Why Are We In A Recession?

A paper was recently published which I found very interesting. Written by Ravi Jagannathan, Mudit Kapoor and Ernst Schaumburg (of Northwestern Kellogg, Indian School of Business, and the New York Fed respectively), it attempts to analyze the true cause of the recession.

...why are we in such a great recession? What is the cause?
According to folk wisdom, the financial crisis caused the recession. That leads to 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 a major part of that savings flows into the the US with the result that there is too much money in the US financial system chasing too few opportunities. Why is there too much savings in Asia and why 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 require 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.
...
In what follows we argue that this huge and rapid increase in developed world’s labor supply, triggered by geo-political events and technological innovations, is the major underlying force that is affecting world events today. 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 absorb 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. The financial crisis was the first symptom.

I should note that I've heard this argument before, although not so formally researched and argued. It is a very interesting piece of analysis and points to us being in the midst of a much larger correction that is taking place. One question to be asked, assuming the analysis is correct, is what is the solution to our problems here? They draw an interesting historical parallel to a rapid increase in labor supply that was solved as follows:

When millions of World War II soldiers returned home that increased the US labor force of about 60 million workers by almost 25% within a very short period of time. At that time the Department of labor, which certainly had no cause to accentuate the negative, predicted that 12 to 15 million workers would be unemployed. That did not happen! We managed that problem well leading to prosperity instead of doom, thanks in no small part to the GI Bill and other governmental fiscal intervention. We can manage this one as well.
For that to happen, the first step is to recognize the problem for what it is. A solution may well require actions similar in scope to the GI Bill and require a national debate.

This seems to be support for serious government intervention, which has already started.

But there's no sugarcoating of how America must deal with things. The authors definitively state that consumption must go down and competitiveness must go up. In other words, less shopping and more education. I'm sure kids around the country will just love to hear that.

A few more random quotes from the paper that are interesting:

As housing prices decline and the charade of cheap credit is lifted, there will be a severe contraction in consumption levels... We should therefore be prepared for a permanent 3% drop in consumption levels. This number does not account for the brewing trouble in the commercial real estate markets where many regional banks may yet be in trouble due to excessive exposures to bad loans which could further delay the recovery in the real economy.

It is likely as recovery takes hold, the value of the U.S. dollar will decline substantially, and that alternative reserve currencies will begin to emerge.

Clearly China’s export led growth strategy of the past cannot continue indefinitely and domestic consumption must be allowed to grow as a share of GDP. At the same time, Western economies must adjust to a new equilibrium in which commodities are scarcer and households will face stiffer competition for jobs.