‘Red Star Spangled Banner’: Scrutinizing the Root Causes of Financial Crisis

Posted by on 11 May 2009

From Christian Fahrholz and Andreas Kern .

In this short note we inquire into the root causes of the present financial crisis by drawing on a Heckscher-Ohlin-Samuelson (HOS-) model. At the origin of the current crisis are global imbalances originating from distorted relative prices in real production. In this regard, financial repression in countries that seek to suppress real appreciation has resulted in excessive labour-intensive production and a global capital shortage. Seemingly, some rather controlled economies have bended the tune of real and particularly financial globalization thus producing the rather awkward anthem “Red Star Spangled Banner”. Crisis remedies, hence, have to rely on revamping the team play in financial globalization affairs.

We argue that in particular a low level of financial development and subsequent politically induced financial repression in emerging market economies has put the chains on relative prices and real exchange rates respectively, supporting macroeconomic stability and spurring economic growth in the short-term not only within emerging economies, but also in mature economies (cf. Rodrik 2008, Eichengreen 2007). Consequently, rather controlled economies have concentrated on exporting labour-intensive production, which in the presence of command economy style distortions has been reflected in a remarkable savings glut. To cope with distorted competition in international production – due to the suppressed upward pressures in real wages abroad – few options exist for more mature economies: possible reactions of rather flexible market economies comprise of lowering real wages and/or pushing ahead with the marginal product of other factors, such as capital including financial services or land. As depressing real and correspondingly nominal wages considerably is not a viable option for rather flexible market economies. Subsequently, practicing a laissez-faire stance towards financial markets, an increase in the marginal product of capital and excess lending has been the natural outcome of distorted international competition. According to our line of argument, suppressing real appreciation in rapidly growing economies results in the production of high net saving surpluses, i.e. an export of real appreciation pressures and severe global imbalances, which are at the heart of the present financial crisis. In the following sections, we present an overview of how we formalised our argument based on comparative statics referring to a Heckscher-Ohlin-Samuelson (HOS-) model.
Financial repression in autarky                                                                                                                                     
In doing so, we assume the representative economy to produce two goods with known characteristics, i.e. one good is labour-intensive in production and the other one capital-intensive, while technologies and preferences in the two countries are identical. After the Stolper-Samuelson proposition given a specific relative factor price, a rise in the real interest rate can be traced back to a decline in relative good prices in terms of a labour-intensive good. This is to say that a corresponding reduction in the produced amount of capital-intensive goods relative to labour-intensive goods may be due to a change in factor prices, i.e. here the real interest rate. An according change in the rental rate on capital shifts the economy towards labour-intensive goods production. Therefore, there is a drop in relative deployment of capital per labour. For the sake of simplicity and taking the Walras’ Law into consideration, we model the market distortion as a minimum rental rate on capital assets, which can be interpreted as financial repression with the aim of preventing real appreciation. In line with the Lerner symmetry, a wage rate policy including a far too low real wage rate would yield the same result. As a result of the Stolper-Samuelson Effect, an artificially high minimum rental rate on capital assets leads to higher relative good prices in terms of labour-intensive good production. Hence, we reach a new equilibrium with less capital-intensive production in order to compensate the high level of financial returns. Accordingly, capital that would have been employed in production in the case of no financial repression must be off-set in terms of ‘stalled investments’, labelled as . This is to say that some portion of capital has been squeezed out of economic production relative to original factor endowments. A flexible interest rate will always ensure that capital will, at all times, be fully employed. However, adding politically induced market distortions to the capital market with a binding minimum on the rental rate of capital, a market clearing via the price mechanism could potentially not occur. By the same token, such financial repression does not allow for re-investment within the domestic economy but results in an export of savings/investments.

Real appreciation controlling: a view from the balance of payments
In order to show that a savings glut results from financial repression and leads to a corresponding drop in capital intensity, we have to take a look towards balance-of-payment issues. Although such an approach presents an ex post view on the international flow of real quantities and according claims and liabilities, a closer look at the balance-of-payments prepares the ground for the subsequent analysis of ‘excess savings’ from the viewpoint of international trade. The following equations link financial repression and its resulting de-capitalization , which must be equivalent to “excess savings” in the related country.


The subsequent equations in (4) highlight the fact that capital and financial accounts, i.e. investments abroad and changes in the reserve level(If-dR) balance the current account (X-M). The latter trade balance must then be identical with the level of ‘fundamental savings’, which are not invested in the domestic economy, plus the ‘excess savings’ due to the de-capitalization in the course of financial repression in terms of ‘stalled investments’ .


