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The Global Economic Crisis: Systemic Failures and Multilateral Remedies - Executive Summary

Report by UNCTAD, 2009

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The report highlights three specific areas (financial deregulation, large-scale financial investors, currency speculation)in which the global economy experienced systemic failures and proposes measures to address them. While there are many more facets to the crisis, UNCTAD examines here some of those that it considers to be the core areas to be tackled immediately by international economic policy-makers because they can only be addressed through recognition of their multilateral dimensions.



UNITED NATIONS CONFERENCE ON TRADE AND DEVELOPMENT


The Global Economic Crisis:
Systemic Failures and
Multilateral Remedies


Report by the UNCTAD Secretariat Task Force on
Systemic Issues and Economic Cooperation


Executive summary


UNITED NATIONS


New York and Geneva, 2009




The Global Economic Crisis: Systemic Failures and Multilateral Remedies


ii


Note


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or reprint should be sent to the UNCTAD


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UNITED NATIONS


PUBLICATION


UNCTAD/GDS/2009/1


Copyright © United Nations, 2009


All rights reserved




Report by the UNCTAD Secretariat Task Force on Systemic


Issues and Economic Cooperation: Executive summary


iii


Key messages


UNCTAD’s longstanding call for stronger international


monetary and financial governance rings true in today’s


crisis, which is global and systemic in nature. The crisis


dynamics reflect failures in national and international


financial deregulation, persistent global imbalances,


absence of an international monetary system and deep


inconsistencies among global trading, financial and


monetary policies.


National and multilateral remedies


x Market fundamentalist laissez-faire of the last 20
years has dramatically failed the test. Financial


deregulation created the build-up of huge risky


positions whose unwinding has pushed the global


economy into a debt deflation that can only be


countered by government debt inflation:


– 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, to stimulate economic growth


and to avoid deflation of prices. The key objective of


regulatory reform has to be the systematic weeding


out of financial sophistication with no social return.


x Blind faith in the efficiency of deregulated financial
markets and the absence of a cooperative financial


and monetary system created an illusion of risk-free


profits and licensed profligacy through speculative


finance in many areas:




The Global Economic Crisis: Systemic Failures and Multilateral Remedies


iv


– This systemic failure can only be remedied through


comprehensive reform and re-regulation with a


vigorous role by Governments working in unison.


Contrary to traditional views, Governments are well


positioned to judge price movements in those markets


that are driven by financial speculation and should


not hesitate to intervene whenever major


disequilibria loom.


x The growing role and weight of large-scale financial
investors on commodities futures markets have


affected commodity prices and their volatility.


Speculative bubbles have emerged for some


commodities during the boom and have burst after


the sub-prime shock:


– Regulators need access to more comprehensive


trading data in order to be able to understand what is


moving prices and intervene if certain trades look


problematic, while key loopholes in regulation need


to be closed to ensure that positions on currently


unregulated over-the-counter markets do not lead to


“excessive speculation”.


x The absence of a cooperative international system to
manage exchange rate fluctuations has facilitated


rampant currency speculation and increased the


global imbalances. As in Asia 10 years ago, currency


speculation and currency crisis has brought a number


of countries to the verge of default and dramatically


fuelled the crisis:


– Developing countries should not be subject to a


“crisis rating” by the same financial markets which


have created their trouble. Multilateral or even




Report by the UNCTAD Secretariat Task Force on Systemic


Issues and Economic Cooperation: Executive summary


v


global exchange rate arrangements are urgently


needed to maintain global stability, to avoid the


collapse of the international trading system and to


pre-empt pro-cyclical policies by crisis-stricken


countries.


Global economic decision-making


x The crisis has made it all too clear that globalization
of trade and finance calls for global cooperation and


global regulation. But resolving this crisis and


avoiding its recurrence has implications beyond the


realm of banking and financial regulation, going to


the heart of the question of how to revive and extend


multilateralism in a globalizing world.


x The United Nations must play a central role in
guiding this reform process. It is the only institution


which has the universality of membership and


credibility to ensure the legitimacy and viability of a


reformed governance system. It has proven capacity


to provide impartial analysis and pragmatic policy


recommendations in this area.






