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.
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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.

Quick Links

Sorry for the lack of posts recently - been quite busy. Here are a few articles I think are worth reading:

• The Baseline Scenario writes about monetary policy, taking a look at hawks vs. doves in the Fed. I never quite thought of hawks or doves in monetary policy, but it's a neat take.
  
  

  Hawks also like to talk a lot about “credibility,” which means a reputation for being willing to fight inflation. People use the word credibility in this context because the conventional wisdom used to be that national governments would not be willing to take tough steps (raising interest rates) against inflation because that would cost jobs, and hence votes in the next election. So central banks had to prove that they were willing to raise interest rates and put people out of work, even though that might be politically unpopular. Now that our Fed governors and bank presidents are accountable to just about no one, beating on their chests and proclaiming how willing they are to be tough in the face of the political winds rings a little hollow to me — especially in a “middle-class” country that considers inflation to be a greater evil than unemployment. Arguably, the situation has reversed; it has become so accepted that the primary job of a central bank is to fight inflation, despite the Fed’s dual mandate (to both fight inflation and promote stable economic growth), that fighting inflation has become the politically safe thing to do.
  

• This is interesting, and for Americans, potentially alarming: China, Russia, Japan, France, and some Middle Eastern countries are planning to "end dollar dealings for oil." There's been quite a bit of noise over the past months about shifting away from the dollar as the main international currency, but (at least in articles I read, which I must note tend to be written by Americans) such talk has been largely dismissed. Apparently, we shouldn't dismiss so easily. The dollar is already weak in value, and such a move only further hurts its reputation. If this is actually going to happen, it will increase tension between China and America. It is also interesting that Japan, who has been a pretty close trade partner and ally since WWII, is part of this non-dollar alliance.
• A profile of Larry Summers and his team.
  
• Mish arguing that deflation is no longer a looming threat, it is here. Furthermore, he argues that it's a good thing! Take a look:
  
  

  Deflation is not a threat because deflation is here by any practical measurement. Deflation is also here by impractical measurements such as falling prices. See Humpty Dumpty On Inflation and Daniel Amerman vs. Mish: Reflections on the Great Inflation/Deflation Debate for a further discussion of a practical definition of deflation, a contraction of money supply and credit marked to market, not falling prices.
  
  Moreover, deflation is not a threat in a second sense. Deflation is needed to purge the excesses of the last credit cycle. Attempts to defeat deflation by force will only prolong the agony while accumulating government debt, just as happened in Japan's two lost decades.
  
  Finally, deflation is not a threat in a third sense. Falling prices are a natural state of affairs because of rising productivity over time.
  

  
  
  
  
  

The Weak Dollar Policy

I received an email from a friend, Nicholas Kreifels, recently. He reads this blog on occassion and wanted to send some thoughts on what he thinks is a "weak dollar policy". I got his permission to post his thoughts here:

...in regards to the Fed's current solution to the crisis.  I think of it like this, they are pouring all the water on the floor (i.e. liquidity flood) and not mopping it up.  Big banks continue to devour smaller, weaker banks, consolidating capital, posing an even larger systemic threat to the global economy.  The dollar weakens each day, which poses a severe threat to the U.S. economy in the long run by depreciating our currency and threatening our reserve currency status.  After all the liquidity floods the market, are we any better off?  I see one of two things happening, domestic companies mop up the liquidity, fueling the inflation of another bubble (think 90s S&L crisis), or inflation balloons and foreign investment, already declining, packs its bags and heads for the hills.  The U.S. has carried a trade deficit since I was born.  I think it's time to realize we need to raise interest rates and let the export industry take it on the chin in order to help the majority (companies that import).  The trade deficit partnered with our currency deficit increases the problems for the U.S.  What will we do when China stops borrowing?  Or, when the dollar is no longer the reserve currency?  I think the negative implications of a weak dollar policy far outweigh its benefits.

