This ambitious paper by Ricardo Caballero, Emmanuel Farhi, and Pierre-Olivier Gourinchas seeks to explain, in one model, all that is wrong in the global economy. The culprit is underdeveloped financial markets in emerging Asia and the oil-producing countries. U.S. fiscal and monetary policies play no role. The three stylized phenomena explained and linked in the model are the large U.S. current account deficits (and the counterbalancing large surpluses in emerging Asia and oil-producing countries), financial bubbles, and volatile commodity prices. The model intriguingly suggests that all three features can persist in equilibrium.

The model begins by dividing the world into two regions, one with developed financial markets, which the authors label U (for the United States), and one with underdeveloped financial markets, labeled M. The M countries extract and consume commodities Z, while U only consumes Z. The model starts with the formation and bursting of a financial bubble in U (although where the bubble starts turns out to be unimportant). With the bursting of the bubble, global savers flee the bubble assets in search of new stores of value in U. Note that savers flee to safer assets in U and not to the M countries, because financial markets are more developed in U. These capital flows (from M to U) lead to a decline in real interest rates in U. Low real interest rates, in turn, lead to speculative commodity hoarding and commodity price jumps, resulting in wealth transfers from U to M. M’s new wealth, however, again finds its way to U, which has comparative advantage in quality asset creation. These capital inflows further lower real interest rates in U and allow U to run ever larger current account deficits.

Changes in interest rates are the driving force in this model. The bursting of the initial financial bubble and the consequent scramble by global [End Page 56] savers to place their wealth in higher-quality assets in U lead to lower real interest rates. It is these low interest rates that make commodity inventory accumulation profitable, driving up commodity prices and leading in turn to wealth transfers from U (the consumers of commodities) to M (the commodity producers). The link between low real interest rates and high commodity prices comes from Harold Hotelling’s insight that for resources in fixed supply with zero extraction costs, extraction in equilibrium is characterized by resource prices that increase at the interest rate.¹ If a resource is in fixed supply and its future price is expected to be high, then low interest rates drive up current prices in order to induce owners to sell.

In the authors’ model the resource, Z, is not assumed to be in fixed supply, but instead there is a flow extraction constraint that is insufficient to meet demand growth and acts to limit supply. The tricky aspect of this assumption is that expectation formation in this sort of model is less straightforward than in the standard Hotelling fixed-supply setup. The link between the interest rate and the commodity price posited by Hotelling will be broken if expectations of future commodity prices systematically change with the same forces that affect interest rates. The paper suggests that the rise in commodity prices in early 2008 and the more recent precipitous decline in oil prices (and many other commodity prices) fit well with their model, in that when demand for these commodities was high, the flow extraction constraint was binding, and when demand growth declined, so did commodity prices as the flow constraint ceased to bind. What is more difficult to connect in this version of Hotelling’s model is the role of interest rates. At the same time that global demand growth declined, counter-cyclical policies in the United States were targeted at reducing real interest rates, so that interest rates remained low, while commodity prices first spiked and then fell. In the first seven months of 2008, commodities posted their best performance in 35 years, rising by 35 percent; then, in August, they had their worst month in 28 years, falling by 11 percent, followed by an even more precipitous decline of 41...