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Describe the Heckscher-Ohlin model and explain the Heckscher-Ohlin Theorem. Provide a critique of the assumptions of the model. Is the Heckscher-Ohlin Theorem robust to the underlying assumptions? Explain and illustrate important points by using diagrams. Based on this critique, analyse the relevance of the model for policymakers.

Developed in the 1920’s by Swedish Economists Eli Heckscher and Bertil Ohlin, and further developed by Paul Samuelson, the Heckscher-Ohlin model attempts to provide more realistic explanations of trade than that of the previous conventional wisdom: the Ricardian Model of Comparative Advantage. Supplementing Ricardo’s model with two key assumptions, namely the introduction of two factors of production (capital and labour), and the necessity that production technology be identical in both countries, the model was able to show that trade and comparative advantage will result from the relative international difference of factor endowments instead of differing labour productivity.

By introducing two factors of production the model is often referred to as the 2x2x2 model (two countries, two commodities and two factors of production), the first three of many assumptions necessary for the model to hold, the rest are listed below as a precursor to succinctly describing the model:

· Each country possesses a fixed supply of the two factors (capital (K) and labour (L)), but their capital to labour ratios differ. Both factors are fully employed and can be substituted in production

· Perfect competition in the factor and commodity markets

· Production technology is identical in both countries, and exhibit Constant

Returns to Scale (CRS)

· One of the commodities is labour intensive and the other is capital intensive, at all input prices. There are no factor intensity reversals

· Preferences are identical and homogenous in both countries

· Perfectly mobile factors within the country, but perfectly immobile internationally

· There are no barriers to free trade, and zero transportation costs

With identical technologies the model neutralises the possibility of a Ricardian comparative advantage, and the introduction of a second factor produces the familiar neoclassical concave production function (in accordance with diminishing marginal products). This results in a more realistic scenario where both countries produce both commodities (unless endowments are radically different) rather than complete specialisation.

Further developing the framework we state that the UK has a higher capital to labour ratio (K/L) than China (Equation 1.1), resulting in an autarky

(K/L)_UK > (K/L)_CHINA (1.1)

scenario where the UK is endowed with relatively cheap capital and China relatively cheap labour in accordance with diminishing marginal products. Additionally the commodities are differentiated by factor intensities, commodity X shall be labour intensive and Y capital intensive (1.2)

(K/L)_Y > (K/L)_X (1.2)

The accumulation of these conditions generates the following Production Possibility Frontiers (PPFs)

(Figure 1.1)

noting that each country is biased towards the production of the commodity that is factor intensive for the same factor that the country is abundant in. It is important to maintain that this model generates trade via relative endowment differences and thus absolute sizes of each PPF are irrelevant in determining the direction of trade but relevant with regard to the terms of trade.

With the PPFs established it is necessary to derive the autarky equilibriums (A_UK and A_CHINA), specifically what each country produces and consumes without trade. Remembering assumptions for identical and homothetic preferences and perfect competition, production and consumption for each country occurs where

MRS = MRT (1.3)

which corresponds diagrammatically in Figure 1.2 to points A_UK and A_CHINA, where the indifference curves are tangent to the respective PPFs. The resulting tangency slope generates the autarky price ratios for each country (P_UK and P_CHINA).

(Figure 1.2)

The important result to derive here is that the differing of resource endowments was sufficient to produce differing autarky equilibrium price ratios (1.3), which is sufficient to generate incentive for international trade.

P_UK > P_CHINA (1.3)

where P = (P_X/P_Y)

With autarky equilibrium established the effects of trade are now examined. Given (1.3) UK consumers notice that commodity X is cheaper in China they will prefer to import X instead of purchase it domestically as long as it remains cheaper in China (vice-versa for China and Y). Hence trade will occur until price ratios are equalised at a level where excess supply and demand are matched, producing an international price ratio P*[1] for both countries such that:

P_CHINA < P* < P_UK (1.4)

.

