Two Views: Blame It on Beijing Redux, or Joint Determination

From the abstract to Why are we in a recession? The Financial Crisis is the Symptom not the Disease!, by Ravi Jagannathan, Mudit Kapoor, and Ernst Schaumburg:

…We argue that the large increase in the developed world’s labor supply, triggered by geo-political
events and technological innovations, is the major underlying cause of the global macro economic
imbalances that led to the great recession. …

… The inability of existing institutions in the US and the rest
of the world to cope with this shock set the stage for the great recession: The inability of emerging
economies to absorb savings through domestic investment and consumption due to inadequate national
financial markets and difficulties in enforcing financial contracts; the currency controls motivated
by immediate national objectives; and the inability of the US economy to adjust to the perverse incentives
caused by huge money inflows leading to a breakdown of checks and balances at various financial
institutions. …

The paper concludes:

While there is plenty of blame to go around for mistakes, the macro forces triggered by
the labor shock is like a tidal wave that needed to wash ashore no matter what. History
might have taken an entirely different path with better risk management controls in place
in the US but then again, financial innovation might just have found a different way of
getting highly leveraged deals done off-shore or through creative accounting. The root
cause of the excess liquidity in the global financial system must be addressed, otherwise we
are just squeezing the proverbial balloon only to see it bulge out somewhere else. However,
this does not negate the need for the development of improved risk management in the
broadest sense in order to ensure financial stability and prosperity going forward.


China and India will continue to need to bring tens of millions of rural laborers into the
productive workforce in the coming decades and the world economy must find a sustainable
way of dealing with this influx. Clearly China’s export led growth strategy of the past cannot
continue indefinitely and domestic consumption will have to grow as a share of GDP. At
the same time, Western economies will necessarily have to adjust to a new equilibrium in
which commodities are scarcer and households face stiffer competition for jobs.

This is a long paper (38 pages of text and graphs), and there’s lots to digest. It’s interesting that US budget deficits and tax policies make not a single appearance in the text (well, not quite — “low taxes” are made possible by the saving glut, on page 6; and the budget balance shows up as a figure on page 16). Pretty remarkable; below is the latest version of a picture I’ve presented many times on this blog.


busnx1.gif

Figure 1: Net exports to GDP ratio (blue), and cyclically adjusted government budget balance to GDP ratio, lagged 2 years (red). NBER defined recessions shaded gray, assumes last recession ended in 09Q2. Source: BEA, 2009Q2 3rd release, CBO, Measuring the Effects of the Business Cycle on the Federal Budget: An Update, September 1, 2009, NBER and author’s calculations.

In any case, my reasons for looking askance at the the “Blame It on Beijing” view are laid out here:

…while I won’t say that the idea of saving flows coming from East Asia had some role in the financial crisis we’re now undergoing is completely without content, I’d say one has to think about how those flows came about, as much as how big they are. We don’t usually think of the rest-of-the-world driving macroeconomic events in the US (here’s my take: [10]), and I still don’t think it’s time to start.

For my money, I think a more plausible worldview is provided by Maurice Obsteld and Ken Rogoff (h/t Mark Thoma). In the intro to “Global Imbalances and the Financial Crisis: Products of Common Causes,” they write:

We too believe that the global imbalances and the financial crisis are intimately
connected, but we take a more nuanced stance on the nature of the connections. In our
view, both of these phenomena have their origins primarily in economic policies
followed in a number of countries in the 2000s (including the United States) and in
distortions that influenced the transmission of these policies through financial markets.
The United States’ ability to finance macroeconomic imbalances through easy foreign
borrowing allowed it to postpone tough policy choices (something that was of course true
in many other deficit countries as well). Not only was the U.S. able to borrow in dollars
at nominal interest rates kept low by a loose monetary policy. Also, until around the
autumn of 2008, exchange-rate and other asset-price movements kept U.S. net foreign liabilities growing at a rate far below the cumulative U.S. current account deficit. On the
lending side, China’s ability to sterilize the immense reserve purchases it placed in U.S.
markets allowed it to maintain an undervalued currency and postpone rebalancing its own
economy. Had seemingly easy postponement options not been available, the subsequent
crisis might well have been mitigated, if not contained.


