ECON-A4000: Economics of Global Challenges Lecture 9: GLOBAL ECONOMY

Matti Liski

March 29, 2021

1 / 47 Plan for this week’s lectures This week we will have two lectures on global economy, linking to units 17-18 in the book. First part for today’s lecture: Three epochs of economic development → facts, lessons EVERY economists must know the lessons learned from the successes and the failures of the three epochs. Unit 17 of the book covers in detail this important material. The lessons help us in understanding the global economy and the economic impacts of the current COVID-19 crises Second part of today’s lecture: Measures of globalization → facts Mechanisms of globalization → policies The material links to Units 13-15: Good policies and institutions can promote economic growth and stabilize the economy during a recession. Specific context of this lecture: What caused the economic failures of the last century? What policy-making lessons can we learn from the past? 2 / 47 A new epoch with new lessons starting?

credit: The Economist

3 / 47 Economic epochs

4 / 47 The three epochs

5 / 47 The Great Depression

6 / 47 The effect of the Great Depression on the US economy (1928-1941)

Understanding these events is important because the lessons had great value in dealing with the future crisis (not only in US)

7 / 47 Causes

The Great Depression = The period during the 1930s in which there was a sharp fall in output and employment in many countries. Caused by 3 simultaneous positive feedback mechanisms in the US: Pessimism about the future – households reacted to the 1929 stock market crash by saving more, further decreasing consumption Banking system failure – many banks failed because loans could not be repaid; surviving banks raised interest rates Deflation – Prices fell due to falling demand

8 / 47 Policy failures Government policy both amplified and prolonged the shock: Fiscal policy – austerity to maintain balanced budget Contractionary monetary policy – real interest rate increased I Gold Standard = The system of fixed exchange rates by which the value of a currency was defined in terms of gold, for which the currency could be exchanged. I To prevent gold outflows, the government kept interest rates high. I This closed off the possibility of using monetary policy to counteract the recession.

9 / 47 Policy changes

Roosevelt’s 1933 reforms changed expectations, which started economy recovery. The New Deal – government spending on public works and relief programmes to increase aggregate demand; resulted in a budget deficit US left the gold standard Nominal interest rate close to zero Banking system reforms to avoid bank runs Aside: New Deal also founded Fannie Mae, a government-sponsored enterprise (GSE) and, since 1968, a publicly traded company. The corporation’s purpose is to expand the secondary mortgage market by securitizing mortgage loans in the form of mortgage-backed securities → A major link to financial crises of 2008

10 / 47 We won’t do it again

“Regarding the Great Depression, . . . we did it. We’re very sorry. . . . We won’t do it again.” Ben Bernanke, November 8, 2002,

11 / 47 The Golden Age

12 / 47 The Golden Age Golden Age = The period of high productivity growth, high employment, and stable inflation extending from the end of the Second World War to the early 1970s. Living standards were doubling every 20 years Productivity increased dramatically (you have seen this in lecture 7)

13 / 47 Growth and catchup

Productivity frontier increased together with more countries coming closer to the frontier → catchup of the most advanced economy Economic growth was fast in many other (initially poorer) economies (such as Finland)

14 / 47 Analytics of growth and catchup

Total GDP is denoted by Y . This is total production. Production factors are inputs: labor L measured in total hours or in number of workers tangible capital K such as machines, equipments etc. human capital H all other inputs N such as land and natural resources. Production function tells us how all these inputs turn into the total output

Y = AF (K, H, L, N)

where inputs (K, H, L, N) inside F all jointly determine the value of F . Parameter A multiplies function F . It is called Total Factor Productivity (TFP). This TFP measures the level of the technology, and it was in fact the measure depicted in the figure on page 13.

15 / 47 Analytics of growth

To simplify further and to focus on the key drivers of growth: land and natural resources are left as out because they are constants over time human capital and labor can be merged to obtain hL where h measures the average training of a worker, say, in years of education Production function becomes then

Y = AF (K, hL)

Output increases when: (i) capital K is larger, (ii) training h is better, (iii) there are more workers L, (iv) technology A is better.