In order for this to occur the change in demand from autarky to free trade must be accompanied by a change in production from both countries. China will respond to the increasing demand for X by increasing its production relative to Y, since X has become relatively more valuable (vice versa for the UK). This continues until

P*=MRT (1.5)

and thus final production occurs at their tangency (Q_UK,Q_CHINA in Figure 1.3). Similarly final consumption (C_UK, C_CHINA) will occur where

MRS = P* (1.5)

Thus resulting in free trade equilibrium

P* = MRS = MRT (1.6)

The final result is succinctly explained by Figure 1.3, noting that both countries are consuming on higher indifference curves than before, producing uneven[2] but overall welfare gains. Observing that the UK exports commodity Y and imports X the result is in accordance with the Heckscher-Ohlin theorem which states that

“Given the assumptions of the model, a country will export the commodity that intensively uses its relatively abundant factor” Markusen et al. (1995, p. 106)

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inflows have distorted the benefits of free trade as a result of the loss of competitiveness for the emerging markets. Whilst sterilisation or fiscal contractions can combat the appreciation, they are costly methods and hence politically unpalatable.

Sixth, capital controls can be used in a developing country as a source of revenue for the government when tax collection is difficult, or to allocate credit without risking capital flight (Johnston and Tamirisa, 1998.) Additionally the tax may be welfare improving in accordance of the Theory of the Second Best if they are used to correct an existing distortion, market failure or negative externality. Seventh, liberalising the capital market offers access for domestic investors to risky foreign investments and holdings which when unhedged can cause widespread insolvency in the event of large currency movements.

Eighth and perhaps the most important is that the inherent volatility of capital flows – particularly if not supported by credible regulation and sound macroeconomic policies – can lead to sudden reversals which cause developmentally and financially costly crises. Reinhart et al. (2003) point to the phenomenon of the “sudden stop” (Calvo, 1998) and reversals of capital experienced by developing countries, where they are suddenly unable to borrow and consequently unable to service their debt. Even countries with excellent track records such as Korea and Malaysia were victims of this, thus emerging markets are said to have a low debt tolerance. This experience is contrasted with that of a developed country, whose high debt tolerance enables it to use counter-cyclical policy in response to a negative shock, whilst a developing country has to tighten, intensifying the shock. Finally, the costs of crises are huge; Eichengreen (2004) estimated that crises countries suffered a 25% loss of income over the last twenty five years as a result of the crises, with an average annual cost of all the crises being $100 billion.

In mid summary it is worthy to note that the benefits of liberalisation are too large to ignore; indeed the inevitable momentum of developing countries liberalisation illustrates this. However, the costs being both numerous and potentially devastating are enough to justify public policy efforts, and perhaps multilateral efforts, to encourage more stable flows and discourage highly reversible volatile flows or to slow down the liberalisation process.

Whilst full capital liberalisation is seen as the most efficient outcome for a developed country by a majority of economists, the path for an emerging market is less clear cut. The rapid elimination of all capital controls was treated as an essential element for emerging markets in the 1990’s, prompting discussion in April 1997 to make it a concrete long term policy target in the IMF articles of agreement. The subsequent Asian crisis beginning in mid-1997 was both devastating and prolonged, despite the region’s previous stability, sound macroeconomic fundamentals and unprecedented size of international rescue packages (upward of $100 billion). For this new breed of crises the interplay of fast capital account liberalisation and a vulnerable financial sector were largely to blame. The result was to force a major rethink on capital market liberalisation and has brought support for reducing capital account liberalisation in emerging markets, although so far without international consensus.

Whilst other candidates have been proposed as a causal factor for crises to shift the blame from capital account liberalisation – including the macroeconomic fundamentals, exchange rate regime, degree of prudent supervision, and crony capitalism – capital account liberalisation stands tall as the most common denominator. Williamson et al (2003) utilised a simple correlation between the Asian crisis countries and each explanatory candidate previously mentioned to demonstrate that “…there is an almost-perfect fit, with countries that had liberalised (scored LL or L) being exactly the ones that succumbed to the crises.” There was one exception, Singapore, which was highly liberalised but interestingly had utilised an anti-speculative capital control. The same correlation can be shown for the Latin American countries that suffered speculative attacks in the 1980’s. Even Soros (1999) himself likened the role of increasing capital mobility to a “wrecking ball” in its ability to cause financial crises. It is simplistic and anachronistic to suppose that sound economic fundamentals provide a solid defence against crises. Whilst unsound fundamentals were largely to blame for the older crises in the 1980’s, the new round of crises in the 1990’s, notably the Asian crisis, occurred despite largely sound policies. Indeed it was the sound fundamental policies which enabled these emerging markets to take on so much short term currency mismatching foreign debt.