We certainly do not agree with the many commentators and scholars who argued
that the global imbalances were an essentially benign phenomenon, a natural and
inevitable corollary of backward financial development in emerging markets. These
commentators, including Cooper (2007) and Dooley, Folkerts-Landau, and Garber
(2005), as well as Caballero, Farhi, and Gourinchas (2008) and Mendoza, Quadrini, and
Rios-Rull (2007), advanced frameworks in which the global imbalances were essentially
a “win-win” phenomenon, with developing countries’ residents (including governments)
enjoying safety and liquidity for their savings, while rich countries (especially the dollarissuing
United States) benefited from easier borrowing terms. The fundamental flaw in
these analyses, of course, was the assumption that advanced-country capital markets,
especially those of the United States, were fundamentally perfect, and so able to take on
ever-increasing leverage risklessly. In our 2001 paper we ourselves underscored this
point, identifying the rapid evolution of financial markets as posing new, untested
hazards that might be triggered by a rapid change in the underlying equilibrium.

Obstfeld and Rogoff are pre-eminent economists working in the international finance field (as opposed to domestic macro and monetary economics). As Paul Krugman has pointed out, international finance types have typically been less enthralled about untramelled financial deregulation, and the self-regulating abilities of financial markets (currency and financial crises being a topic we discuss). So far, such skepticism seems to have been validated by recent events.


See also this discussion of an earlier presentation by Obstfeld and the Chinn and Frieden view.


Update 10/15/09, 10:40am:


jag.gif

Figure 2: Net exports (blue), trade balance on BoP basis (red), budget deficit (green), and budget deficit lagged 2 years (purple), all expressed as ratio to GDP. Source: R. Jagannathan.

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39 thoughts on “Two Views: Blame It on Beijing Redux, or Joint Determination

  1. DickF

    Menzie wrote:
    It’s interesting that US budget deficits and tax policies make not a single appearance in the text…
    This is not all that remarkable when you understand where the analysis is coming from. But what is more amazing to me is that nowhere, not Ravi Jagannathan, Mudit Kapoor, Ernst Schaumburg, Maurice Obsteld, Ken Rogoff, Menzie Chinn mention government fiscal mistakes and Fannie and Freddie just no longer exist nor does it seem they existed in the past if you read the current analysis.

  2. ppcm

    If well understood the theory as laid out:
    A supply side economy backed by technological inovations (they are numerous which one has/had such an impact?)
    As long as one country can print money and can exhibit positive growth differential with the creditor country Rf – Pf is irrelevant.
    A benevolent creditor and a reluctant consumer
    Fine we have the rosette stone but how do we explain this situation and how do we solve it?
    http://research.stlouisfed.org/fred2/series/LLRNPT?cid=93

  3. Steve Kopits

    Ravi Jagannathan, Mudit Kapoor, and Ernst Schaumburg express my sense of this recession exactly.
    Certainly, policy of the Fed exacerbated the severity of the recession, but there was an awful lot of liquidity in China, and it does appear likely that this liquidity would have shown up somewhere, even if not in US housing.
    We had a panel on the Great Recession here at the ASPO Conference in Denver yesterday (moderated by yours truly), and there was considerable skepticism on the panel (if I am interpreting correctly) that a central bank and senior decision makers would have the political will to take away the punch bowl when there’s a go-go economy. So, it would seem that nothing has changed and we may expect a repeat of this sort of event in the future.
    On another topic, here’s the score regarding economists quoted at the conference:
    James Hamilton: 3 mentions
    Menzie Chinn: 1 mention
    All other economists: 0 mentions
    It’s amazing what impact running a blog can have.

