I keep thinking about how the global economy could get out of its present fix.

The story is that everybody needs to export their way out of recession, but, of course, not everybody can. This will be even more true as fiscal retrenchment reduces both government and consumer spending. With economies weak and inventories rebuilt, there would seem to be little scope for investment spending to rise to fill the gap. That leaves net exports as the only available path to growth, and it isn’t one that everybody can use.

One counter to this miserable picture is that emerging markets (EM) are presently importing more goods from stricken Western economies. If this situation can persist for long enough for the developed world to advance the process of balance-sheet repair in the government, household and financial sectors then the West may be able to export its way out of trouble before the next emerging-market crash. Or, at least, the market may believe that it can for long enough for risk assets to rally.

EM imports are partly dependent on strong credit flows into certain emerging markets that have their origins in Western quantitative easing (QE) policies. Consequently there is a risk of a vicious cycle emerging whereby concerns about the health of Western banks based on their exposures to sovereign risk breaks the transmission mechanism between QE and EM credit inflows. That could lead to rising trade balances in the EM and a new recession in the developed world. However, it is hard to be too bearish about this: first, because European politicians are putting together a short-term fix that may alleviate concerns about bank solvency; and second, because China’s bubble is self-funding. China may be tightening, but its monetary policy is still far from tight, and the lesson of bubbles is that they can go on for much longer than anybody believes possible. Continued strength in China should build confidence in EM and make it more likely that QE liquidity flows will return to other EM.

So an optimistic case would be that the developed world is able to grow through net exports during a period of weak consumer spending, government spending and investment (the Eurozone benfiting more than the US as the euro falls), and that EM booms will last for long enough for the developed-world recovery to become self-sustaining. Thereafter the bubbles can burst. Thus the heavy lifting in restoring the world to financial health would be done by those that can afford to do it — EM and, to a lesser extent, the US. The price would be an eventual bursting of an EM credit bubble.

What is wrong with this picture?

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