Wednesday, October 14, 2009

A Positive Global AS Shock + Loose U.S. Monetary Policy = Trouble

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.


  1. While I can see how an increase in the supply of labor in China and India would increase the world real interest rate. I am not sure, however, that this translates into higher nominal interest rates in the U.S. How does this work out if the U.S. is targetting slow, steady growth in nominal expenditure?

  2. Did you see that David Altig argues in his blog that the federal funds rate was not inappropriate and therefore not a significant contributor to the housing boom ? I guess the fight for the control of the "narrative" about what happened in the last 10 years continues! Was it driven by real factors (global supply shocks and savings gluts) or US-generated monetary policy/deregulation?

  3. Bill:

    I think you can tell the story several ways.

    First, given integrated global capital markets, the higher world real interest rates should mean higher real interest rates in the United States too (absent any monetary mishcief by the Fed). This development in conjunction anchored inflation expectations should lead to a higher nominal interest rate.

    Second, the positive AS shock itself that increases the return to capital may cause U.S. firms to increase their demand for investment and in so doing push up nominal interest rates. (Alternatively, cheaper labor costs increase firm profitability and thus, increase demand for capital expenditures.)

    If driven by the global AS shock, the higher interest rates should not cause nominal spend to decline--firms after all are increasing investment spending--but actually keep it growing at a sustainable pace. On the other hand, if interest rates don't go up--because of monetary easing--the nominal sending will grow too fast.

  4. ECB:

    Yes, I saw the Altig piece and sighed. Coming from the Fed it is not too terribly surprisig though. But then the CATO intitute, of all places, just put out a policy paper that defends the Fed during this time. All this Fed cheerleading is wearing me out. I thought about blogging about these pieces, but am getting Fed fatigue. Now that you mentioned the Altig piece maybe I will say something brief about the articles.

  5. Yes and what is frustrating is we do not have the tools, ie a fully developed model that we can use to make reasonable "allocations" of RGDP innovations to various factors. This frustration leads to regression to childhood toys. The Krugmanites go back to IS/LM and the Sumnerites go back to MV=PT. Mark Gertler's mini-course on financial intermediation and macro I suppose points how we might grow up and ditch the lego models.

  6. I agree that US policies contributed to the financial crisis. A point that I have made in many different forums (but I don't get no respect!) is that Fed monetary policy implementation (as opposed to the policy setting) was partly responsible for the low long term interest rates that Greenspan described as a conundrum, because the Fed unnecessarily used longer-term treasuries to distribute and collateralise its base money supply (unlike, say the ECB and the BoE, which predominantly used repo). In fact, until about 2007, despite the focus on Japanese and then Chinese forex reserve accumulation, the Fed was almost certainly the largest central bank holder of longer term US treasuries. When I first raised this point, the riposte was that long term interest rates are set by monetary policy expectations, but the fact that the Fed's QE programme is supposed to bear down on longer term interest rates suggests that their view has changed.

  7. Rebel Economist:

    Interesting point. It highlights another channel through which the Fed's low interest rates in the early 2000s created distortions. Why don't you turn this idea into a paper?

  8. Thank you David.

    I think that a bit more process analysis is necessary to go from more rapid growth of labor supply in India and China to higher interest rates in the U.S. than to note that there is a world capital market.

    For example, one story would be that U.S. investors, wanting to take advantage of the cheap Chinese and Indian labor, make investments in India and China. This results in a net capital outflow from the U.S. Or, perhaps, Chinese and Indian investors, that had been investing in the U.S., keep their funds at home. Or, other foreign investors move funds from the U.S. to China and India. As these investors sell dollars and buy foreign exchange, the dollar falls in value. This makes imported goods in the U.S. more expensive, and U.S. exported goods cheaper to foreigners. The result is an expansion in nominal expenditures in the U.S. To avoid the excessive growth in nominal expenditures, interest rates in the U.S. must rise.

    I am sure that we can find some testable implications that would be falsified regarding this story. For example, the large net capital inflow by the U.S. during the period.

    The more interesting scerio is the one where it is outsourcing by U.S. firms that is in question. Foreign labor is substituted for domestic labor, labor is cheaper. There is inceased demand for complementary capital. As you say, the inceased investment expenditure requires higher interest rates. But, more generally, there should be a shift in the factor distribution of income--more to capital and less to labor. But, of course, labor complementary to outsourced workers would earn more income too.

    Of course, what is important about the story is that during this period of very low interest rates, some measures of U.S. employment were falling. Employment only returned to its previous peak in 2004. We can imagine a scenario where there is a shift in the factor distribution of income, or really, just a decrease in nominal equilibrium wage rates of domestic labor that competes with foreigners through outsourcing. If nominal expenditure grows on target, and so nominal incomes grow on target, some nominal and real incomes may need to fall, resulting in shrinking employmnet. Possible.

    The Fed followed an overexpansionary policy aimed (perhaps unconsiously) at lowering the real wages of those domestic workers displaced by outsourcing. Maybe.

  9. Thanks David. It is a simple observation, but no-one else is making it, so if it could be made into a paper, I would like to do so. In my experience, academics are reluctant to credit ideas that have not been published via their own media - I had a battle with Willem Buiter about his obstinate refusal to acknowledge another idea of mine. Do you know where such a paper might be published, and what more might be required beyond simply explaining the point?

  10. Rebel Economist:

    I think numerous policy journals would be interested it. Ones that come to mind include Contemporary Economic Policy and Cato Journal. You could also do it as note for say Economic Letters or Applied Economic Letters.

    One way to expand upon what you have is to create a longer time series of Treasury holdings by the Fed and plug it into a VAR or some statistical model. That in addition to the descriptive graphs would make a strong case. I plan to blog soon about your point

  11. Thanks David. I await your post with interest. I do not have the software to fit VARs efficiently, and have little experience of using them, but perhaps there will be scope for us to collaborate in writing a paper - if you want to discuss this in more detail, I can be reached directly at

  12. Bill:

    Thanks for the possible stories. I would add that in addition to the global labor supply shock there was also the delayed productivity shock from the late 1990s IT investment. This too would have further reduced the demand for U.S. labor.

    I also wonder that to the extent interest rates were were inordinately low or below their "natural rate" they caused a substitution of capital for labor beyond that motivated by the labor and productivity shocks.