  4. Steve Kopits

    On regulation:
    There is a recurring theme in your pieces that liberals (fiscal conservatives) want no regulation. As a practical matter, liberals (as opposed to some libertarians) acknowledge public goods and externalities (following Adam Smith). Therefore, the ability of a transacting party to count on the ability of a counter-party to pay up is a critical property right and some measures are warranted to insure this capability. This is particularly true for conditional or time-displaced transactions like those related to insurance or pensions.
    Therefore, many–if not most–liberals (fc’s) would agree that steps need to be taken to insure that the counterparty can pay if called upon to do so. The sort of default insurance written by AIG does not appear to meet this criteria, so some form of regulatory intervention appears warranted and in place to prevent it doing so. As a free market sort, I am appalled that the regulators let AIG get away with it.
    Second, a free market view is not incompatible with the notion that systemtic risks exist and matter, and that we can apply some provisional cost-benefit analysis to certain securities to see if they should be allowed. Naked credit default swaps would appear to be securities that should be prohibited, as they do not appear (best I can tell) to add to economic efficiency and yet collectively represent systemic risk.
    So liberals are about protecting the property rights of the individual, but in certain cases, these rights may conflict with the right to voluntary interaction.
    On the other hand, liberals have serious reservations about much of regulation, for a number of reasons. Regulations often represent populist priorities rather than technical considerations related to risk management in the respective industry. For example, the choice of Citi to sell Phibro–its most consistently profitable unit–because it couldn’t get it’s head around paying a $100 m bonus to Andy Hall, Phibro’s MD, is one example of disfunctional behavior driven by populist, rather than technical risk management, considerations.
    Second, regulators value Type II errors (things that you should have done, but didn’t) effectively at zero. So, when airport security takes away my shaving cream, from their point of view, this is a costless transaction. Were security run by the airline, there would be pressure to balance security against convenience. The TSA faces no such pressure.
    This matters enormously in finance. Investment banking was, and remains, a highly–and in some cases, quite disfunctionally–regulated industry. Bankers have the legitimate concern that incremental regulation will not solve the root problem while driving up costs and limiting flexibility.
    Third, regulation requires competent regulators. As pay for regulators is typically below their private sector equivalents, the quality of enforcement can be quite variable. So even if the regulations make sense, it is not clear the enforcers of these regulations will act appropriately.
    And then there are the legislators. I am disturbed that Congress appears clueless about the finance industry (it’s not really surprising) and therefore does not appear to understand the distinction between must-have and nice-to-have legislation, and how this will impact the industry.
    For example, trying to tackle systemic, pay, and incidental issues (like mortgage disclosures) at the same time means that high importance issues are treated similarly to relatively minor ones, causing confusion and creating friction in the legislative process.
    Systemic issues matter, and they should receive top priority. If the Obama administration could achieve some consensus on the notion that insitutions presenting systemic risk should be treated as such, that in itself would be a huge achievement.
    So, liberalism should not be entirely confused with voluntary interaction. The ideology has at least two goals: the protection of property rights and the right to voluntary interaction. In some cases, like public markets’ disclosure, regulation can enhance property rights.
    Also, volunteerism is bounded by the scope of the parties involved, ie, it has no means of incorporating exogenous risks of a systemic sort. Therefore systemic risks, at least from my perspective, may be best handled at a higher level.
    So, liberals prefer volunatry interaction. However, it doesn’t mean that they’re incapable of understanding or appreciating systemic risk or compulsory steps taken to enhance property rights.

  5. Cedric Regula

    I do have to say that the proposed concept that the Chinese drove our financial sector to a life of crime is one for the Hyperbolic Humor Hall of Fame. Leno could do at least an entire monologue on it, Letterman would be coughing up hairballs, and NBC would require Conan to run with it for an entire season.
    Considering that the Chinese basically recycled dollars directly back into treasuries and GSEs means there wasn’t even any direct intermediation by the financial sector (or FX, which is what makes it work so well. But we are the reserve currency, so assigning blame there is difficult, but currency pegging by China, with the intent of running large trade surpluses, was the part of the problem China was responsible for). And their peak holdings of GSEs was around $700B out of a $11T mortgage market. Something under a trillion for Treasuries out of eventually a $7 trillion marketable treasury market.
    So “liquidity” flowed into the US, after flowing out, but look who got their hands on it first. In parallel, Wall Street turned into a high speed “innovative” credit mill.

  6. ppcm

    Central banks are still to be hold responsibles.
    They have the hands on the tapes (money supply)
    The eyes on the books (banks supervision)
    Banks were only negligent and cupid, this is why supervisory bodies are established. Central banks and moreover regional Fed,were providing enough realistic data as a first warning.
    Fed Boston was showing evidences of the inadequate credit risk assessments by all parties involved (June/July 2007)

  7. MarkS

    “The fundamental flaw in these analyses, of course, was the assumption that advanced-country capital markets, especially those of the United States, were fundamentally perfect, and so able to take on ever-increasing leverage risklessly.”

    Menzie Chin


    You don’t need to be a rocket scientist to recognize that the current financial crisis is caused by excess leverage. Whether it be residential or commercial mortgages, industrial or commercial bonds, credit cards or auto loans, government spending or trade balance; Bankers and Financiers in the United States and Britain (the gatekeepers and managers of global finance) have hyped the system for years to extract the maximum future value of every conceivable asset as profit today. Who among them cares about inevitable repercussions when they can fatten their accounts today?

  8. BKarn

    “I do have to say that the proposed concept that the Chinese drove our financial sector to a life of crime is one for the Hyperbolic Humor Hall of Fame.”
    This is a somewhat straw-laced restatement of the arguments made on this issue, and, regardless, it seems no more hyperbolic than what the scenarios being dwelled on increasingly in the global mass media and commonly in public discourse on America’s economy, its currency and its future.