The most common argument against capital controls remains the benefit for a country to borrow on the international market to achieve higher growth. However, controls (or restricted liberalisation), if well implemented, will not necessarily undermine a country’s ability to borrow. An emerging market country must consider whether there are sufficient additional benefits to perfect capital mobility to a stylised partial liberalisation, given the devastating negative effects of crises. Empirical findings are mixed: Quinn (1997) and Rodrik (1998) disagree on the presence of a relationship between liberalisation and growth; whilst qualitative studies emphasise that the lion’s share of benefits are to be reaped from FDI and long term capital. Consequently the improved stability from imposing controls on volatile short term capital may outweigh the minor benefits. Rogoff (2002) succinctly explains that when restricting capital flows the “real debate is about debt instruments”, highlighting that debt does not possess the risk sharing properties of FDI and equity flows and thus the most vulnerable to major reversals and subsequently crises. Consequently if controls are utilised they need only to be strategic and limited, focusing on changing the structure of debt.

In conclusion, the experience of the Asian Crisis has shown that while sound macroeconomic fundamentals are a pre-condition to avoid the crises of old, they were not sufficient to avoid the new kind. The tendency to blame the weaknesses of the financial sectors is plausible, but ultimately financial systems need time to mature and thus rapid liberalisation was the wrong answer given the circumstances. A brief foray into possible capital restrictions has shown that as a temporary measure restrictions can be put in place that sharply reduce the probability of a crisis at little cost to the benefits of capital flows. However, rather alarmingly, the inertial trend towards liberalisation continues at a rapid pace whilst many of the original vulnerabilities remain. It is unfortunate to postulate that the future promises many more financial crises, both old and new.

References

Bhagwati, Jagdish N. (2004) “In Defense of Globalization”. New York: Oxford University Press, 2004

Brecher, R.A. and Carlos F. Daiz Alejandro., 1977. ‘Tariffs, foreign capital and immiserizing growth’, Journal of International Economics,7(3): 317-322.

Calvo, Guillermo A., 1998, “Capital Flows and Capital Market Crises: The Simple Economics of Sudden Stops,” Journal of Applied Economics, CEMA, Argentina, Vol. 1, No. 1, November 1998, pp. 35-54.

Eichengreen, Barry. (1999) Toward a New International Financial Architecture: A

Practical Post-Asia Agenda, Institute for International Economics, 1999.

________, Michael Mussa, Giovanni Dell’Ariccia, Enrica Detragiache,

Gian Maria Milesi-Ferretti, and Andrew Tweedie. (1999) “Liberalizing Capital

Movements: Some Analytical Issues,” IMF Economic Issue No. 17,

February 1999.

__________, Ricardo Hausman and Ugo Panizza (2003). Currency mismatches, debt

intolerance, and original sin: why they are not the same and why it matters. NBER

Working Paper, No. 10036. Cambridge, Massachusetts: National Bureau of

Economic Research.

Friedman, Thomas L. (2002). “The Lexus and the Olive Tree: Understanding Globalization”, Anchor

Johnston, Barry R., and Natalia T. Tamirisa. “Why Do Countries Use Capital Controls?” IMF Working Paper 98-181, December 1998.

Mead, Russell Walter, and Sherle R. Schwenninger (2000). A financial architecture for middleclass-oriented development: a report of the Project on Development, Trade, and

International Finance. A Council on Foreign Relations Paper. New York: Council

on Foreign Relations.

Obstfeld, Maurice, and Alan M. Taylor, (1998) “The Great Depression as a Watershed:

International Capital Mobility over the Long Run.” In Bordo, Michael D., Claudia D. Goldin, and Eugene N. White, eds., The Defining Moment: The Great Depression and the American Economy in the Twentieth Century. Chicago: University of Chicago Press, 1998, pp. 353-402.

Ocampo, Jose Antonio and Martin, Juan eds. (2003). Globalization and Development: A Latin American and Caribbean Perspective. Palo Alto, California: Stanford University Press and World Bank.

Persaud, Avinash (2000). “Sending the herd off the cliff edge: the disturbing interaction

between herding and market-sensitive risk management practices.” Institute of

International Finance Competition in Honour of Jacques de Larosiere. First Prize

Essay on Global Finance for 2000. Washington. D.C.

Quinn, Dennis (1997), “The Correlates of Change in International Financial

Regulation”, American Political Science Review, 91(3), Sep., 531-51.

Reinhart, Carmen M., Kenneth S. Rogoff, and Miguel A. Savastano (2003), “Debt

Intolerance”, paper presented to the Brookings Panel on Economic Activity, March.

Rodrik, Dani, (1998) \Who Needs Capital-Account Convertibility?” mimeo, Harvard University, February 1998.