The basic link between financial repression and excess savings is rather simple: For competitive firms to access financial funds on capital markets at the higher interest rate, they need to sell off their products at least at the higher relative price. When financial repression puts a binding constraint on firms, the goods price will only be attained, if the relative scarcity of capital increases. This will apply only if a sufficiently large share of capital is unemployed in production.

Open economy model
We now consider the world economy consisting of two countries with free trade and zero transaction costs. The mature country (A), representing the group of flexible market economies, has completely liberalized financial markets, in which the interest on capital assets is determined freely by market forces. The representative real appreciation controlling economy (C) has imposed some form of financial market repression to support their economic development strategies, leading to an upward bended minimum real interest rate, though still in line with competitive cost conditions. Let a bar of the variable represent the level of that variable in the integrated equilibrium. Let index  represent goods and  index countries A and C. The set of divisions of world endowment among involved countries in line with the integrated equilibrium concept can thus be described in the form of factor price equalization (FPE) set:


If the integrated equilibrium is to be replicated, the global savings glut must be at the same level as in the integrated economy. But ‘excess savings’ do not arise in liberalized financial markets in country A. However, the real appreciation controlling country C must build up ‘excess savings’ (equivalent to some form of de-investments ) in order to comply with the higher interest rate. Beyond this, we only need to satisfy the conventional restrictions in terms of employed factors. These require that both countries use the integrated equilibrium techniques, and that the integrated equilibrium output in both sectors can be divided among the countries. In a stable equilibrium, demand will exactly exhaust employed factors in the two countries, which exist in the overall reduced ratio of capital per labour. Under the conditions noted above, international trade equalizes factor prices between the financially liberalized economy A and the financially repressed economy C. The according distortion in relative factor prices resulting from financial repression shifts the economy to a new equilibrium. Here capital intensity in the production of the labour-intensive good has decreased. At the same time, capital intensity in the capital-intensive production within country A has increased. In the face of a global market, free commodity trade fully equalizes factor prices and thus exports warped relative prices from real appreciation controllers to flexible economies.
Trade adjustments in the course of financial repression
Now we have to demonstrate how economic integration in the form of trading between a mature, flexible market economy A and a non-mature, real appreciation controlling economy C are impacting on both economies. In particular, we are interested in investigating how financial repression in one country affects the production in the other country. In the HOS-model framework it is particularly the Rybczynski theorem that deals with the effects of endowment changes. With one factor price fixed, i.e. financial repression and an upward bended rental rate for capital, our result is just the Rybczynski theorem in reverse. When we look at country C with financial repression and an upward bended rental rate for capital, not trading with country A the warped relative price leads to a change in production. The decreasing production of the capital-intensive good reflects the expansion of savings, exactly necessary to eliminate the excess demand for capital-intensive goods (i.e. investments). In our stylized framework the country C’s opening of trade with country A would even further increase country C’s ‘excess savings’ in terms of ‘stalled investments’ and the ruled-out demand for capital-intensive goods in country C respectively. The reason is that country C would be quasi forced to generate the full integrated amount of savings to sustain a higher interest rate for both economies. In country A, the absence of financial repression results in a relatively lower but ‘natural’ (Wicksell) interest rate. However, once trade commenced, the flexible market economy of country A comes to share country C’s high real interest rate. The fact that country A shares the high interest rate under trade follows from the fact that trade links goods prices, which both countries remain diversified and that producers still face competitive cost conditions. In effect, trade forces country C to bear the burden of ‘excess savings’ to maintain country C’s comparative advantage and hinder a real appreciation. However, forcing capital markets in country A to increase capital rental rates implies that opening to free trade will lead to a deviation of the capital rental rate from its economic fundamental value. This would lead to an over-utilization of capital and increasing capital intensity in country A’s economy. Accordingly, an economic bubble emerges at the heart of country A, which cannot be detected by simply looking at isolated country-specific fundamentals.
Transfer of ‘excess savings’

‘Excess savings’ of country C are indeed exported to the flexible market economy in country A. The previously outlined balance-of-payments arithmetic has already shown that real appreciation controlling is achieved by a contraction of capital-intensive good production in terms of ‘stalled investments’, fuelling the current account surplus of country C. However, such balance-of-payment matters only depict the ex post view on economic formation. We have now to set forth, how distorted relative factor and good prices affect the formation of import-export relations ex ante. Regarding import demand and export supply between country A and C fills this niche and buttresses the results gained thus far.