I asked for further clarification on what he meant by "I think it's time to realize we need to raise interest rates and let the export industry take it on the chin in order to help the majority (companies that import)." Here is his followup:

The sentence about "taking it on the chin" references basic strong/weak dollar policy.  If the dollar is weak, compared to foreign currencies, this proves to be in an exporter's advantage because he can sell his goods cheaply, due to the fact that foreign countries' purchasing power increases as the dollar weakens.  We know that the U.S. maintains a trade deficit, which signals that our economy is IMPORT heavy.  Hence, it appears, based on trade, that the U.S. has more domestic companies that import than export, making the majority of domestic companies importers and the minority exporters.  By instituting a strong dollar policy, the export companies take a direct hit (also known as taking it on the chin) because they cannot sell their goods as cheaply as before.

My argument is to institute a strong dollar policy to benefit the majority (importers), instead of the minority (exporters).  Not only does the weak dollar policy hurt the majority of the companies, it harms the status of the dollar as the reserve currency because weak dollar policy promotes inflation.  The Fed has expanded its balance sheet by 2 trillion dollars, and it currently practices a weak dollar policy.  Inflation, if not monitored closely, can flame up quickly.  I understand the Fed's motive to promote and thaw the credit markets; however, the liquidity in the market is there, the banks simply are not lending it.  So, the question becomes: when will the Fed cease to flood the market with liquidity?  I don't see an end in sight, and that is discouraging. 

Does anyone have thoughts on this? I have not thought about the strength of the US Dollar, and how that affects our country, much at all. However, at first glance, it's not clear to me that having a weaker dollar is all bad, at least in the short-term. First of all, I don't see any other currency that can legitimately replace the US Dollar as the global reserve currency. Though some countries may diversify into Euros, or other globally respected currencies, the dollar is in my mind still the safest play due to the position of the US economy. This economy is the largest and strongest in the world despite the downturn, and no other country is as of yet ready to take that role. Also, might it not be a good thing for us to start exporting more? This may lead to job creation in manufacturing or services industries, providing both blue- and white-collar jobs that would greatly help the middle-class.
I have written about the inflation scare potential, and it indeed lurks on the horizon. In this, I feel Nick is correct: we will eventually see inflationary issues from all the money the Fed has pumped into the system (note: I wrote that the short-term worry is actually deflation. I should revisit this topic at some point.). That is intentional, as Nick articulates: the Fed is purposefully practicing a weak dollar policy. I also feel the long-term dangers are severe. Though in the short-term, this policy could help alleviate the recession, a long-term weakened dollar doesn't help our country.
I'd love to get some opinions on this weak dollar policy business. Is Nick's premise correct? If so, are the repercussions he envisions, and his preferred response, with merit? Does my response have any merit? Any thoughts on Bernanke's policy in general?

More Random Reading

• Warren Buffett at the NYT, discussing our rapidly-increasing national debt.
• A reminder that we still may need more bank regulation. Remember how in the immediate aftermath of Lehman/Bears, everyone was crying out for more regulation? Now some are claiming that the government simply dropped the ball, and that sufficient regulation already existed. I've linked to an article of that opinion before in this post.
• Perhaps free-market health care is the answer (in two parts: part 1, part 2). Part 2 is the more interesting segment. I think the author is not adequately dealing with underprivileged kids and the elderly; otherwise, he makes a pretty good case that a free-market system may be best assuming we as a society take care of 'pre-existing conditions'. Also, as pointed out by a reader with whom I discussed this article earlier, he does not deal with tort reform.
• More on healthcare: an article that talks about why Obama is struggling to convince people to work with him on reform. Note that the article is focused on why he's struggling; there does not seem to be much of an opinion either way on free-market vs universal care. More importantly, it contains 20 links (count it, 20!!) to different articles, ranging from conservative to liberal. I still haven't read through all 20, but it seems like a nice resource. *UPDATE* I was wrong, he does lean to universal care. I missed that in my first read-through.
  
• A representative saying Social Security could default within two years!
• PIMCO on the dollar, both valuation and as global reserve currency. Plenty of re-hash of popular, recent economic commentary, but a nice summary nevertheless.