16 / 47 Analytics of growth

What happens if we scale up all inputs? There are constant returns to scale if by scaling all inputs by some constant λ, the total output is scaled by λ as well λ = 2 ⇒ capital is multiplied by 2, labor hL is multiplied by 2, and the total output is multiplied by 2. Simple! by choosing λ = 1/L we transform everything into per capita units. Simple? Production function becomes then Y K = AF ( , h) ⇔ y = AF (k, h) L L

Y K y = L is per capita output, k = L is per capita capital

17 / 47 Analytics of growth

During the Golden Age Output y increased dramatically: 3.8 per cent growth per year on average Capital k had crazy growth: 5.5 per cent growth per year on average TFP as measured by A increased as in the figure on page 13

18 / 47 Analytics of catchup Functional form for F (k, h) commonly used is the following

Y = AK αL1−α ⇔ y = Akαh1−α

where L = hL dY α−1 1−α dK = αAK L tells how much a marginal increase in capital increases output: marginal product of K dY α −α dL = (1 − α)AK L tells how much a marginal increase in labor increases output: marginal product of L In competitive market equilibrium, factor compensations equal these dY dY marginal products so that interest rate is r = dK and wage is w = dW You can check that the total factor compensations sum up to total output: rK + wL = Y . This is consistent with national accounting. rK α = Y is the share of capital compensation of the total GDP wL 1 − α = Y is the share of labor compensation of the total GDP The value of α is typically around 1/3 19 / 47 Analytics of catchup Two countries α 1−α In US: y1 = A1k1 h1 α 1−α In Finland: y2 = A2k2 h2 The differences in GDP y A k αh 1−α 1 = 1 1 1 y2 A2 k2 h2 This allows to evaluate what factors explain the difference between the two countries. All else can be measured but A so we can think A explains what is left to be explained after accounting all inputs. The following table shows the breakdown of factors that explain the situation between US and FIN in 1998. Finland is lagging behind mostly because of A (=distance to the technology frontier)

y k h A US 1 1 1 1 Fin .71 1.14 .89 .74 credit: Weil,D.N.,EconomicGrowth, Pearson/Addison Wesley, Boston 2005 (s. 189) 20 / 47 End of the Golden Age: Stagflation

Stagflation = Persistent high inflation combined with high unemployment in a country’s economy. This was the result of an upward shift of the Phillips curve. The end of the golden age was a supply-side crisis: problems on the supply side of the economy depressed the rates of profit, investment, and productivity growth.

21 / 47 Stagflation and the financial crisis

22 / 47 Supply-side reforms: Great Moderation Policies shifted the balance of power between employers and workers: Restrictive monetary and fiscal policy – governments tolerated high unemployment rates to lower inflation and reduce workers’ bargaining power Shifting the wage-setting curve down via cuts in unemployment benefits and legislation that reduced trade union power

The Great Moderation is the name given to the period of decreased macroeconomic volatility from 80’s to the financial crises in 2008 23 / 47 Problems with Great Moderation Rising debt Increasing house prices Rising inequality due to end of fair-shares bargaining Higher debt was the result of rising inequality and financial deregulation that allowed households to improve their consumption via borrowing → Housing market boom

Financial accelerator: when house prices go up, so does the value of collateral, and households can borrow more. This pushes up house prices further and sustains the bubble. 24 / 47 The role of financial sector

Rising house prices, and the development of new, apparently less risky financial assets (CDOs and MBSs) tied to mortgages made it profitable for banks to become highly leveraged. Credit ratings agencies gave high ratings to many assets created from subprime mortgages.

25 / 47 The financial crises

The Great Moderation was ended by the global financial crisis, triggered by falling US house prices from 2007 onwards. Despite the bank bailouts and stabilisation policies, there followed a sustained global fall in aggregate output (the Great Recession).

26 / 47 The role of banks in the crises

Many banks were highly leveraged and at risk of insolvency. Financial assets were hard to value, so it was difficult to judge which banks were in trouble Liquidity problems: the high risk of default made banks unwilling to lend or only at a high interest rate (the ‘credit crunch’) Fire sales reinforced the fall in asset prices and hastens the insolvency of banks (positive feedback process) Governments had to rescue the banks

27 / 47 The Crises teaches us Principles of Financial Regulation

Why regulation? The costs of crises to society are invariably enormous and exceed the private cost to individual financial institutions. The main tool which regulators use is capital adequacy requirements But banks, and other highly leveraged financial intermediaries, can behave in a way that collectively undermines the system. I risks up, sell assets. But if many banks do the same, the price of assets collapses, forcing even further sales. Leads to enhanced correlations between balance sheets and volatility in asset markets. I such interconnectedness has increased: mark-to-market valuation of assets; use of credit ratings;