  9. don

    The authors come closer to my view of what happened than those who blame deregulation and overly lax U.S. monetary and fiscal policies. However, going forward, regardless of the cause of our current malaise, we have to address the global imbalances. The following is apt: “Clearly China’s export led growth strategy of the past cannot continue indefinitely and domestic consumption will have to grow as a share of GDP.” Apparently, this view is not yet fully accepted and we will need to face a bigger crisis before it is. The U.S., despite a dramatic lack of aggregate demand, is still running an unustainable current account deficit, which looks poised to grow with any hint of U.S. ‘recovery.’ Yet we hear such nonsense as ‘the U.S. needs to rely on foreign borrowing to finance its stimulus.’ The U.S. expansionary policies may have ‘enabled’ export-led growth strategies in Asia (and Germany) after the dot-com bust, but they would have led to a natural monetary tightening without the foreign lending spurred by currency interventions (including implicit currency policies that spurred the yen carry trade). Such policies now are as clearly detrimental to the U.S. economy as competitve devaluations in GD1.

  10. DickF

    Cedric,
    Your post is excellent!!!!!
    The only disagreement I have with you is the concern about China pegging the RMB to the dollar. If one country is playing games with their currency so that it is falling against all of the major currencies in the world and one of the major trading partners pegs its currency to that country’s currency how can you say the pegged currency is being manipulated? In fact the US is manipulating the dollar to drive it lower under the foolish belief that it will increase imports and strengthen the economy. China is not to blame in this but the US monetary authorities. It is the US not China manipulating the currency. All China is doing with the peg is offsetting the games being played by the US monetary authorities and it makes them angry because they cannot drive an advantage as their theory tells them.
    In truth never in history has a country with a weak currency remained a world economic power. The weaker the US currency the weaker the US economy. And that has absolutely nothing to do with the RMB.
    But other than that your post is spot on.

  11. DickF

    MarkS and Menzie,
    Isn’t saying “ever-increasing leverage” just another way of saying loose monetary policy and excessive materialism driven by a consumption driven economy?

  12. Cedric Regula

    DickF,
    We might have different ideas about what are market forces and what is “manipulation”. I go by the theory that in an idealized world of floating currencies, and no cross border investment flows, there would be an inverse relationship between bilateral trade deficits and the exchange rate of the two currencies. Here market forces set an equilibrium point for the currencies that would drive trade deficits to zero.
    Before anyone starts laughing at the simple mindedness of this, I’ll state that macro stuff works unevenly on economies, and bad things start to happen to individual players, and that’s why people don’t want to adhere to simple macro concepts.
    But then we can’t ignore financial flows, especially nowadays since there seems to be so much of it. Ignoring what the CBs do (many things are legitimate), we have private investment, hot money, international banking, etc…moving around the world.
    Generally investors are chasing either growth or yield. Here is where CB interest rate policy can impact the value of a currency. Milton Friedman said a central bank can target the domestic economy with interest rate policy, or foreign exchange with interest policy, but not both at the same time. I think he’s right about that, except when you aren’t playing by free market rules. (China, others)
    So that’s the simple model, but it doesn’t get played that way.
    Depends where you start with the process when you try and make heads or tails of it. Beginning of the decade the dollar index was 110. That was probably too high and I think we had a lot of foreign money chasing the stock bubble. We had ZIRP in Japan driving Japanese investment into Treasuries for the first part of the decade, then China picked up along with the Middle East due to increasing oil prices. Monetary policy was kept loose in the US and longer maturity rates were held down by plenty of foreign inflows, (Greenspan Conundrum, Bernanke Savings Glut) but then US investors started going elsewhere for returns(Dark Matter). Since the trade deficit was coming back dollar for dollar into US financial assets, there was no pressure on the dollar from trade deficits. The only thing weighing on the dollar left being US financial outflows, and also the fact that international banking (ours and theirs) where using dollars (and eurodollars) for dollar denominated loans elsewhere in the world. Summing it all up made the dollar go as low as 70. But someone did have to print them up in first place, and then also say you don’t get much real yield for holding them.