Rogoff, Kenneth S. (2002). “Straight Talk — Rethinking capital controls: When should we keep an open mind?” Finance and Development, IMF Publications, December 2002, Volume 39, Number 4

Soros, G. (1999). “To Avert the Next Crisis.” Financial Times

(January 7).

Williamson, J.; Griffith-Jones, S.; and Gottschalk, R. (2003) “Should Capital

Controls Have a Place in the Future International Monetary System?” (2

May). Paper prepared for a meeting of the International Monetary Convention

in Madrid (www.ids.ac.uk/ids/global/pdfs/Madrid3.pdf).

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What can economic theory tell us about the economic benefits and costs of the free international movement of capital? By reference to one of more recent financial crises, assess whether there is a significant case for the adoption of restrictions on such movements.

Widely thought of as an important aid to development, the record of capital market liberalisation for developing countries has been mixed. What follows is a discussion of the benefits and costs of liberalisation which leads to an argument for capital restrictions given the recent events of the Asian crisis.

The most cited benefit of capital flows is the international de-linking of savings and investment which allows for a more efficient global allocation of capital. This idea is coupled with the neo-classical production function, in particular Solow’s Growth model, which exhibits diminishing returns to capital, demonstrates that greater returns to capital can in theory be achieved by transfer to developing countries. This transfer of capital will enhance growth and living standards in the developing country if utilised in sound investment for the future. Second, financial benefits which include portfolio diversification, risk sharing and intertemporal trade (Eichengreen, et al. 1999) raise welfare for both developed and developing countries by improving allocative efficiency of investment; maximising investment options as a result of different age structures, saving rates, opportunities for investment and risk profiles between countries. The greater urgency and opportunities for a developing country to invest today allows them to borrow in advance to invest, and indeed there should be an even greater potential to do this in the future with the ageing population of developed countries becoming a larger source of savings. Third, the ability of a country to borrow should allow it to act counter-cyclically to falls in national consumption and thus smooth major fluctuations, although as explained later this is not always possible. Fourth, there are gains of specialisation and competition to be made. Firstly a small developing country will be able to import financial services, freeing resources enabling it specialise elsewhere. Alternatively it is argued that the presence of foreign financial services will promote efficiency in the domestic sector, raising productivity.

Another commonly cited benefit is that capital flows put governments under a “Golden Straitjacket” (Friedman, T. 2002), a recent example being the experience of Lula’s government in Brazil. Capital mobility is believed to promote good policies as the government’s decision are keenly watched by the market, and thus unsound macroeconomic policies will be severely punished; in effect “your economy grows and your politics shrinks” as capital flows fix in political support for reforms. However, this relationship may prove capricious as capital inflows switch from flood to drought, in addition to the perverse short term anti-growth policies that the straitjacket may enforce.

Special mention should be made of the benefits of Foreign Direct Investment (FDI). FDI’s have proved stable during times of crisis and present a developing country will additional spillover benefits. The relocation of manufacturing plants and customer services have not only improved human capital and managerial know-how but also bring rapid technological transfer and facilitate access to the international markets by establishing a competitive export capacity. Recently however the stability of FDI has been called into question as multinational companies have increasingly hedged their short term foreign exchange risks, and increased financial engineering and re-labelling have blurred the relative volatilities of flows.

The costs of capital market liberalisation are more numerous and shall be covered expediently. The most common argument is the presence of asymmetric information, resulting in three market failures: adverse selection, moral hazard and herding. These asymmetries prevent the efficient allocation of resources, and are amplified by international transactions typically associated with low quality information. Adverse selection will deter desirable transactions, because perverse incentives ensure that lower quality firms crowd out high quality firms. Moral hazard identifies the propensity for borrowers to increase the risk of their project once they have carried out the transaction. Two prime examples are when the government guarantees various firms without necessary supervision to prevent excessive risk taking, and when the government guarantees against domestic bank failures which encourages excessive inflows. Herding behaviour carries the burden of systematic risk, since the presence of information cascades give rise to rational volatility. This has been emphasised by the increasing use of market sensitive risk management techniques (Persuad, 2000) and increasing salience of short term profits for investment managers. Furthermore, correlations between industry segments and emerging markets give rise to inter-industry and international contagion, deepening the consequences of volatility. Second, the effect of domestic trade distortions reduces allocative efficiency, as demonstrated by Brecher and Diaz-Alejandro (1977). They show that protection of capital intensive industries attracts capital to lower-value uses which reduces world welfare.

