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The Crisis That Couldn’t Happen

Matt Yglesias has a good post up pointing out what should be obvious to anyone who ever took Economics 101:  the great crisis so many were expecting and predicting prior to 2008 is not the crisis that we actually got.   There were those who correctly pointed to the housing bubble, but even those people mostly got it wrong.

The crisis people were expecting (including me) was a “sudden stop” or “currency crisis”.   A nation racks up too much debt, foreign lenders stop lending and the result is a crisis.   Think Argentina (2001/2002).

The counterargument, though, seems to have not gotten much attention.  The paper I’m thinking of is called “Financial Integration, FinancialDevelopment and Global Imbalances”  by Mendoza, Quadrini and Rios-Rull.  The point, basically, is that the global imbalances between the US and China (in particular) may be stable in the long-run.  Essentially, the US isn’t just operating as a place for the Chinese to park their money, but more importantly it is was a safe place for them to park their money.   The US has deep financial markets, China does not.  When they lend us their money, they are not just lending money  but also accessing that deep financial market and that is valuable.  In return, some of those funds are recycled back into China by Americans seeking high returns – this is something that the deep market can’t provide.

The end result is more like trade than is usually understood.  Americans get free money when the Chinese revalue and a partial stake in China’s growth, while the Chinese get more financial stability.   This is sustainable because the Americans earn a lot of interest and the Chinese only a little per unit of debt.   Of course, this comes to an end eventually, but it’s a soft landing:   China eventually develops deeper financial markets and industrializes (so that the returns on new capital projects falls).   I would go so far as to point out that a developing country which is not maintaining a trade surplus the way China does, is bound to fall into a currency crisis: developing countries will always have more high return investments than rich countries and that means capital outflows inflows, and that means indebtedness which will eventually stunt growth.

At any rate, MQR convinced me, personally, that the global imbalances were in for a nice gradual soft landing (eventually).  Then, the financial crisis hit.   At first, I thought MQR was wrong, but as Yglesias correctly points out; a currency crisis is not the crisis that we see (at least not in the US).  The bilateral US-China relationship is continuing exactly as it always has.   It was US households that absorbed the lion’s share of the government debt issues that followed  and US businesses are continuing to invest in China – not what you would expect to see if the country were on an unsustainable fiscal path.

To make a long story short(er), a few years ago MQR was really big with these RBC-types, like the ones that Yglesias mentions – they are almost certainly aware of it.   They should know that their own formerly-favored model is telling them something very different from what they are now claiming.   Isn’t it strange that they being to ignore a model as soon as it contradicts their worldview?

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