Understanding Understanding
the Global Economic Crisisthe Global Economic Crisis
Presentation by Heiner Flassbeck
Director, Division on Globalization and Development Strategies
Geneva, 3 April 2009
OutlineOutline
• First sessionThe global economic crisis : what went wrong
• Second sessionSystemic failures and multilateral remedies
Reference text:
“The Global Economic Crisis:
Systemic Failures and
Multilateral Remedies”
Report by the UNCTAD Secretariat Task Force on
Systemic Issues and Economic Cooperation
First SessionFirst Session
The global economic crisis : The global economic crisis : what went wrongwhat went wrong
Understanding the Globalized EconomyUnderstanding the Globalized Economy
When there is a mouse trap in the house,
the whole farmyard is at risk
The subprime credit collapse highlighted the exposure to risk in many areas and triggered the sudden unwinding of
speculative positions in different markets
Subprime Credit Collapse
Stock Market
Commodity Market
Currency Market
Understanding the Globalized EconomyUnderstanding the Globalized Economy
Unwinding of speculative flows
Starting point…Starting point…
The fact that the global financial crisis originated in a relatively obscure corner of the United States housing credit system means that it cannot be analysed adequately by just looking at this segment of the market while ignoring the huge asset-price bubbles that arose elsewhere seemingly
independently
Causes of the CrisisCauses of the Crisis
What really went wrong:
The blind faith in the efficiency of financial markets
What made it worse:
Global imbalancesAbsence of a regulatory scheme
Causes of the CrisisCauses of the Crisis
• There are no simplistic explanations:
– “too much liquidity”,
– saving glut in China
– individual misbehavior
• The drivers of the crisis are more complex and the analysis needs to entail three specific areas in which the global economy experienced systemic failures:
Financial marketCommodities marketCurrency market
FINANCIAL MARKETSFINANCIAL MARKETS
Financial MarketsFinancial MarketsFundamental misconceptions:
• Assumption that “markets know best”
• Regulators should not play an active role
• More financial innovation would always be beneficial from society’s point of view
Implications:
• Poorly designed regulation can backfire and lead to regulatory arbitrage
→This is what happened with banking regulation
Arbitrage as a Result of the Regulatory Arbitrage as a Result of the Regulatory FrameworkFramework
5
10
15
20
25
30
1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007
Le
vera
ge
Banks Financial services Life insurance
Figure 2.1LEVERAGE OF TOP-10 UNITED STATES FINANCIAL FIRMS BY SECTOR
Source: UNCTAD secretariat calculations, based on balance sheet data from Thomson Datastream.Note: Leverage ratio measured as share of shareholders equity over total assets. Data refer to 4 quarter moving average.
The decrease in the leverage ratio of commercial banks was accompanied by an increase in the leverage ratios of non-
bank financial institutions
Asset backed securities issuers
4.1
Brokers and dealers
2.9
Finance companies
1.9
Government sponsored enterprises
7.7
0
2
4
6
8
10
12
14
16
18
Market based Bank based
$ tri
llion
Credit unions 0.8
Savings institutions
1.9
Commercial banks10.1
Figure 2.2THE SHADOW BANKING SYSTEM, 2007, Q2
Source: Shin (2009).
Financial Innovation and the Shadow Banking SystemFinancial Innovation and the Shadow Banking System
• Financial Innovation as an instrument for shifting leverage
• The shadow banking system in the United States held assets of more than $16 trillion
While regulation focused on banks, it was the collapse of the shadow banking system which kick-started the
current crisis.
Financial RegulationFinancial Regulation
• Wrong belief that securitization had contributed to both diversifying and allocating risk to sophisticated economic agents who could bear such risk
• Regulators assumed that, unlike deposit taking banks, the collapse of large non-bank institutions would not have systemic implications
BUT IT HAD
COMMODITY MARKETSCOMMODITY MARKETS
Commodity Markets and the Financial CrisisCommodity Markets and the Financial Crisis
The build-up and eruption of crisis in the financial system was paralleled by an unusually sharp increase and subsequent strong reversal of the prices of internationally traded primary commodities
Commodity Price Index (S&P GSCI)
200.00
300.00
400.00
500.00
600.00
700.00
800.00
900.00
1000.00
03.0
1.20
07
03.0
2.20
07
03.0
3.20
07
03.0
4.20
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5.20
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6.20
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2.20
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9.20
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03.1
1.20
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03.1
2.20
08
Ind
ex N
um
ber
The Growing Presence of Financial Investors The Growing Presence of Financial Investors in Commodity Marketsin Commodity Markets
0
5
10
15
20
25
30
35
40
45
50
Dec.1993
Dec.1995
Dec.1997
Dec.1999
Dec.2001
Dec.2003
Dec.2005
Dec.2007
Source: BIS, Quarterly Review , March 2009, table 23B.
