Friday, August 15, 2008

Galton's Fallacy and the Myth of 'Decoupling'

A long, long time ago, I wrote my Master's thesis critically examining the neoclassical convergence models tested in a cross-section of country GDP histories (based on the Barro-Baumol regression). In short, these models claimed that poor countries were catching up to richer nations (the "convergence hypothesis").

A few sharp economists, including the late Milton Friedman and Danny Quah, were skeptical of the results that these models were suggesting. Friedman and Quah independently identified problems which they attributed to Galton's fallacy, or regression to the mean (see Quah's paper and Friedman's paper for more details).

"Galton's fallacy" can be traced back to the 19th century statistician and geneticist Sir Francis Galton who plotted the height of fathers against the height of their sons and discovered sons of tall fathers tended to be tall, but on average not as tall as their fathers. Similarly, sons of short fathers tended to be short, but on average not as short as their fathers. He—and this was his mistake—was immediately concerned that the sons of tall fathers are regressing into a pool of mediocrity along with the sons of everybody else.

So what’s the 'fallacy' in Galton's analysis? Well, height tends to be normally distributed—i.e., the distribution takes a bell-shaped form—and sons’ heights are, due to heredity, correlated with the father’s height. So there is a linear dependence between fathers’ and the sons’ heights.

Now, the world has changed considerably since Friedman and Quah wrote their papers in the early nineties. There is little doubt that the BRIC economies (Brazil, Russia, India and China) have made significant gains in the last 15 years. But has the global economy really 'decoupled' from the United States or are people committing similar fallacies on global growth?

I believe that the global economy has not decoupled from the U.S. economy, but the longer than usual lag makes it appear as if it did. Importantly, even though the bubble originated in the U.S., it spread throughout the world and it will take years to undo the damage.

There is increasing evidence that the global economy is heading into the tank (funny how Mr. Blodget is a lot more honest now that he is not a sell-side analyst touting internet stocks!).

Mr. Blodget notes the following:

One reason we've been bearish about the US economy and stock market is that we've never bought the "decoupling" theory. And, slowly but surely, the global economic superpowers appear to be falling in line behind the United State
  • UK headed for first recession in 15 years (and earlier in its property bubble implosion)
  • Germany "growth" now negative
  • Whole Eurozone now contracting: -0.2% in Q2
  • Japan "growth" now negative
  • China slowing (and stock market forecasting a far worse fate)
  • And so on... (I would also incude poor Canadian employment figures)
In fact, "Every region of the world except the Middle East and North Africa -- a beneficiary of high oil prices -- will experience a slowdown this year," Global Insight, a Massachusetts research firm, is quoted as saying in today's WSJ global economic slowdown essay.

An article in today's Times of London discusses how house repossessions in the U.K. have skyrocketed, up 24% to the highest level in 15 years, reflecting the increased burden placed on British borrowers as the cost of living soars. Currency markets are starting to price in weaker global growth as the dollar rally picks up steam.

One of the best articles on this subject, The Myth of 'Decoupling', was written back in January by Desmond Lachman of the American Enterprise Institute.

Mr. Lachman notes the following:

Sadly, the “decoupling” thesis has little support in theory or in practice. Its proponents overlook the fact that during the past five years the U.S. economy grew faster than all the other G-7 economies. During that time, America’s economy remained the principal generator of global aggregate demand, accounting for around one-fifth of global imports and 25 percent of global production. This evidence suggests that, as in the past, if the U.S. economy sneezes the rest of the world will catch a cold.

To be sure, the dip in U.S. housing construction at the start of 2007 did not have much impact on U.S. imports, since America’s housing activity is primarily domestic in nature. However, weaknesses in the housing market are now spilling over into the rest of the economy, which is far more import-intensive than the residential construction sector. Meanwhile, declining home prices at the national level are now damaging consumer sentiment and exacerbating credit problems in the U.S. banking system.

As the credit crisis deepens and banks tighten their lending standards, we can expect more troubles for the non-housing economy. These troubles will be amplified by high global oil prices and a continued drop in housing prices (under the weight of unsold inventories and the resetting of the adjustable rate).

More telling for the rest of the world economy has to be the pronounced weakening in the U.S. dollar since it peaked in 2002. Over the past five years, the dollar has lost around one-third of its value on a trade-weighted basis, as foreigners have grown increasingly reluctant to fund America’s huge current account deficit. This has led to a marked improvement in U.S. global competitiveness, which has helped U.S. exports but hurt foreign economies.

Judging by the rapid pace of dollar depreciation since the onset of the subprime mortgage crisis in August 2007, we can expect the dollar to fall a lot further as the Federal Reserve continues to reduce interest rates aggressively. This will almost certainly deal a further body blow to the European and Japanese economies, whose currencies bear the brunt of U.S. dollar depreciation in a world where many non-Japanese Asian countries manipulate their currencies for competitive advantage.

A number of the shocks presently affecting the U.S. economy are global in nature, and are already slowing European and Japanese growth. The credit crunch flowing from America’s subprime woes is causing a global increase in market interest rate spreads and a global tightening of bank lending standards. This is hardly surprising: almost half of all U.S. asset-backed subprime mortgage securities were distributed abroad.

While the dollar’s decline will make the recent spike in oil prices more sorely felt in America than it is abroad, the oil shock will have global consequences. After all, while the dollar lost about 10 percent of its value in 2007, international oil prices roughly doubled. That leaves oil prices very high even in non-dollar terms.

Mr. Lachman ends his analysis by stating:

The “decoupling” optimists are ever hopeful that China’s rapid growth, together with the rest of Asia’s emerging market economies, will offset any U.S. economic downturn. But they tend to forget that Asia is filled with export-dependent economies: in some countries, exports to the United States alone account for more than 10 percent of annual GDP. The “decouplers” also forget how relatively small these Asian economies still are, at least in relation to the G-7 industrialized economies. Even the vaunted Chinese economy is barely 15 percent the size of the U.S. economy.

Speaking of China, can it really expect to continue increasing exports by 30 percent a year at a time when the industrialized countries are slowing rapidly? In an American election year, one cannot discount the possibility of a large political backlash against China, which is viewed as pursuing a mercantilist trade policy at the expense of U.S. workers. China is acutely vulnerable to a rise in Western protectionism.

Indeed, those who peddle the “decoupling” myth distract attention from what are still very strong global economic linkages. In the process, they undermine the case for a coordinated policy approach to address today’s international economic challenges.

The main point I am trying to get across here is that the world economy has never decoupled from the U.S. economy. There are serious signs of weakness everywhere, including in the commodity markets. The global linkages created by the U.S. housing and securitization crisis are real and they should not be underestimated.

In this environment, geographic diversification is a chimera that will end up hurting investors who look for refuge in international assets.

On that cheerful note, I wish all of you a great weekend.

Update (16-08-08): John Mauldin's latest weekly comment discusses the decoupling thesis in more detail. As always, his weekly comments are a must read for anyone who wants to understand what is going on in the economy and markets.

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