As we have already argued, a surge in relative price levels results in an increased production of labour-intensive goods and a contraction of capital-intensive production respectively. Accordingly, we may now argue that the upward bended relative price corresponds to country C’s real exchange rate and inversely affects its terms of trade. This is to say that country C improves its terms of trade with the help of financial repression. As indicated in the FPE set, resulting ‘excess savings’ in country C are transferred in terms of an export supply of labour-intensive goods. At the same time, country A heavily borrows from country C and absorbs these ‘excess savings’, which, in turn, allows for spurring capital-intensive production in country A. From the viewpoint of country C, this is simply an export of its real appreciation pressure towards country A via its downward bended terms of trade. Interestingly, it is the labour force in country C that bears the burden of internal economic adjustment to suppressed real appreciation.

Conclusions and Outlook

As we argued in the beginning, financial crisis stems from distortions in global real production. To put it bluntly, real undervaluation in context of financially and thus real exchange rate suppressed economies is at the heart of the root causes of current international financial crisis. In contrast to conventional monetary approaches, we have set forth an analytical framework of international trade economics in order to investigate the root causes of recent financial turmoil in a broader context. We demonstrate how economic dynamics in an asymmetric global financial integration process have contributed to fuelling international liquidity and thus contributed to an expansion of financial markets in mature, flexible market economies beyond their fundamental economic capacity. In this regard, our central assumption has been that financial repression has been applied in non-mature economies in order to prevent real appreciation pressures, as well as to stabilize economic growth processes in these economies. However, these policy measures have worked as a push factor and a driving force behind international capital flows to mature financial markets. For this reason, we argue that latter non-mature economies are the ‘producers’ of the global savings glut, which, in turn allows for capital intensification in the sector of capital-intensive production in mature and thus financially developed and liberalized economies. At the same time, the according absorption of international liquidity also reflects global asset shortages (Caballero et al. 2008) as depicted in the fall of global capital intensity in the integrated world equilibrium.

Furthermore, the combination of both the saving glut and a lack of appropriate financial market regulation has been fuelling consumption and production in these mature economies beyond their fundamental capacities. From this perspective standard approaches and measures applied in assessing financial and macroeconomic vulnerabilities must have failed to show signs of overexpansion and misalignments. In fact, a large current account deficit in combination with a stable US Dollar exchange rate and increasing labour productivity in the US have been rather persuading policy makers and investors to put trust in the sustainability of global imbalances in recent years. Nevertheless an artificial contraction of capital-intensive production in real appreciation controlling economies lies at the heart of the economic expansion of financial industries and consumption in the US beyond their fundamental limits.

According to this view from the production side, it becomes apparent that accruing real misalignments between mature and non-mature economies in a globalized world are a root cause of the current global financial crisis. For that reason, any policy measure aimed at restoring misaligned economic structures will lead to a freeze of a suboptimal equilibrium, exposing mature and non-mature economies to substantial economic vulnerabilities in the near future. Nevertheless such demand-side oriented measures are possible instruments which may deliver short-run relief to the global economy and employment in the US and other mature economies. At this stage, however, escaping costly structural adjustments on the supply side in form of industrial cutbacks and rising unemployment will hardly be possible. In order to prevent a potential collapse of the global economy in the medium to the long run, correcting structural misalignments should be high on the policy agenda. Hence, fixing structural misalignments on a global scale with the help of international policy coordination may represent the natural order of things. Revamping the latter ideas may help to surmount the discontent from current international financial crisis. Obviously, advanced and rather controlled economies can hardly get along together in a world that is globalized in real but not in financial terms. In order to reap the benefits of extensive globalization in the long run crafting a financial and thus ‘real’ sound globalization is warranted.

Christian Fahrholz,  Friedrich-Schiller-University Jena and University of Mannheim


Andreas Kern,  Jean Monnet Centre of Excellence, Free University Berlin



Caballero, Ricardo J., Emmanuel Farhi, and Pierre-Olivier Gourinchas, “Financial Crash, Commodity Prices and Global Imbalances,” NBER Working Paper No. w14521, 2008.
Eichengreen, Barry, “The Real Exchange Rate and Economic Growth,” (http://www.econ.berkeley.edu/~eichengr/real_exc_rate_econ_grow.pdf, 2007).
Rodrik, Dani, “The Real Exchange Rate and Economic Growth,” (http://www.brookings.edu/economics/bpea/~/media/Files/Programs/ES/BPEA/2008_fall_bpea_Paper/2008_fall_bpea_rodrik.pdf, 2008).

Note: This column is based on Global Financial Markets Working Paper No.5/04-2009 (URL: http://www.gfinm.de/images/stories/workingpaper5.pdf).