Figure 3.2FUTURES AND OPTIONS CONTRACTS
OUTSTANDING ON COMMODITY EXCHANGES, DECEMBER 1993–DECEMBER 2008
(Number of contracts, millions)
0
2
4
6
8
10
12
14
Dec.1998
Dec.2000
Dec.2002
Dec.2004
Dec.2006
June2008
Other commodities
Other precious metals
Gold
Source: BIS, Quarterly Review , December 2008, table 19.
Figure 3.3NOTIONAL AMOUNT OF OUTSTANDING OVER-
THE-COUNTER COMMODITY DERIVATIVES, DECEMBER 1998 – JUNE 2008
(Trillions of dollars)
Trading volumes on commodity exchanges strongly increased during the recent period of substantial commodity price
increases
What Evidence for a Correlation between Speculative What Evidence for a Correlation between Speculative Position and Price Development ?Position and Price Development ?
Wheat
-100
-50
0
50
100
150
200
250
01/01/2002 06/01/2004 03/01/2006 01/01/2008
0
200
400
600
800
1000
1200
1400
Maize
-200
-100
0
100
200
300
400
500
01/01/2002 06/01/2004 03/01/2006 01/01/2008
0
100
200
300
400
500
600
700
800
Soybeans
-100
-50
0
50
100
150
200
250
01/01/2002 06/01/2004 03/01/2006 01/01/2008
0
200
400
600
800
1000
1200
1400
1600
1800
Net long non-commercial positions, '000contracts, left scale
Net long non-commercial positions excl. CIT,'000 contracts, left scale
Net long CIT positions, '000 contracts, leftscale
Price, cents/bushel, right scale
Soybean oil
-60
-40
-20
0
20
40
60
80
100
01/01/2002 06/01/2004 03/01/2006 01/01/2008
0
10
20
30
40
50
60
70
80
Net long non-commercial positions, '000contracts, left scale
Net long non-commercial positions excl. CIT,'000 contracts, left scale
Net long CIT positions, '000 contracts, leftscale
Price, cents/lb, right scale
Correlation between Correlation between Speculative Position and Price Development (?)Speculative Position and Price Development (?)
• The scepticism among economist is based on the efficient market hypothesis
• However,– Short-term price elasticity of many commodities is
low Position changes that are large relative to the size of
the total market have a temporary, or even persistent, price impact
– Changes in market positions may result from the behaviour of a certain group of market participants who respond to factors other than information about market fundamentals
• Strong correlation between the unwinding of speculation in different markets that should be uncorrelated
• All participants react to the same kind of information
Correlations between the Exchange Rate of Selected Correlations between the Exchange Rate of Selected Countries and Equity and Commodity Price IndexCountries and Equity and Commodity Price Index
y = -1E-05x + 0.0463
R2 = 0.9561
0.014
0.016
0.018
0.020
0.022
0.024
0.026
0.028
1723 2223 2723 3223
Reuters Commodities Price Index
y = -2E-05x + 0.0443
R2 = 0.9222
0.014
0.016
0.018
0.020
0.022
0.024
0.026
0.028
752 952 1152 1352
S&P 500 Composite Equity Price Index
NEW ZEALAND DOLLAR TO JAPANESE YEN
BRAZILIAN REAL TO JAPANESE YENJune 2008–December 2008June 2008–December 2008
y = -7E-06x + 0.0325
R2 = 0.9576
0.012
0.013
0.014
0.015
0.016
0.017
0.018
0.019
0.020
1723 2223 2723 3223
Reuters Commodities Price Index
y = -1E-05x + 0.031
R2 = 0.9057
0.012
0.013
0.014
0.015
0.016
0.017
0.018
0.019
0.020
752 952 1152 1352
S&P 500 Composite Equity Price Index
Future and Options Market PositionsFuture and Options Market Positions
Average long position of index traders is very large, sometimes more than ten
times the size of an average long position held by either
commercial or non-commercial traders
Futures and options market positions, by trader group,
selected agricultural commodities, January 2006 – December 2008
(Per cent and number of contracts)
Long positions
Average position size
Non-
Commodity Commercial Commercial Index
Maize 1134 1499 16260
Soybeans 590 1052 6024
Soybean oil 790 1719 4418
Wheat CBOT 553 964 8326
Wheat KCBOT 680 632 1816
Cotton 363 1010 4095
Live cattle 580 409 4743
Feeder cattle 258 162 469
Lean hogs 419 712 3983
• Positions of this order are likely to have sufficiently high financial power to drive prices
• Speculative bubbles may form and price changes can no longer be interpreted as reflecting fundamental supply and demand signals
Commodity futures exchanges do not function in accordance with the efficient market view
CURRENCY MARKETSCURRENCY MARKETS
Currency Speculation and Financial BubblesCurrency Speculation and Financial Bubbles
The uncertainty associated with the subprime crisis generated an unwinding of speculativespeculative currency positions
- causing large depreciation of former high-hielding currencies
70
80
90
100
110
120
130
Ind
ex
Nu
mb
er
Hungarian Forint Brazilean Real Mexican Peso Czech Koruna
The Carry Trade PhenomenonThe Carry Trade Phenomenon
Currency carry trade is a strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate
Yen Carry trade on the Icelandic Krona and the Brazilian Real
Krona
-10
-8
-6
-4
-2
0
2
4
6
8
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12
123456789101112123456789101112123456789101112123456789
2005 2006 2007 2008
Per
cen
t
Uncovered interest return
Nominal exchange-rate change
Interest rate differential
Real
-10
-8
-6
-4
-2
0
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4
6
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123456789101112123456789101112123456789101112123456789
2005 2006 2007 2008
Per
cen
t
Uncovered interest return
Nominal exchange-rate changeInterest rate differential
The Carry Trade PhenomenonThe Carry Trade Phenomenon
• In this framework, nominal exchange rate movements are mainly driven by speculative flows, moving away from their “fundamentals”
• Currency specualtion and currency crisis has brought a number of countries to the verge of default and dramatically fuelled the crisis
• Risk exposure! Trade distortion effect!
