NBER WORKING PAPER SERIES WHY ARE WE IN A RECESSION? THE FINANCIAL CRISIS IS THE SYMPTOM NOT THE DISEASE! Ravi Jagannathan Mudit Kapoor Ernst Schaumburg Working Paper 15404 http://www.nber.org/papers/w15404 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 October 2009 We would like to thank Sumit Agarwal, John Boyd, Chun Chang, Darrell Duffie, Martin Eichenbaum, Andrei Jirnyi, Arvind Krishnamurthy, Jonathan Parker, Ashwin Ravikumar, Shamika Ravi, Sergio Rebelo, Mike Sher, and Vefa Tarhan for helpful discussions, Andrei Shleifer for helpful comments on an earlier version of the paper, and Athreya Sampath for excellent research assistance. All errors are our own. The views expressed in this paper are those of the authors and do not represent the views of the institutions they belong to. © 2009 by Ravi Jagannathan, Mudit Kapoor, and Ernst Schaumburg. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. Why are we in a recession? The Financial Crisis is the Symptom not the Disease! Ravi Jagannathan, Mudit Kapoor, and Ernst Schaumburg NBER Working Paper No. 15404 October 2009, Revised November 2009 JEL No. E0,E00,E2,E3,G0,G00,G01,G2 ABSTRACT Globalization has brought a sharp increase in the developed world’s labor supply. Labor in developing countries – countries with vast pools of underemployed people – can now more easily augment labor in the developed world, without having to relocate, in ways not thought possible only a few decades ago. We argue that the large increase in 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: The inability of emerging economies to absorb savings through domestic investment and consumption due to inadequate national financial markets and difficulties in enforcing financial contracts; the currency controls motivated by immediate national objectives; and the inability of the US economy to adjust to the perverse incentives caused by huge money inflows leading to a breakdown of checks and balances at various financial institutions. The financial crisis in the US was but the first acute symptom that had to be treated. A sustainable recovery will only occur when the natural flow of capital from developed to developing nations is restored. Ravi Jagannathan Ernst Schaumburg Kellogg School of Management Kellogg School of Management Northwestern University Northwestern University 2001 Sheridan Road 2001 Sheridan Rd 431 Jacobs Center Evanston, Illinois 60208 Evanston, IL 60208-2001 [email protected] and NBER [email protected] Mudit Kapoor Indian School of Business Gachibowli Hyderabad - 500032 India [email protected] Jagannathan, Kapoor & Schaumburg (2009) Why are we in a recession? Contents 1 Introduction 3 2 A Global Perspective 5 3 The Emergence of China, Labor Supply Shock, Current Account Deficit, and Capital Flows 7 3.1 The Rise of China . .7 3.2 Labor Supply Shock . .9 3.3 Current Account Deficits and Capital Flows into the US . 14 4 US households 18 4.1 A Stylized Model of Households’ Consumption Choice . 23 5 House Prices and the Current Account Balance 26 6 Role of Financial Engineering 29 7 Role of Government Deficit 34 8 Why Housing Bubbles are Different 34 8.1 Money Channeled into Housing has a Bigger Price Effect . 34 8.2 A Housing Bubble is Different from a Stock Market Bubble . 35 9 Why Did the Bubble Burst? 37 10 The US is not Alone: Some International Evidence 38 11 The Way Forward 38 A Data Sources 45 2 Jagannathan, Kapoor & Schaumburg (2009) Why are we in a recession? 1 Introduction Without doubt we are in the middle of a severe recession, the worst since the great de- pression. A large part of the wealth we thought we had has evaporated: For example, the value of corporate equities has come down substantially during the past decade, from $19.4 trillion (2.1×GDP) in 1999 to $15.2 trillion (1.1×GDP) in 2008. Household net worth in the US (including nonprofit organizations) has gone from $42.1 trillion (4.4×GDP) to $51.7 trillion (3.6×GDP) in 2008.1 At the same time, the consumer price index (CPI) increased by 29% from 1999 to 2008, and the number of households in the US increased to 117 million in 2008 from 104 million in 1999. As a result, the net worth per household in real terms (1999 dollars) declined sharply from $402,000 in 1999 to $343,000 in 2008, i.e., a 15% drop during the past decade. Averages mask the magnitude of the sufferings of the masses. The unemployment rate captures the difficult times of the average citizen even better: it has gone up from 4.4% in 1999 to 7.2% in 2008 – and is currently estimated to be 9.5% (July 2009.) This raises the question, why are we in such a great recession? What is the cause? According to folk wisdom, the financial crisis caused the recession. That of course begs the question: what caused the financial crisis? The standard answer is, easy credit and lax regulation led to the crisis. But then, what caused easy credit and lax regulation? According to popular press, it is due to the savings glut in Asia, and the fact that a major part of these savings flow into the US resulting in too much money chasing too few opportunities in the US financial system. Why is there too much saving in Asia and why do those savings flow to the US? Asians just like to save and Americans just like to consume more! According to this logic all that is needed to remedy the situation is to induce Asians to save less and consume more. In this paper we argue that this logic is misleading. All these phenomena – savings glut, easy credit and lax regulation, and financial crisis – are closely interlinked and there is a deeper driving force. While each piece is well understood, our focus here is to emphasize how a common driving force is linking them all together. Understanding of the deeper driving force is the first step in laying the road to a sustainable recovery and prosperity. The world has been subjected to several major unanticipated shocks during the last three decades that have led to globalization. President Nixon’s opening of China to the West led to the normalization of diplomatic relations between US and China in January 1979. It took China more than a decade to get organized to compete in world markets. India too liberalized during the early nineties which set the stage for opening of trade between India and the rest of the world. The fall of the Soviet Union ended the cold war and helped the developing world focus on economic growth based on trade with the Western world. 1Table F.100 of the Flow of Funds, http://www.federalreserve.gov/releases/z1/Current/z1r-3.pdf 3 Jagannathan, Kapoor & Schaumburg (2009) Why are we in a recession? The innovations in communications and transportation during the last two decades of the twentieth century accelerated the globalization process tremendously. The impact of globalization has been a sharp increase in the developed world’s effective labor supply. Labor in developing countries – countries with vast pools of grossly under- employed people – can now compete with labor in the developed world without having to relocate in ways previously not possible. For example, a hedge fund can hire an analyst in the Philippines to produce research reports on American firms at a fraction of the cost of an analyst living in the US, without sacrificing quality. A radiologist in Nigeria can analyze the X-Ray of a patient taken in Boston over the internet and send her diagnosis back thereby competing with a local radiologist located in Boston. A non emergency call to the doctor’s office can be answered by a triage nurse located in India and without noticeable difference to the patient. A snow blower manufacturer in Wisconsin can move a large part of the manufacturing operations to China resulting in substantial savings with little impact on quality. In essence, the internet and innovations in transportation are virtually reshaping the world economy. The productive citizens of less developed countries have increasingly joined the workforce of developed countries, without the need to change their citizenship. China, (and to a lesser extent, India) being well organized with a stable political system, a large trained labor force, and excellent infrastructure facilities within special economic zones, has been the major beneficiary of this recent technological revolution. Even if only 10 percent of the population of India and China are potentially qualified enough to compete in the western world’s labor market, that translates into an increase in the western world’s labor supply of nearly 200 million people, almost the same size as the U.S. labor force. In what follows we argue that this huge and rapid increase in the 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 ab- sorb 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.