28 / 47 An Example of Interbank Relationships Bank 1 has borrowed from Bank 2. Bank 2 has other assets, as well as its loans to Bank 1. Bank 2 suffers credit losses on these other loans, but that the creditworthiness of Bank 1 remains unchanged.

to ensure the solvency of Bank 2 is for it to reduce its overall lending, including its lending to Bank 1. By reducing its lending, Bank 2 reduces its risk exposure. Bank 1’s perspective, the reduction of lending by Bank 2 is a withdrawal of funding. In the case where we have the combination of (i) Bank 1 not having alternative sources of funding, (ii) the reduction in Bank 2’s lending being severe, and (iii) Bank 1’s assets being so illiquid that they can only be sold at fire sale prices

29 / 47 Lessons learned

30 / 47 Lessons learned from the last century

31 / 47 Measuring globalization

32 / 47 1. Integration of Goods Markets Reduction in trade costs (price gaps) between countries Law of One Price should hold if there are no transport costs or barriers to trade Price gap: Difference in the price of a good in the exporting and importing country. Due to arbitrage, in competitive equilibrium the price gap should equal the sum of all trade costs.

33 / 47 Illustration how goods markets become integrated: Cotton trade in the mid-nineteenth century Cotton accounted for more than one-half of US exports and one-third of Great Britain’s imports (The Economist 1866). On July 28, 1866 the first telegraph message, a congratulatory message from the Queen of England to the President of the United States, was transmitted. Among the next messages were already the most important commercial news, which included cotton price quotations (Steinwender, 2018)

34 / 47 Cotton trade in the mid-nineteenth century

Differences between Liverpool and New York Cotton Prices, Freight Cost, and Transport Cost

credit: Steinwender, 2018

35 / 47 1. Integration of Goods Markets: Trends Two separate periods of increasing global economic integration: Globalization I: before 1870 until 1914 Globalization II: the end of the Second World War until now

Deglobalization: increasing trade costs during the Depression. Partly due to protectionist policies aimed at protecting domestic employment (tariffs and quotas on imports).

36 / 47 2.Integration of Capital Markets

Countries lend and borrow from each other to finance investment. The balance of payments records the sources and uses of foreign exchange, which include: Portfolio investment: buying foreign stocks/bonds Foreign direct investment: ownership of foreign physical assets Current account (CA) = exports – imports + net investment CA deficit: Country is borrowing (receiving net capital flows) CA surplus: Country is lending (net capital outflow)

37 / 47 Trends in globalization of capital markets

Historically, increased trade resulted in larger CA imbalances. (Countries that trade more also tend to borrow and lend more) International asset holdings increased over the 20th century.

38 / 47 Global integration of labor markets To be covered by the guest on Tuesday

39 / 47 Comparative Advantage

40 / 47 Comparative Advantage Absolute advantage: The comparison among producers of a good according to their productivity Describes the productivity of one person, firm, or nation compared to that of another. The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good. Compare US and China: the cost of making a computer can be lower in China the cost of making a car can be lower in China → China can have absolute advantage in both activitites Comparative advantage: Compares producers of a good according to their opportunity cost (or relative costs) Whatever must be given up to obtain some item: producing more cars means less resources for producing computers → China cannot have absolute comparative advantage in both!

41 / 47 China Cannot Have Comparative Advantage in Everything

cost of making a computer in China cost of making a car in China cost of making a computer in US < cost of making a car in US ⇒ cost of making a car in China cost of making a computer in China cost of making a car in US > cost of making a computer in US

42 / 47 Comparative advantage for countries

43 / 47 Comparative advantage for countries: Illustration I There are 2 goods: cars (capital-intensive) and computers (labour-intensive). The US is relatively capital abundant, whereas China is relatively labour abundant -> specialization according to factor endowments Winners in the US: Owners of capital -> inequality should rise Winners in China: Workers (higher wages) -> inequality should fall We have seen evidence for these changes in the lectures on inequality

