Menzie Chinn is not pleased with the new paper by Ravi Jagannathan, Mudit Kapoor, and Ernst Schaumburg. In this paper the authors argue the underlying cause of the current crisis was a large positive labor supply shock to the global economy that originated in Asia:
Labor in developing countries – countries with vast pools of grossly underemployed people – can now augment labor in the developed world, without having to relocate, in ways not thought possible only a few decades ago. We argue that this large shock to 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[.]Menzie notes there is (1) no discussion in the paper on the role U.S. economic policies played in contributing to the financial crisis and (2) it implies that forces outside the U.S. are the sole driver of U.S. macroeconomic activity. I too am skeptical of studies that suggest developments elsewhere alone are the source of our current problems. However, this study does make a good point in that there was a large positive labor supply shock to the global economy with the opening up of China and India over the past decade. This development created a large positive global aggregate supply shock (AS) that--in addition to positive AS shocks coming from ongoing IT gains--had implications for the global economic policy. The primary implication is that global interest rates should have gone up since the return to the global capital stock increased as a result of this shock (i.e. the marginal product of the global capital stock increased as the global labor supply increased). Instead, the global monetary superpower, the Federal Reserve, pushed global short-term interest rates down and created a global liquidity glut. Throw in some financial innovation, credit market distortions, complacency created by the Great Moderation and the stage is set the greatest financial crisis in the world since the 1930s Great Depression. This point was made by The Economist magazine back in July 2005 in an article titled "From T-Shirts to T-Bonds." Here is a key excerpt:
The entry of China's army of cheap labour into the global economy has increased the worldwide return on capital. That, in turn, should imply an increase in the equilibrium level of real interest rates. But, instead, central banks are holding real rates at historically low levels. The result is a is allocation of capital, most obviously displayed at present in the shape of excessive mortgage borrowing and housing investment. If this analysis is correct, central banks, not China, are to blame for the excesses, but China's emergence is the root cause of the problem.So, contrary to the paper's assertions, the U.S. could have handled this global AS shock better had its monetary policy been more appropriate. Until we began to take seriously the role U.S. economic policy played in the buildup of global imbalances that ultimately led to this global crisis we are bound to repeat history.
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