This was originally published on www.ft.com on August 10, 2009.

Decoupling versus Recoupling Remember Statler and Waldorf, the Muppet characters that heckled performers from their balcony seats? In one of my favorite sketches as a child, the duo talk themselves into a full circle: initially praising a performance only to pan it before praising it again.

This roundtrip is reminiscent of the decoupling versus recoupling debate and it risks clouding issues that have consequences for both investors and policymakers. Specifically, while decoupling is a reality, the international dimensions are much more nuanced than suggested by traditional analyses. As a result, investment and policy implications are skewed.

The decoupling camp was firmly in control in the run-up to the “sudden stop” experienced by the global economy in the last 3½ months of 2008. Emerging market (EM) growth was buoyant, and self-insurance (in the form of large and growing reserve cushions) insulated many of them from the disruptions being experienced by the U.S. financial sector. As a result, market consensus increasingly viewed emerging economies as the growth locomotive for a world looking to reduce its dependence on highly-indebted U.S. consumers.

Recoupling proponents regained the upper hand in October when the post-Lehman disruptions in global payments and settlements halted trade financing. The consensus characterization of EM flipped – from global locomotive to caboose – as these economies outpaced industrial countries in experiencing sharp contractions in activity and asset prices.

With the ongoing normalization of the financial system, the decoupling camp is again in strong ascension today. It is buoyed by the developing pick-up in economic activities and the fact that equity valuations are now back above the pre-Lehman levels.

To some, this round trip illustrates how flimsy market consensus can be. Others see it as indicative of the fluidity of a global economy experiencing cyclical shocks and secular realignments. To me, it is an important reminder of the need to be much more specific in the analysis – an approach that confirms that decoupling is real but qualifies its spillover effects.

Some notable emerging economies (including Brazil, China and India) are exiting the global financial crisis with an ability to sustain significantly higher medium-term growth than industrial countries. This reflects stronger financial conditions, greater policy flexibility and, most importantly, the beneficial impact of a multi-year development breakout phase. As such they offer investors the potential of more attractive risk-adjusted returns: greater upside in the event of a global V-shaped recovery, and lower downside risk in the more likely event of sluggish and uneven global growth.

The international dimensions of the decoupling process are much more nuanced than suggested by consensus analysis. Specifically, the beneficial spillover impact of a unit of growth in emerging economies varies a great deal from country to country.

Overall, while emerging economies’ contribution to global growth will continue to rise, they are not yet in a position to act as a powerful locomotive for industrial countries. The base effects are still low; and part of the growth is based on transient factors, including a huge stimulus in China. Moreover, like their industrial country counterparts, governments will come under more pressure to better “internalize” the impact of their stimulus spending.

Investors looking to pursue the generalized international dimensions of decoupling should await signals of sustainable consumption growth in emerging economies and, more generally, an accelerated shift in policy emphasis from the producer to the consumer. Milestones include more aggressive measures to strengthen social safety nets and greater exchange rate flexibility. Pending such progress, investors should adopt a highly differentiated approach. They should emphasize deeply integrated regional transmission mechanisms and, in the case of China, also commodity-based linkages. They should not expect EM growth to materially improve the difficult outlook for industrial countries activity.

This also speaks to the skew in the policy implications. Growth in emerging economies will not do much to alleviate what is quickly becoming the major policy issue in industrial countries – namely, high and rising unemployment, combined with sluggish wages. Indeed, as the growth gap widens in favor of EM, industrial country governments will face even greater protectionist pressures. Their ability to counter them would be facilitated by actions in emerging economies to accelerate the handoff of demand growth from the government sector to consumption.

Mohamed A. El-Erian is chief executive and co-chief investment officer of PIMCO. His book “When Markets Collide: Investment Strategies for the Age of Global Economic Change” won the 2008 FT/Goldman Sachs Business Book of the Year.