1. Understanding the Global Economic Crisis Presentation by Heiner Flassbeck Director, Division on Globalization and Development Strategies Geneva, 3 April 2009

2. Outline First session The global economic crisis : what went wrong Second session Systemic failures and multilateral remedies

3. Reference text: “The Global Economic Crisis: Systemic Failures and Multilateral Remedies” Report by the UNCTAD Secretariat Task Force on Systemic Issues and Economic Cooperation

4. First Session The global economic crisis : what went wrong

5. Understanding the Globalized Economy When there is a mouse trap in the house, the whole farmyard is at risk

6. 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 Economy Unwinding of speculative flows

7. 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

8. 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

9. 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

10. FINANCIAL MARKETS

11. 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

12. Arbitrage as a Result of the Regulatory Framework The decrease in the leverage ratio of commercial banks was accompanied by an increase in the leverage ratios of non- bank financial institutions

13. Financial 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.

14. 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

15. COMMODITY MARKETS

16. 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

17. The Growing Presence of Financial Investors in Commodity Markets Trading volumes on commodity exchanges strongly increased during the recent period of substantial commodity price increases

18. What Evidence for a Correlation between Speculative Position and Price Development ?

19. 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

20. 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 Countries and Equity and Commodity Price Index Correlations between the Exchange Rate of Selected Countries and Equity and Commodity Price Index NEW ZEALAND DOLLAR TO JAPANESE YEN BRAZILIAN REAL TO JAPANESE YEN June 2008–December 2008

21. Future 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- CommodityCommercial Index Maize1134149916260 Soybeans59010526024 Soybean oil79017194418 Wheat CBOT5539648326 Wheat KCBOT6806321816 Cotton36310104095 Live cattle5804094743 Feeder cattle258162469 Lean hogs4197123983

22. 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

23. CURRENCY MARKETS

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

25. 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

26. 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!

27. Exchange Rate Fluctuations and the Trade Distorsion Effect 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

28. Second session Systemic failures and multilateral remedies

29. 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

30. 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

31. 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” mentality

32. 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

33. 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

34. 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

35. 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

36. Thank you for your attention Heiner.Flassbeck@unctad.org