Third, the economic theory of the “incompatible trinity” (Obstfeld and Taylor, 1998) – specifically the inability to maintain a fixed exchange rate, free capital mobility and an independent monetary policy at the same time – leaves a country with a fixed exchange rate unable to lean against the wind. Reducing capital flows enables a country to “square the triangle” (Williamson et al., 2003), and act counter cyclically to its employment, inflation and the balance of payments variations. This is in contrast to perfect mobility which generates strong biases toward pro-cyclical macroeconomic policies (Kaminsky et al, 2004).

Fourth, Ocampo and Martin (2003) discuss the three asymmetries that exist between developed and developing countries. Firstly the “Original sin” (Eichengreen, Hausman and Panizaa, 2003) of developing countries’ inability to issue liabilities in their own currencies leading to currency mismatches. Secondly the undersupply of long term financial instruments causing maturity pressures. Thirdly the small size of the domestic financial market against the speculative pressure they face (Mead and Schwenninger, 2000). Whilst these are strictly not problems with capital market liberalisation, they demonstrate the vulnerabilities the emerging market face if they liberalise too fast.

Fifth, IMF statistics show the rapid tripling of net flows to $150 billion from 1987-1997 lead to a real appreciation of the exchange rates of emerging markets. This occurs either via the nominal exchange rate under a flexible regime or an increase in prices under a fixed exchange rate. Bhagwati (2004) suggests that these excessive capital

Found this great little paper on NBER http://www.nber.org/papers/w13879

It is about the economic value of teeth.

Key result: “We find that women who resided in communities with fluoridated water during childhood earn approximately 4% more than women who did not, but we find no effect of fluoridation for men. ”

Interesting to consider why we do not see this effect for men

In reverse order:

10. Economists are armed and dangerous: “Watch out for our invisible hands.”
9. Economists can supply it on demand.
8. You can talk about money without ever having to make any.
7. You get to say “trickle down” with a straight face.
6. Mick Jagger and Arnold Schwarzenegger both studied economics and look how they turned out.
5. When you are in the unemployment line, at least you will know why you are there.
4. To an economist, real life is a special case
3. We come up with interesting ways to research the law of diminishing marginal utility.
2. Economists have forecasted 9 out of the last 5 recessions.
1. Economists do it with interest.

Lord Skidelsky provides some insightful wisdom on the link between morals and the meltdown, and shows us that some of the aspects of the recent financial crisis / credit crunch could have been easily avoided if we had tighter regulation like in Spain

This came from Project Syndicate

LONDON – After World War I, H.G. Wells wrote that a race was on between morality and destruction. Humanity had to abandon its warlike ways, Wells said, or technology would decimate it.

Economic writing, however, conveyed a completely different world. Here technology was deservedly king. Prometheus was a benevolent monarch who scattered the fruits of progress among his people. In the economists’ world, morality should not seek to control technology, but should adapt to its demands. Only by doing so could economic growth be assured and poverty eliminated. Traditional morality faded away as technology multiplied productive power.

We have clung to this faith in technological salvation as the old faiths waned and technology became ever more inventive. Our faith in the market – for the market is the midwife of technological invention – was a result of this. In the name of this faith, we have embraced globalization, the widest possible extension of the market economy.

For the sake of globalization, communities are de-natured, jobs off-shored, and skills continually re-configured. We are told by its apostles that the wholesale impairment of most of what gave meaning to life is necessary to achieve an “efficient allocation of capital” and a “reduction in transaction costs.” Moralities that resist this logic are branded “obstacles to progress.” Protection – the duty the strong owe to the weak – becomes Protectionism, an evil thing that breeds war and corruption.

That today’s global financial meltdown is the direct consequence of the West’s worship of false gods is a proposition that cannot be discussed, much less acknowledged. One of its leading deities is the “efficient market hypothesis” – the belief that the market accurately prices all trades at each moment in time, ruling out booms and slumps, manias and panics. Theological language that might have decried the credit crunch as the “wages of sin,” a come-uppance for prodigious profligacy, has become unusable.

But consider the way in which the term “debt” (the original sin against God, with Satan as the great loan shark) has become “leverage,” a metaphor from engineering that has turned the classical injunction against “getting into debt” into a virtual duty to be “highly leveraged.” To be in debt feeds the double temptation of getting what we want as quickly as possible as well as getting “something for nothing.”