  13. Cedric Regula

    DickF,
    We might have different ideas about what are market forces and what is “manipulation”. I go by the theory that in an idealized world of floating currencies, and no cross border investment flows, there would be an inverse relationship between bilateral trade deficits and the exchange rate of the two currencies. Here market forces set an equilibrium point for the currencies that would drive trade deficits to zero.
    Before anyone starts laughing at the simple mindedness of this, I’ll state that macro stuff works unevenly on economies, and bad things start to happen to individual players, and that’s why people don’t want to adhere to simple macro concepts.
    But then we can’t ignore financial flows, especially nowadays since there seems to be so much of it. Ignoring what the CBs do (many things are legitimate), we have private investment, hot money, international banking, etc…moving around the world.
    Generally investors are chasing either growth or yield. Here is where CB interest rate policy can impact the value of a currency. Milton Friedman said a central bank can target the domestic economy with interest rate policy, or foreign exchange with interest policy, but not both at the same time. I think he’s right about that, except when you aren’t playing by free market rules. (China, others)
    So that’s the simple model, but it doesn’t get played that way.
    Depends where you start with the process when you try and make heads or tails of it. Beginning of the decade the dollar index was 110. That was probably too high and I think we had a lot of foreign money chasing the stock bubble. We had ZIRP in Japan driving Japanese investment into Treasuries for the first part of the decade, then China picked up along with the Middle East due to increasing oil prices. Monetary policy was kept loose in the US and longer maturity rates were held down by plenty of foreign inflows, (Greenspan Conundrum, Bernanke Savings Glut) but then US investors started going elsewhere for returns(Dark Matter). Since the trade deficit was coming back dollar for dollar into US financial assets, there was no pressure on the dollar from trade deficits. The only thing weighing on the dollar left being US financial outflows, and also the fact that international banking (ours and theirs) where using dollars (and eurodollars) for dollar denominated loans elsewhere in the world. Summing it all up made the dollar go as low as 70. But someone did have to print them up in first place, and then also say you don’t get much real yield for holding them.

  14. Vangel

    LOL. I guess that common sense, coherent theory and real world observations don’t matter very much to the authors.
    When they ignore the massive liquidity injections by the Fed, the huge growth in government and implicit guarantees to the reckless bankers who were using leverage that would make hedge fund managers nervous and wind up blaming the crisis on productivity increases in the developing world Jagannathan, Kapoor, and Schaumburg show that they are not to be considered as serious thinkers.

  15. Bill

    Looks like a game of chicken between the US and China: we’ll keep printing money and keep low interest rates until you decide it is not worthwhile to peg to the dollar and continue purchasing dollars to depress your currency.
    In games of chicken it pays not to flinch and to be oblivious to the problem so the other person changes first.

  16. Dick Fox

    Cedric,
    Two of our primary differences are, first, that you believe there are people so intelligent that they can actually manipulate monetary policy for the better. I do not.
    Second, you believe that it is possible to manipulate monetary value and create economic growth, while I believe that a stable value of money allows traders to create growth and that any increase or decrease in that value hinders their ability to create growth.
    Money is only “money” if it is a unit of exchange. Anything that disturbs this function disturbs the economy.

  17. Cedric Regula

    Dick,
    I didn’t mean to imply that anyone has been smart enough to get monetary policy right. In fact I believe they got it so wrong that they almost killed the country, and replaced us with China, and maybe the Middle East. But they didn’t think they were doing this. They were trying to stimulate maximum employment in the US. (See Milton Friedman rule)
    Milton Friedman rule #2. You need some growth in the money supply to support growth. The reason is (and this is one of the Ten Commandments of Economics) that otherwise you would get price deflation. This would be a disincentive for capital investment because falling prices reduces cashflow to repay the original investment.
    Actually, I point to the semiconductor industry as an example of an industry that handles that scenario quite well, but me arguing with every economist that ever lived is pointless, so I just go with the flow.

  18. Rob

    Cedric,
    You point out one issue that has always confounded me: why is inflation of the money supply (or simply, inflation) a prerequisite of a fiat currency? Why do people accept this *theft*?

  19. DickF

    Cedric,
    Milton Friedman was one of the greatest economists to ever live, but he made a huge mistake following the monetarist road of Irving Fisher.
    Why do you need money supply growth to support real growth? To prevent deflation, defined as falling prices? You mention one example in the semiconductor industry. If we look at computers in general Friedman’s whole premise looks foolish. Should we have supplied enough liquidity to prevent computer prices from falling?
    As I stated before, money is simply a medium of exchange and any change in its value hinders free exchange. Milton missed this because he was founded in demand side thinking. Price declines are healthy in a growing economy because processes and technology improve driving prices down.
    Now if deflation is defined properly as an increase in the value of the monetary standard, then deflation hinders transactors giving one side of the exchange a windfall profit and other a windfall loss. Milton’s solution actually creates the problem of reducing the value of the monetary standard once again giving windfall profits or losses.
    Friedman recognized this recommending his theory only include an inflation of 2-4%, but taking a little poison is still taking poison. Monetarism failed us in the 1970s finally ending in the 1981-82 recession with Volker finally leaving the M1 standard.

