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

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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

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4

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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

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03.0

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The Growing Presence of Financial Investors The Growing Presence of Financial Investors in Commodity Marketsin Commodity Markets

0

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35

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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

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4

6

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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

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-50

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01/01/2002 06/01/2004 03/01/2006 01/01/2008

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Maize

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Soybeans

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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

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-40

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01/01/2002 06/01/2004 03/01/2006 01/01/2008

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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

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Ind

ex

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mb

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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

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Uncovered interest return

Nominal exchange-rate change

Interest rate differential

Real

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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

Thank you for your attention

Heiner.Flassbeck@unctad.org