Exchange Rate Fluctuations and the Trade Distorsion EffectExchange Rate Fluctuations and the Trade Distorsion Effect
0.00000
0.00005
0.00010
0.00015
0.00020
0.00025
0.00030
0.00035
0.00040
1993 1996 1999 2002 2005 2008
P EERcontributionNEERcontributionVAR (REERgrowth)
Euro area
0.00000
0.00005
0.00010
0.00015
0.00020
0.00025
0.00030
0.00035
0.00040
1993 1996 1999 2002 2005 2008
P EERcontributionNEERcontributionVAR (REERgrowth)
Emerging market economies in Europe and other transition economies
0.00000
0.00005
0.00010
0.00015
0.00020
0.00025
0.00030
0.00035
0.00040
1993 1996 1999 2002 2005 2008
P EERcontributionNEERcontributionVAR (REERgrowth)
Emerging market (non-Europe)
The real exchange rate is a measure of countries’ competitiveness
Evidence shows that nominal exchange rate changes appear to explain most of the real exchange rate changes
The present monetary chaos exerts a huge and distorting influence on the effectiveness of international trade
Second sessionSecond session
Systemic failures and multilateral Systemic failures and multilateral remediesremedies
The Global and Systemic CrisisThe Global and Systemic Crisis
• The crisis dynamics reflect:
failures in national and international financial deregulation,
persistent global imbalances,
absence of an international monetary system
deep inconsistencies among global trading, financial and monetary policies
The most important task is to
break the spiral of falling asset prices and falling demand
and to revive the financial sector’s ability to provide credit for productive investment
The key objective of regulatory reform has to be
devise a system that allows shutting down the casino and weeding out financial instruments with no social
return
In 1983, the financial sector generated 5 per cent of the United States’ GDP and “statistically” accounted for 7.5
per cent of total corporate profits
In 2007, the United States financial sector generated 8 per cent of GDP and “statistically” accounted for 40 per cent
of total corporate profits
Strong indications that this “industry” does not contribute much to overall productivity
The “money –for-nothing” mentalityThe “money –for-nothing” mentality
Financial Regulation: Policy ImplicationsFinancial Regulation: Policy Implications
• Banks and the capital markets need to be regulated jointly and financial institutions should be supervised on a fully consolidated basis
• Creating a clearinghouse that would net out the various positions could increase transparency
• Micro-prudential regulation has to be complemented by macro-prudential regulation
• Need of an international dimension to financial regulation and institution to take into account systemic risk
Commodity Markets : Policy ImplicationsCommodity Markets : Policy Implications
Better regulation of these markets and direct intervention in case of destabilizing speculation is needed
• Need to ensure that swap dealer positions do not lead to ‘excessive speculation’: key loopholes in regulation
• regulators need access to more comprehensive trading data in order to be able to intervene
• In addition to regulatory measures, international measures are needed: the world needs a new global institutional arrangement consisting of a minimum physical grain
reserve to stabilize markets
Currency Markets: Policy ImplicationsCurrency Markets: Policy Implications
Multilateral or even global exchange rate arragment are urgently needed for the stability of the financial system
and a balanced international trade
Only one exchange rate/price adjustment rule:
nominal exchange rate changes should follow the difference in the price levels of the trading partners
ConclusionConclusion
The state is back but national action is not sufficient:
• Preventing the competition of nations
(a new code of conduct is needed)
• Intervention in financial markets is indispensable
• No “crisis solution” by markets