Financial innovation has enlarged both temptations. Mathematical whiz kids developed new financial instruments, which, by promising to rob debt of its sting, broke down the barriers of prudence and self-restraint. The great economist Hyman Minsky’s “merchants of debt” sold their toxic products not only to the credulous and ignorant, but also to greedy corporations and supposedly savvy individuals.

The result was a global explosion of “Ponzi” finance – named after the notorious Italian-American swindler Charles Ponzi – which purported to make such paper as safe and valuable as houses. By contrast, the virtuous Chinese, who save a large proportion of their incomes, were castigated by Western economists for their failure to understand that their duty to humanity was to spend.

The key theoretical point in the transition to a debt-fueled economy was the redefinition of uncertainty as risk. This was the main achievement of mathematical economics. Whereas guarding against uncertainty had traditionally been a moral issue, hedging against risk is a purely technical question.

The main uncertainty in life – the destination of one’s immortal soul – nudges one toward morality. Even the existence of mundane uncertainty gives rise to conventions and rules of thumb that embody the best of human experience in dealing with the unknown. The abolition of uncertainty abolishes the need for moral rules.

Future events could now be decomposed into calculable risks, and strategies and instruments could be developed to satisfy the full range of “risk preferences.” Moreover, because competition between financial intermediaries steadily drives down the “price of risk,” the future became (in theory) virtually risk-free.

This monstrous conceit of contemporary economics has brought the world to the edge of disaster. Obviously, the traditional moral taboos surrounding money had to be loosened for capitalism to get going centuries ago. For example, the classical prohibition on usury was softened from a ban on charging interest on all loans to a ban on charging interest on loans for which the lender had no alternative use, i.e., for charging interest on “hoards” or cash balances.

Without the development of debt finance, the world would be a lot poorer than it is.  Yet going from one extreme (keeping one’s spare cash under the bed) to the other (lending out money one does not have) is to cut out the sensible middle.

The prudential supervision regime initiated by the Bank of Spain in response to the Spanish banking crises of the 1980’s and 1990’s shows what a sensible middle way might look like. Spanish banks are required to increase their deposits in proportion to their lending and set aside capital against assets in their off-balance sheets.

With little incentive to manufacture “structured investment vehicles,” few Spanish banks created them, thereby avoiding excessive leverage. As a result, Spanish banks typically make provision to cover 150% of bad debts whereas British banks cover only 80-100%, and Spanish homebuyers must pay between 20% and 30% deposit on a house, whereas 100% mortgages have routinely been given in the United States and the United Kingdom in recent years.

H.G. Wells was only partly right: the race between morality and destruction encompasses not just war, but economic life as well. As long as we rely on technical fixes to plug moral gaps and governments rush in with rescue packages that enable the merry-go-round to start up again, we are bound to keep lurching from frenzy to frenzy, punctuated by intervals of collapse. But, at some point, we will confront some limit to growth.

Many economists saw the current financial crisis coming for a long time but have been ignored

One example is Ron Paul who testified before the House Financial Services Committee:

As Paul saw the situation some five years ago, the government backing isolated GSE management from market discipline. If Fannie and Freddie were not underwritten by the federal government, he told the committee, investors would demand the institutions held to higher management and accounting practices.

“Ironically, by transferring the risk of a widespread mortgage default, the government increases the likelihood of a painful crash in the housing market,” Paul predicted. “This is because the special privileges granted to Fannie and Freddie have distorted the housing market by allowing them to attract capital they could not attract under pure market conditions. As a result, capital is diverted from its most productive use into housing. This reduces the efficacy of the entire market and thus reduces the standard of living of all Americans.

“Despite the long-term damage to the economy inflicted by the government’s interference in the housing market, the government’s policy of diverting capital to other uses creates a short-term boom in housing,” Paul went on. “Like all artificially created bubbles, the boom in housing prices cannot last forever. When housing prices fall, homeowners will experience difficulty as their equity is wiped out. Furthermore, the holders of the mortgage debt will also have a loss. These losses will be greater than they would have otherwise been had government policy not actively encouraged over-investment in housing.

 

Another famous example is “Dr. Doom” Nouriel Roubini who predicted the financial crisis over two years ago 

I’ve also seen an article by the former Chief Economist of the IMF Professor Rajan, but cannot find it

 

J

I received an email asking to join the Economics Social Network http://economists.ning.com

Thought this is great, we look forward to using it!

View my page on Economics Social Network