Oct-Dec 2009

Why Are We In A Recession?

The global economy is in a recession and unemployment rates are soaring. But the financial crisis is a mere symptom and not the disease itself, say the authors in this article. 

Conventional Wisdom

Folk wisdom blames the financial crisis for the recession. But what caused the financial crisis? The savings glut in Asia, says the popular press. A major part of these savings flew into the US financial system. This led to too much money chasing too few opportunities and too cheap credit becoming available in the US. Then why was there so much saving in Asia? And why did this saving flow to the US? The easy answer:  Asians simply like to save more, and Americans simply like to consume more. By this logic, all that is needed to fight such recessions in the future is to induce Asians to save less and consume more. That definitely does not sound right.

This paper argues that all these individual phenomena – the savings glut, easy credit, lax regulations, and the financial crisis – are interlinked by a deeper and a central driving force. This force is the sharp increase in world’s labour supply due to globalisation. Understanding this development is the first step on the way to recovery.

Globalisation And The Legal System’s Inability To Enforce Financial Contracts

Technological innovation and globalisation have led to a sharp increase in the developed world’s labour supply in the recent past. With the advent of offshore offices and call centres, citizens of developing countries have increasingly joined the workforce of developed countries.  Now combine the extra income in these developing countries with the inability of these emerging economies to absorb savings, and the result is a lot of money flowing to the US and the rest of the developed world. With this excess liquidity flowing in and a breakdown of checks and balances at various financial institutions in the US, the stage is set for a financial crisis, which is the first symptom.

Globalisation led to a global competition for investments. Hence it ensured efficient use of resources. In fact, the emerging economies of Asia as a group experienced a growth rate in excess of 7 percent in real GDP over the period 1982-2008.

Combine the extra income in these developing countries with the inability of these emerging economies to absorb savings, and the result is a lot of money flowing to the US and the rest of the developed world.

Another major consequence of globalisation was the emergence of the dollar as the ‘world’s currency’. What this means is that the inadequate domestic financial systems in emerging economies had the effect of channelling savings into dollar-denominated assets. In order to defend their currencies after the 1997 Asian crisis, most Asian countries started building up dollar reserves as a buffer against future macroeconomic shocks. The result was that the current account surplus of the BRIC (Brazil, Russia, India, China), NIAC (Hong Kong, South Korea, Singapore and Taiwan) and ME (Middle Eastern oil exporting countries) countries rose from $4billion in 1996 to $798billion in 2007 – roughly equal to the US current account deficit of $788 billion in 2007.

This excess inflow of foreign investment into US treasuries and mortgage pools from countries like China was what led to cheap financing of government debt and mortgage debt. This, in turn, facilitated lower taxes and cheap home equity loans. Easy loans translated into greater demand for houses and hence rising house prices, i.e., the real estate bubble. Moreover, low taxes and rising house prices made US households feel wealthy. With the availability of easy debt, this spurred an increase in consumption including imports.

To explore this phenomenon further, consider the case of the Oriental Dragon and various macroeconomic interplays.

This excess inflow of foreign investment into US treasuries and mortgage pools from countries like China was what led to cheap financing of government debt and mortgage debt.

The Rise of China and Labour Supply Shock
China has benefited the most from globalisation. It is one of the most important creditors and trading partners of the US. Adjusted for purchasing power parity (PPP), China’s economy was 12 percent of the world GDP in 2007, up from 2 percent in 1980. This meteoric rise has been made possible by recent innovations in communications and transport. These innovations have helped open up the services of China’s enormous pool of underemployed labour to the western world.

This export-led growth enabled the movement of large segments of China’s rural population to the cities. Between 1990 and 2007, China’s urban working population increased by nearly 300 million, which is roughly 1.5 times the US working population. This enormous labour supply coupled with China’s exports acted like a sudden supply shock to the global economy. A shock of such magnitude is likely to adversely affect some and positively affect others in the short run, even when everyone is better off in the long run. In order to understand these effects, let us dig deeper into the labour shock and the new globalised world.

With the availability of abundant cheap labour in China, a lot of low-skill jobs moved from the US to China. This inevitably meant job losses for certain sections in the US. The other side of the coin was that since the wages paid to these Chinese could be much lower than the wages of those who lost jobs in the US, the employees who retained their jobs in the US would get higher salaries now. In a nutshell, newly hired Chinese and Americans who retained jobs were better off and Americans who were fired were worse off in the short run. In the long run, however, those employees who were fired could be trained and employed in other productive activities. This would increase the productivity and the GDP of the US in the long run. Moreover falling prices due to Chinese production would soften the impact of short-term adversity.
According to the argument we have outlined above, one should expect significant investment in China and increased Chinese exports to the US. In fact, a lot of Foreign Direct Investors (FDIs) in China came from South Korea, Taiwan and Japan, and the Chinese trade surplus with the US increased rapidly. Another interesting phenomena accompanying China’s increased income was the increase in savings as a percentage of Income. But Chinese markets could not absorb these savings. So where did these savings go?

Capital Flows To Us
The increasing savings from China and other emerging economies flowed into US treasuries and other assets. This abundant capital flow had a two-fold effect. First, it caused an undue downward pressure on real interest rates in the US, and second, it led to gradual appreciation of Chinese currency relative to the US dollar. Artificially low interest rates in the US led to much higher consumption by US citizens despite an increasing current account deficit, while the increasing value of the Chinese yuan threatened China’s export-driven boom.