44 / 47 climateclimate change change in in agricultural agricultural markets markets 207 207 AA sample sample of of the the GAEZ GAEZ predictions predictions can can be be seen seen in in figure figure 1. 1. Here Here we we plot,plot, for for each each grid grid cell cell around around the the world, world, the the predicted predicted percentage percentage changechangechange in in in productivity productivity productivity associated associated associated with with with climate climate climate change change change for for for two two two of of of the the the worldworld’’’sss most most most important important important crops: crops: crops: wheat wheat wheat panelpanel AA andandand rice rice rice panelpanel BB ... As As As ððð ÞÞÞ ððð ÞÞÞ isisis clear, clear, clear, there there there exists exists exists a a a great great great deal deal deal of of of heterogeneity heterogeneity heterogeneity in in in the the the effects effects effects of of of climate climate climate changechangechange both both both across across across crops crops crops and and and over over over space; space; space; many many many regions regions regions see see see a a a differential differential differential productivityproductivity change change in in wheat wheat and and rice, rice, and and this this relative relative productivity productivity changechangechange is is is different different different from from from that that that of of of other other other regions. regions. regions. Further, Further, Further, the the the contours contours contours ofof the the effects effects of of climate climate change change on on rice rice and and wheat wheat appear appear not not to to reflect reflect Illustration:countrycountrycountry comparative borders. borders. borders. Within-country Within-country Within-country advantage heterogeneity heterogeneity heterogeneity in is is is a a a agriculture central central central feature feature feature of of of thesethesethese data. data. data. During the 12thToTo go go and beyond beyond 13th the the evolution evolution centuries of of comparative comparative – pre-dating advantage advantage Ricardo’s documented documented famous in in example of comparativetheagronomicGAEZdataandquantifytheeconomicmacro-consequencestheagronomicGAEZdataandquantifytheeconomicmacro-consequencestheagronomicGAEZdataandquantifytheeconomicmacro-consequences advantage – England was exporting wine to France, and ofof climate climate change, change, we we need need an an economic economic model model of of agricultural agricultural markets markets vineyards werethatthatthat can can can found predict predict predict asiii farwherewhere north crops crops are are as produced produced southern and, and, Norway. in in turn, turn, which which produc- produc- ðððÞÞÞ tivitytivitytivity changes changes changes are are are relevant relevant relevant and and and which which which ones ones ones are are are not; not; not; iiiiii howhow shocks shocks to to the the ððð ÞÞÞ

Climate has and will change the change of comparative advantage in agriculture. Prediction of global wheat output (gaining regions dark). Global trade will lead to new specialization and mitigate the impact of climate change Credit: Costinot et al. 2016 45 / 47

FFFIGIGIG.1..1..1.——PredictedPredictedPredicted yield yield yield changes. changes. changes. Percentage Percentage Percentage changes changes changes in in in yield yield yield due due due to to to climate climate climate change change change in in in the the the GAEZGAEZ model. model. Areas Areas with with diagonal diagonal stripes stripes indicate indicate regions regions for for which which predicted predicted yields yields are are zero zero bothbothboth before before before and and and after after after climate climate climate change: change: change:AA,,, wheat; wheat; wheat;BBB,,, rice. rice. rice. Color Color Color version version version available available available as as as an an an online online online enhancement.enhancement.enhancement.

ThisThisThis content contentcontent downloaded downloadeddownloaded from fromfrom 046.030.132.172 046.030.132.172046.030.132.172 on onon August AugustAugust 17, 17,17, 2018 20182018 05:35:26 05:35:2605:35:26 AM AMAM AllAll use use subject subject to to University University of of Chicago Chicago Press Press Terms Terms and and Conditions Conditions (http://www.journals.uchicago.edu/t-and-c). (http://www.journals.uchicago.edu/t-and-c). Globalization and economic performance

Some countries have benefitted more from globalization than others. Economic success depends on how well policies have managed growth due to economic integration. During industrialization, Germany and the US achieved high economic growth despite high manufacturing tariffs. Nordic countries prospered through openness, with policies that help displaced workers.

46 / 47 Summary

Economic epochs Great depression → demand-side crisis Golden age → supply-side crisis Financial crisis → banking crisis Globalization Economies have become more integrated over times Specialization and trade can be mutually beneficials Winners and losers in the short run, both within and between countries, depending on relative factor abundance All parties can benefit in the long-run with good policymaking! Next lecture: Guest (Matti Sarvimäki) on global labor markets and immigration

47 / 47