  20. MarkS

    DickF:
    I believe that “ever-increasing leverage” describes the process of securitization: providing banking credits for the promise of future cash payments sometimes collateralized by real assets.
    “Loose monetary policy”, in my opinion, involves four things: Reducing the robustness of bank reserves (the Basel accords); Elimination of bank reserves (Eurodollar transactions); Fraudulent off balance sheet entities (SIVs); and total obfuscation of credit risk and financial activity (OTC derivatives).
    I am very sympathetic to the concept of “excessive materialism”. In my opinion, too much of western culture is involved in mindless consumption and entertainment, rather than life supporting creative or altruistic activities. This is more a spiritual/philosophical issue than an economic one.
    As to what “drives” the economy: I think it involves some push and some pull. The pull is easy, its the demand for goods and services that motivate entrepeneurs to supply products. The push is supplied by government or private foundations to provide funding, advertising, or regulation to hopefully encourage socially valuable activities. Anyone that thinks that mindless consumption occupies too much of America’s attention should be involved with organizations that help and encourage citizens to achieve a more balanced and productive life.
    Although I have at times disagreed with some of your comments at this post, I have always appreciated your infectuous enthusiasm, injection of moral values, and willingness to share your wisdom. Keep it up!

  21. don

    Vangel -
    Interesting ideas. But please explain exactly how ‘massive liquidity injections by the Fed’ led to an increase in real net indebtedness of Americans. (The explanation must, of course, recognize that an increase in real net indebtedness of Americans requires a corresponding increase in real net saving somewhere else in the world.)

  22. glory

    i thought thomas palley wrote a good ‘first draft’ — http://www.thomaspalley.com/?p=99 — locating the origins of the crisis, esp wrt “detachment of wages from productivity growth,” which someone (i forget who) on brad setser’s blog used to hit on a lot…

  23. Cedric Regula

    Rob, Dick
    Rob says “You point out one issue that has always confounded me: why is inflation of the money supply (or simply, inflation) a prerequisite of a fiat currency? Why do people accept this *theft*?”
    I think you have to go back to the late 1900s and study the populist movement for silver coinage to really understand the deep rooted fears of economists.
    We had a gold standard, but the economy was growing faster than the gold supply. Rich people of course liked lending in gold. Problem was farmers borrowed in gold to plant crops, and if they had a good year, prices would drop, they wouldn’t make enough money to pay off their gold loans, and then they were ruined. English farmers may have been thrown in debt prison back at that time as a reward for their farming prowess. The call for silver coinage was really a call to increase the money supply.
    Then along came the Great Depression. Both Keynes and Fischer were quite wealthy in the 20s, but both lost their butts in GD1.
    This caused much damage to their psyches, and influenced their economic theories.
    Then along came young Milt, and he confirmed that tight monetary policy was the tipping point from recession to depression. He also pointed out settling foreign exchange in gold didn’t help much.(even tho the US was a net creditor with a trade surplus at that time)
    Of course later in his career Milt suggested abolishing the Fed and replacing the Fed with a computer that just steadily increased money supply at a slow constant rate.
    Then late in his career he advocated 100% reserve banking. I guess he decided the money multiplier in fractional banking made the money supply too difficult to control by the Fed.
    And nowadays we have the things that Marks described above, which sounds too much like allowing banks to have their own private printing presses.
    So it is all a matter of degree.

  24. Cedric Regula

    glory,
    He describes the box that economists don’t know how to get out of.
    I view the problem as the structure of production has shifted significantly over the last 30 years. When we had a manufacturing sector that was the largest part of the economy, you have companies employing a high number of people relative to sales revenue because there is a lot of value added. As we slowly shifted to retailing and offshoring more and more of the value added work, we become more like a distribution model. This requires high sales volume per employee.
    So we sold a bunch of stuff by encouraging consumer debt growth, and now we have run into our collective credit limit, and it’s game over.
    And we (Japan and Europe too) did transfer technology, capital and manufacturing expertise to the EMs, and now it is there and we can’t get it back. That was the competitive edge that would support higher wage differentials in the US.
    So now we are stuck flipping burgers.

  25. don

    glory – thanks for the cite. Not a fan of Palley’s, but he makes some good points. Closer to the truth, it seems to me, than the views of our more highly academically credentialed host, IMHO.
    As to what causes the trade deficits, that is an interesting question. Within pre-2004 Japan, when massive foreign reserves were accumulated, there were those within the central bank who laughed at the Finance Ministry’s attempts to keep the yen low through currency interventions, on grounds private capital flows would offset. I think those views were as misguided as Michael Porter’s (with P. Kouri) very stupid article in the JPE, in which he surmised that the artifact of a stable German monetary base in the face of large changes in the domestic reserve component were attributable to private capital flows offsetting official changes in the monetary base. To confuse the obvious cause-and-effect issue, he corrected for simultaneous equations bias, which I’m sure many thought treated the main problem of possible reverse causation. A casual look at the remarkably steady growth in the total monetary base (even through a big speculative episode that Porter treated with a dummy variable) should convince anyone that the stable relationship was an artifact.
    In short, I’m of the opinion that currency interventions abroad are an important cause of U.S. trade deficits and should be strongly discouraged now.

