The Bankwatch

Tracking the consumer evolution of financial services

The Real Cause of the Financial Crisis | Global Labour Supply Shifts

Over at Econbrowser Menzie highlights this new paper from two Profs, and someone from the NY Fed (no title). It closes the loop for me on something thats been bothering me about economists and the financial crisis. The debate about the cause of the crisis vacillates between Greenspan and loose credit, versus, global imbalances and Chinese who save too much. Neither of these resonate much, appear as reactions to a situation, and are therefore more symptomatic than causal.

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:


This paper lays the cause of the crisis on the increased labour supply in developing countries. Now this sounds more like a root cause. Things are no longer manufactured in Pittsburgh, but now China. That labour supply in China is net new to the world. There could be a debate about whether that represents an increase in labour supply, or transfer of labour supply.

In what follows we argue that this huge and rapid increase in developed world’s labor supply, triggered by geo-political events and technological innovations, is the major underlying force that is affecting world events today.2 The inability of existing financial and legal institutions in the US and abroad to cope with the events set off by this force is the reason for the current great recession: The inability of emerging economies to absorb savings through domestic investment and consumption caused by inadequate national financial markets and difficulties in enforcing financial contracts through the legal system; the currency controls motivated by immediate national objectives; the inability of the US economy to adjust to the perverse incentives caused by huge moneys inflow leading to a break down of checks and balances at various financial institutions, set the stage for the great recession. The financial crisis was the first symptom.

In my simplistic interpretation of that, globalised labour supply got ahead of globalised finance. Yes there are international financial markets and products, but to what extent do they factor in the new value transfer from developed to developing countries.

Relevance to Bankwatch:
In any event, I will leave the economic analysis to experts. What matters is the extent that the labour supply shifts are indeed the root cause, because that cause remains in place, and is unresolved. It will not be solved by new bank regulation. Nor can we expect banks to solve it. The instability which results will continue, and that is the reality Banks must operate within.
why are we in a recession labour markets jagannathan090309 (3).pdf


follow up – root cause of crisis – capital reserves, capital flows:

The end of financial globalization 3.0?

What followed was financial globalization 3.0. Emerging markets heeded Martin Feldstein’s advice and took out an insurance policy against the vagaries of financial globalization.[2] By running current account surpluses, intervening in foreign exchange markets and building up currency reserves Asian and other emerging economies were sustaining export led growth and buying insurance against future financial instability. These policies turned developing markets into net capital exporters to the developed world, mainly to the US. Between 1990 and 1998 – during what I have termed financial globalization 2.0 – emerging and developing economies (according to the IMF classification) were running an average current account deficit of about 1.7% of their GDP. Between 1999 and 2008 – during financial globalization 3.0 – this deficit turned into a surplus of 2.5% of GDP.[3]Just like its predecessor, financial globalization 3.0 seemed a success story for a while, generating financial stability and high rates of economic growth. Yet the accumulation of large war chests of foreign reserves through currency intervention carried negative externalities. The arrangement opened up a Pandora’s box of financial distortions that eventually came to haunt the global economy. The glut of savings from emerging markets has been a key factor in the decline in US and global real-long term interest rates – despite the parallel decline in US savings.[4] Lower interest rates in turn have enabled American households to increase consumption levels and worsened the imbalance between savings and investment. And because foreign savings were predominantly channeled through government (or central bank) hands into safe assets such as treasuries, private investors turned elsewhere to look for higher yields. This led to a more general re-pricing of financial risks and unleashed the ingenuity of financial engineers to develop new financial products for the low interest rate world – such as securitized debt instruments.[5]

Written by Colin Henderson

October 13, 2009 at 00:59

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