Understanding

the Global Economic Crisis

Presentation by Heiner Flassbeck

Director, Division on Globalization and Development Strategies

Geneva, 3 April 2009

 Outline

• First session
The global economic crisis : what went wrong

• Second session
Systemic 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 Session

The global economic crisis :

what went wrong
Understanding the Globalized Economy

When there is a mouse trap in the house,

the whole farmyard is at risk
 Understanding the Globalized Economy
Commodity Market

Stock Market Currency Market

Unwinding of speculative flows

Subprime Credit Collapse

The subprime credit collapse highlighted the exposure to risk

in many areas and triggered the sudden unwinding of
speculative positions in different markets
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 Crisis
What really went wrong:
The blind faith in the efficiency of financial
markets
What made it worse:
Global imbalances
Absence of a regulatory scheme
 Causes 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 market
Commodities market
Currency market
FINANCIAL MARKETS
 Financial Markets
Fundamental 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
Framework
Figure 2.1
LEVERAGE OF TOP-10 UNITED STATES FINANCIAL FIRMS BY SECTOR
30

25

20
Leverage

15

10

Banks Financial services Life insurance

5
1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

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
Financial Innovation and the Shadow Banking System
Figure 2.2
THE SHADOW BANKING SYSTEM, 2007, Q2
18 • Financial Innovation as an
16
instrument for shifting
14 Government
sponsored
enterprises
leverage
12
7.7

10
$ trillion

Finance
8

• The shadow banking

companies
1.9
Commercial banks
6 Brokers and 10.1

system in the United States

dealers
2.9
4

2
Asset backed
securities
issuers
Savings
institutions
held assets of more than $16
trillion
4.1 1.9
Credit unions 0.8
0
Market based Bank based

Source: Shin (2009).

While regulation focused on banks, it was the collapse of

the shadow banking system which kick-started the
current crisis.
 Financial 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 MARKETS
Commodity 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)

1000.00

900.00
800.00
Index Number

700.00

600.00
500.00

400.00
300.00

200.00
03.01.2007

03.03.2007
03.04.2007
03.05.2007

03.08.2007

03.10.2007
03.11.2007
03.12.2007

03.02.2008
03.03.2008
03.04.2008

03.06.2008
03.07.2008
03.08.2008
03.09.2008
03.10.2008

03.12.2008
03.02.2007

03.06.2007
03.07.2007

03.09.2007

03.01.2008

03.05.2008

03.11.2008
 The Growing Presence of Financial Investors
in Commodity Markets
Figure 3.2 Figure 3.3
FUTURES AND OPTIONS CONTRACTS NOTIONAL AMOUNT OF OUTSTANDING OVER-
OUTSTANDING ON COMMODITY EXCHANGES, THE-COUNTER COMMODITY DERIVATIVES,
DECEMBER 1993–DECEMBER 2008 DECEMBER 1998 – JUNE 2008
(Number of contracts, millions) (Trillions of dollars)
50 14

45
12
40

35 10

30
8 Other commodities
25 Other precious metals
6 Gold
20

15 4
10
2
5

0 0
Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. Dec. June
1993 1995 1997 1999 2001 2003 2005 2007 1998 2000 2002 2004 2006 2008

Source: BIS, Quarterly Review , March 2009, table 23B. Source: BIS, Quarterly Review , December 2008, table 19.

Trading volumes on commodity exchanges strongly increased

during the recent period of substantial commodity price
increases
What Evidence for a Correlation between Speculative
Position and Price Development ?
Wheat Maize
250 1400 500 800

200 1200 400 700

600
150 1000 300
500
100 800 200
400
50 600 100
300
0 400 0
200
-50 200 -100 100
-100 0 -200 0
01/01/2002 06/01/2004 03/01/2006 01/01/2008 01/01/2002 06/01/2004 03/01/2006 01/01/2008

Soybeans Soybean oil

250 1800 100 80
200 1600 80 70
1400
150 60 60
1200
40 50
100 1000
20 40
50 800
600 0 30
0
400 -20 20
-50 200 -40 10
-100 0 -60 0
01/01/2002 06/01/2004 03/01/2006 01/01/2008 01/01/2002 06/01/2004 03/01/2006 01/01/2008