  26. don

    Cedric – I think in the longer run, our bigger problem will prove to be a Dutch disease-type-malaise, as U.S. food production, which requires very little labor, makes virtually all other U.S. output uncompetitive globally. Right now, though. much of the U.S. uncompetitiveness in tradeables is a result of artificially depressed currencies in Asia.

  27. Cedric Regula

    Well, we do have farm support programs, so personally I’m not that worried about farmers anymore. Tho I’m worried about all our cows, pigs, and chickens leaving the country if Asia does ever stop pegging to the dollar.
    But I also think Europe must be scared to death seeing this monolithic US-Asian block of devaluing currency. I don’t think they are capable of spending the rest of us to prosperty.
    And the other odd problem China thinks it has stems from the diversity in its manufacturing base. They have made strides in moving up the value chain, ie semis, software, machine tool, aerospace and defense, but are getting competition from other small EM Asian economies in areas like clothing, textiles and other low tech production. To remain export competitive in these areas they would need to weaken RMB.

  28. Tom

    These are interesting topics, but methinks economists are getting carried away playing a sort of “pin the tail on the donkey” game with all these papers proposing alternate versions of the causes of the crisis. Economic activity is cyclical, get used to it. We all should be looking at why this contraction was particularly deep, and accept that just about every country’s government was to blame, mostly in proportion to their global influence. We all should be looking at whether our policies are supporting or impeding long-run improvements in living standards.
    I do think it’s legitimate to blame Beijing for causing problems by confiscating hard currencies from Chinese exporters and stashing them away in a mammoth stockpile. Not surprisingly, undemocratic governments tend to disregard human welfare, including in their trade policies.

  29. don

    CR: “But I also think Europe must be scared to death seeing this monolithic US-Asian block of devaluing currency. I don’t think they are capable of spending the rest of us to prosperty.”
    Exactly.
    Tom: “I do think it’s legitimate to blame Beijing for causing problems by confiscating hard currencies from Chinese exporters and stashing them away in a mammoth stockpile. Not surprisingly, undemocratic governments tend to disregard human welfare, including in their trade policies.”
    I’m of the opinion that China’s trade policies have played an important role in the dramatic growth in their per capita income over the last decade. And I also think that halting all currency intervention now would cause their population considerable pain. That’s the main reason it will be so hard to get rid of this particular trade distortion.

  30. Ravi Jagannathan

    Dear Professor Chinn:

    Thanks for taking the time to cover our paper in such detail in Econobrowser.

    Regarding your observation that we ignore government budget deficits: I agree that government budget deficits are very important, given our view that US households do not adequately take into account the liability created by government debt, especially debt that is held by foreigners.


    In footnote 24 we say, “We find that the slope coefficients for the changes in domestic and foreign holdings of government debt are not significantly different from zero (results available upon request) which is consistent with the view that investors ignore any changes in their financial liabilities due to changes in foreign or domestic holdings of government debt when making consumption decisions.”

    On page 36 we say, “Policies that promote household understanding of the burden of the public debt in the United States would also contribute to higher saving.”

    From your observation it is evident that these points should not be buried in a footnote.

    Clearly, there are two sides to the story — foreign money flowing into the US is one side, and we think an important one. The other side has two components:

    (a) The first is the US government deficit because it plays an important role in the nation’s willingness to accept foreign money inflows – especially when households do not fully internalize the fact that they will have to pay it back eventually (i.e. behave as if it were a gift, not a loan). We think that this is likely to be more so in the case of government debt held by foreigners.

    (b) The second aspect is the housing bubble, and the foreign money flowing into housing. In this case, households realized that they have to pay it back. However, they were comfortable with that because they felt that the increases in home prices were permanent and that the bubble would not burst.

    While we focus on the latter in the paper, I agree that the former, government deficit, deserves more discussion.

    Regarding Net Exports to GDP and Government budget balance to GDP figures in your blog: I replicated the figures and also included the Balance of Payments series, which is the one we focus on in our analysis. During 1980 – 2008 we see one cycle, from the trough in the mid 80s to the trough in 2006/7 (soon to be eclipsed by the 2009/10 numbers). The deficit needs to be lagged once to match the first trough, and trice to match the second. So lagging twice is a suitable compromise if one wants to match both.

    While this is interesting, we are making a different observation, which I think is important. During mid 80s, government deficits were around 4.5%, larger than the Balance of Payment deficits which were around 3.25%. Since the capital flows into the country that were needed to offset the Balance of Payment deficits were smaller than the government deficits, part of the government deficits were offset by net domestic private sector savings, i.e., the private sector accounted for a net surplus of capital flows. This had changed dramatically starting in the late 90′s. By 2006, the federal deficit was around 2.5% and dwarfed by the Balance of Payment deficit of around 6%, the result of a decade of net capital inflows that we discuss in our paper. In other words, while the government deficits are clearly important, they are not necessarily the main driver of capital inflows. The private sector and household behavior played an important role.