To maintain the competitiveness of the Chinese export sector, the Chinese government intervened to maintain the yuan-dollar exchange rate. This further increased Chinese dollar reserves. After the stock market crash of 2000, this unabated capital flow from China to the US got directed towards safer fixed income instruments and other government-backed investments, such as Government Sponsored Enterprises’ (GSE) mortgage pools. The flow of money to securitised mortgage pools helped drive down the cost of borrowing and created record profit years for Fannie Mae and Freddie Mac. With the decreasing spread on GSE mortgages, investment banks set up their own pools of “private label” mortgages, providing investors a higher yield at seemingly negligible additional risk. This was how the flow of capital funnelled into the US housing market, leading to a housing bubble.

Most economists would agree that China could effectively use its savings in real capital investments domestically rather than in the US. But such investments would not suit Chinese policymakers, carrying as they do the danger of higher consumption growth in cities and perhaps, social unrest in the long run. As long as these sets of issues are not addressed by Chinese policymakers, they will continue to impede the long term sustainable equilibrium.

To sum up, the sudden increase in labour supply from workers in developing countries because of globalisation should have resulted in significant sections of the population in developed countries experiencing a decline in living standards.  However, the cheap flow of liquidity created the illusion of wealth among households, sustaining high levels of consumption.
Let us now add other known culprits to the story.

Wall Street’s Financial Ingenuity

The financial ingenuity of Wall Street further facilitated what was already a crisis in making. During the late 1990s, a flurry of innovations in the mortgage industry enabled otherwise unqualified buyers to qualify for mortgages. Through their financial engineering, Wall Street and credit rating agencies transformed these “subprime” mortgages into Asset Backed Securities (ABS), making it difficult for investors to understand the underlying risk. Given the low rates on alternative investments, investors flocked towards subprime loans, not realizing the potential delinquency levels down the road. Subprime loans increased from $500 billion a year to $1500 billion a year between 2001 and 2005.

The sudden increase in labour supply from workers in developing countries because of globalisation should have resulted in significant sections of the population in developed countries experiencing a decline in living standards.

Effects Of Housing Bubble

Money channelled into housing has a bigger price effect than money channelled into other assets. A small amount of money channelled into housing can be leveraged by easily accessible bank loans, resulting in a money multiplier effect on housing prices. The same is not possible for asset classes like stocks where there is no leverage effect in the aggregate. Hence, a relatively modest housing bubble can have more severe real effects than other asset price bubbles.

Residential real estate constitutes a greater percentage of household wealth compared to stocks. Hence, declines in prices of houses could have severe effects on the overall wealth of households. Recovering from recession often involves households moving geographically to seek new and better opportunities. However, the recovery will be more difficult when the recession is associated with a collapse in housing prices.  Hence, a housing bubble burst has a much more severe effect than a stock market collapse – the stock market downturn in 2001 led to a shallow recession but the collapse of the housing bubble has led to the worst recession since the Great Depression.

Why Did The Bubble Burst?

The export-led growth in emerging markets led to an increase in prices of intermediate goods and commodities. The ratio of Producer Price Index (PPI) to Consumer Price Index (CPI) increased sharply from 2005 to 2007, suggesting that there was very limited pass-through of higher prices from producers to consumers. This caused downward pressure on wages in the manufacturing sector.

With this pressure on wages, some subprime households defaulted on their loans, leading to downward pressure on house prices due to foreclosures. Spreads on mortgage-based securities (MBS) tranches started blowing out, putting subprime originators in trouble.  Re-pricing of risk dried up availability of teaser rate loans to home-owners with Adjustable Rate Mortgages (ARMs). All this had a downward spiral effect, resulting in dramatically increasing numbers of foreclosed properties in bank inventories.

Other International Examples

A number of other countries apart from the US experienced current account (CA) imbalances and extremely low saving rates. Interestingly, every country running a significant CA deficit also suffered a housing bubble and a subsequent crash.  These countries now have the mammoth task of stimulating their economy while credibly promising to impose fiscal discipline, and all this, without the benefit of a reserve currency at their disposal.

The Way Forward

The fundamental cause of the crisis is the labour supply shock and not the glut in liquidity which is often blamed. A higher savings rate in the debt-laden developed nation and greater capital flows to the developing nation will correct the structural imbalances in global capital flows.
In the US, institutions that allow households to reduce their debt burden and policies that promote household understanding of the public debt would contribute to higher savings. Amongst the developing world, China’s export-led growth strategy would be unsustainable in the long run and domestic consumption will have to grow. The world will need to find a better way of handling the influx of millions of rural labourers from China and India into the productive workforce.

There are significant challenges that lie ahead of us. There is trouble brewing in commercial real estate markets. Many regional banks could take a hit due to excessive exposure to bad loans, resulting in further delay in recovery. Additionally, as firms economise in the downturn, there will be increasing outsourcing pressure on them to cut costs. This would only add to the underlying structural problems accentuating the recession. Countries might be tempted to close doors to outsourcing of manufacturing and other activities – while this may provide temporary relief, it will accentuate other structural problems.

The paper, ‘Why are we in a recession? The Financial Crisis is the Symptom not the Disease!’ was adapted for ISBInsight by ISB alums of the Class of 2009, Rakesh Gupta and Sumit Popli.

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