Net long non-commercial positions, '000 Net long non-commercial positions, '000
contracts, left scale contracts, left scale
Net long non-commercial positions excl. CIT, Net long non-commercial positions excl. CIT,
'000 contracts, left scale '000 contracts, left scale
Net long CIT positions, '000 contracts, left Net long CIT positions, '000 contracts, left
scale scale
Price, cents/bushel, right scale Price, cents/lb, right scale
 Correlation between
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
Correlations between the Exchange Rate of Selected
Countries and Equity and Commodity Price Index
BRAZILIAN REAL TO JAPANESE YEN
June 2008–December 2008

0 .0 2 8 0 .0 2 8

• Strong correlation y = -1E-0 5x + 0 .0 4 6 3 y = -2 E-0 5x + 0 .0 4 4 3

0 .0 2 6 0 .0 2 6
R 2 = 0 .9 56 1 R 2 = 0 .9 2 2 2
0 .0 2 4 0 .0 2 4

between the 0 .0 2 2

0 .0 2 0
0 .0 2 2

0 .0 2 0

unwinding of 0 .0 18
0 .0 16
0 .0 18

0 .0 16

speculation in 0 .0 14
172 3 2223 2 72 3 3223
0 .0 14
752 9 52 1152 13 52

different markets Reut ers Co mmo d it ies Price Ind ex S&P 50 0 Co mp o s it e Eq uit y Price Ind ex

that should be
uncorrelated NEW ZEALAND DOLLAR TO JAPANESE YEN

0 .0 2 0 y = -7E-0 6 x + 0 .0 3 2 5 0 .0 2 0 y = -1E-0 5x + 0 .0 3 1
0 .0 19 R 2 = 0 .9 576 0 .0 19 R 2 = 0 .9 0 57
0 .0 18 0 .0 18
0 .0 17 0 .0 17
0 .0 16 0 .0 16

• All participants
0 .0 15 0 .0 15
0 .0 14 0 .0 14
0 .0 13 0 .0 13

react to the same 0 .0 12

172 3 2223 2 72 3 3223
0 .0 12
752 9 52 1152 13 52

kind of information Reut ers Co mmo d it ies Price Ind ex S&P 50 0 Co mp o s it e Eq uity Price Ind ex
 Future and Options Market Positions
Futures and options market positions, by trader group,
selected agricultural commodities, January 2006 –
December 2008

Average long position of (Per cent and number of

contracts)    
index traders is very large, Long positions

sometimes more than ten Average position size

Non-
times the size of an average Commodity Commercial Commercial Index
long position held by either
commercial or non- Maize

Soybeans
1134

590
1499

1052
16260

6024

commercial traders 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 MARKETS
 Currency Speculation and Financial Bubbles
The uncertainty associated with the subprime crisis generated an
unwinding of speculative currency positions
- causing large depreciation of former high-hielding currencies
130

120
In d e x N u m b e r

110

100

90

80

70

Hungarian Forint Brazilean Real Mexican Peso Czech Koruna

 The 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 Real
12 12
10 10
8 8
6 6
4 4

Per cent
Per cent

2 2
0 0
-2 -2
-4 -4
-6 -6
-8 -8
-10 -10
12345678910
11 212345678910
11212345678910
11 2123456789 12345678910
11 212345678910
11 212345678910
11 2123456789
2005 2006 2007 2008 2005 2006 2007 2008

Uncovered interest return

Uncovered interest return
Nominal exchange-rate change
Nominal exchange-rate change
Interest rate differential Interest rate differential
 The 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 Effect
E m e rg in g m a rk e t e c o no m ie s in E uro pe Em e rg ing m a rke t (n o n -E uro p e )
E uro a re a
a n d o the r tra ns it io n e c o no m ie s
0.00040
0.00040 0.00040
P EER P EER P EER
0.00035
0.00035 co ntributio n 0.00035 c o ntributio n co ntributio n
NEER NEER NEER
co ntributio n c o ntributio n 0.00030 co ntributio n
0.00030 0.00030
VAR (R EER VAR (REER VAR (R EER
gro wth) gro wth) gro wth)
0.00025
0.00025 0.00025

0.00020 0.00020 0.00020

0.00015 0.00015 0.00015

0.00010 0.00010 0.00010

0.00005 0.00005 0.00005

0.00000 0.00000 0.00000

1993 1996 1999 2002 2005 2008 1993 1996 1999 2002 2005 2008 1993 1996 1999 2002 2005 2008

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 session

Systemic failures and multilateral

remedies
 The 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
 The “money –for-nothing” mentality

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
 Financial 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 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 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
 Conclusion

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