    During the peak of the bubble, there is a lot of casual evidence to the effect that the demand for “safe” fixed income assets far out-stripped supply. Banks were simply unable to underwrite mortgages fast enough to satisfy their structured product production lines. In fact, traders at large US institutional investors lament how, in 2006/7, structured finance deals would be 10x oversubscribed within 30 min of being brought to market, leaving investors precious little time for due diligence. This is what we consider to be the main story: too much money chasing too few opportunities.

    Finally, the words “Blame It on Beijing” in the title may suggest that the paper is negative on the role of China. On the contrary, I think that the creation of over 300 million new jobs in China at the rate of 20 million a year is one of the most monumental contributions to world peace and prosperity going into the 21st century.

    Sincerely,

    Ravi Jagannathan

    October 15, 2009

  31. Bill

    The paper was quite good and confirmatory of the statements of my clients on their decisions to offshore to China. So was the discussion about the rapid accumulation of dollars to peg their currency. My view is that we are, and we have been, playing a game of chicken with the Chinese: we’ll keep printing money until you stop pegging the currency. If we cannot have an agreement to float the currency, a dominant strategy of letting the other fellow blink seems best for us, and not so good for them if the value of their accumulating dollar reserves declines.

  32. RicardoZ

    Cedric wrote:
    Problem was farmers borrowed in gold to plant crops, and if they had a good year, prices would drop, they wouldn’t make enough money to pay off their gold loans, and then they were ruined. English farmers may have been thrown in debt prison back at that time as a reward for their farming prowess. The call for silver coinage was really a call to increase the money supply.
    Cedric,
    I don’t think you have thought through the implications of your comments above.
    Let us assume that the increase in the money supply actually did suddenly allow the farmers to pay their debts. What did that actually mean for the contractual agreement between the farmer and the bank?
    What if rather than expanding the money supply the farmers organized into a gang and broke into the bank and stole enough money to pay their bills? Is there a difference from what you are suggesting?
    The only difference between direct theft and inflation is that inflation is legal theft and the theft is of everyone in the economy rather than just the bank.
    But also consider this. If the currency is inflated such that the farmer can now pay his debt and the bank takes the loss what will the bank do to interest rates? The bank will not allow the loss next year and the farmer will be twice screwed perhaps not even being able to secure the loans for planting.
    Manipulation of the value of the money always has unintended consequences because money is a medium of exchange not a driver of economic activity.
    In your example the problem was no a limited money supply but poor planning on the part of the farmer. He should have diversified his crops, limited his production, or worked for a way to preserve his produce. Production excesses are not resolved by inflating a currency.

  33. GNP

    Question: Would the US have avoided this crisis if the 10 to 15 years ago the Federal Reserve had formally adopted inflation targeting?

    Or are American citizens incurable growth junkies constrained by short time horizons?

  34. Tom

    Don – When, as in China, a government forces exporters to exchange their hard currency earnings for domestic currency at a rate lower than they would get from a free market, the direct result is to depress wages in hard currency terms, or in other words, to make imports more expensive than they would be in a free market.
    I think I understand your position: you believe that by depressing wages, China attracts more investment, develops faster, and thus increases living standards faster. I assume the “pain” you think ordinary Chinese would feel from letting the market dictate (and thus increase) their wages would be higher unemployment.
    It’s a popular theory, especially if you’re not a Chinese laborer or if you just really enjoy hand-washing clothes, but I’m not convinced. There’s a big logical flaw: yes, wages are depressed in hard-currency terms, but that discount is not passed on to foreign customers, it is taken by the government and stashed away as reserves. Moreover, by discouraging Chinese people from buying imports, China’s trade partners are deprived of export income, and thus have less money with which to buy Chinese goods. (True, some of the hard currency confiscated by the Chinese government is sent back to China’s trade partners in the form of purchases of securities, eg Treasuries, and besides, stockpiling a currency on the scale that China stockpiles dollars does boost its value – but these are only partial compensatory effects, and they have other, negative side effects).
    I think ex-communist Europe and Turkey have been much more successful in increasing living standards with their relatively free-market policies. The pace of China’s industrialization is indeed impressive, but average living standards there are still miserably poor.

  35. don

    Tom – We definitely differ on at least one point: I believe that an important effect of the currency interventions is to provide an effective subsidy for exports that increases both their price competitiveness their real volume.

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