an economist or a fool could believe such an obvious fraud. The Japanese fought the downturn by adding to the supply of bridge abutments. They might just as well have bought aircraft carriers. The taxpayer now has concrete up the kazoo, and a public debt that’s headed to 300% of GDP…or to Hell…whichever comes first.