Report by the UNCTAD Secretariat Task Force on Systemic


Issues and Economic Cooperation: Executive summary


vii


Foreword by the Secretary-General of UNCTAD


The global deleveraging that first hit the world economy in


mid-2007 and that accelerated in autumn 2008 could not have been


possible without the rare coincidence of a number of market failures


and triggers, some reflecting fundamental imbalances in the global


economy and others specific to the functioning of sophisticated


financial markets. Chief among these “systemic” factors were the


full-fledged deregulation of financial markets and the increased


sophistication of speculation techniques and financial engineering.


Other determinants were also at play, particularly the systemic


incoherence among the international trading, financial and monetary


systems, not to mention the failure to reform the global financial


architecture. Most recently, the emergence of new and powerful


economic actors, especially from the developing countries, without


the accompanying reform needed in the framework governing the


world economy, accentuated that incoherence.


For many years, even when the global economic outlook was


much more positive than today, UNCTAD stressed the need for


systemic coherence. It has regularly highlighted the shortcomings of


the international economic system and has defied mainstream


economic theory in its justification of financial liberalization without


a clear global regulatory framework. UNCTAD has drawn attention


to the fact that the world economy was overshadowed by serious


trade imbalances and has questioned how they could be corrected


without disrupting development. We have warned that, in the absence


of international macroeconomic policy coordination, the correction


could take the form of a hard landing and sharp recession. In recent


years, we noted the growing risk that the real economy could become


hostage to the whims and volatility of financial markets. Against this


background, UNCTAD has always argued in favour of stronger


international monetary and financial governance.


A better understanding is required of how lack of proper


financial regulation set the scene for increasingly risky speculative


operations in commodities and currency markets and of how across-


the-board financial deregulation and liberalization have contributed to




The Global Economic Crisis: Systemic Failures and Multilateral Remedies


viii


global imbalances. In doing so, a clearer vision may emerge of how


these and other systemic shortcomings can only be remedied by


vigorous reform of the international monetary and financial systems


through broad-based multilateral cooperative processes and


mechanisms that strengthen the role of developing countries in global


governance.


Against this backdrop, I established in October 2008 an


UNCTAD interdivisional Task Force on Systemic Issues and


Economic Cooperation, chaired by the Director of the Division on


Globalization and Development Strategies. This group of UNCTAD


economists was tasked with examining the systemic dimensions of


the crisis and with formulating proposals for policy action nationally


and multilaterally. Needless to say, the development dimension and


the appropriate responses are at the forefront of UNCTAD’s concerns


and the issues addressed in this report were identified with that in


mind.


There can be no doubt that, apart from the need to strengthen


financial regulation at the national level, the current problems of the


global economy require global solutions. The United Nations must


play a central role in this reform process, not only because it is the


only institution which has the universality of membership and


credibility to ensure the legitimacy and viability of a reformed


governance system, but also because it has proven capacity to provide


impartial analysis and pragmatic policy recommendations in this area.


Supachai Panitchpakdi


Secretary-General of UNCTAD




1


Executive summary


The global economic crisis has yet to bottom out. The


major industrial economies are in a deep recession, and growth in


the developing world is slowing dramatically. The danger of


falling into a deflationary trap cannot be dismissed for many


important economies. Firefighting remains the order of the day,


but it is equally urgent to recognize the root causes for the crisis


and to embark on a profound reform of the global economic


governance system.


To be sure, the drivers of this crisis are more complex


than some simplistic explanations pointing to alleged government


failure suggest. Neither “too much liquidity” as the result of


“expansionary monetary policy in the United States”, nor a


“global savings glut” serves to explain the quasi-breakdown of the


financial system. Nor does individual misbehaviour. No doubt,


without greed of too many agents trying to squeeze double-digit


returns out of an economic system that grows only in the lower


single-digit range, the crisis would not have erupted with such


force. But good policies should have anticipated that human


beings can be greedy and short-sighted. The sudden unwinding of


speculative positions in practically all segments of the financial


market was triggered by the bursting of the United States housing


price bubble, but all these bubbles were unsustainable and had to


burst sooner or later. For policymakers who should have known


better to now assert that greed ran amok or that regulators were


“asleep at the wheel” is simply not credible.


Financial deregulation driven by an ideological belief in


the virtues of the market has allowed “innovation” of financial


instruments that are completely detached from productive


activities in the real sector of the economy. Such instruments




The Global Economic Crisis: Systemic Failures and Multilateral Remedies


2


favour speculative activities that build on apparently convincing


information, which in reality is nothing other than an extrapolation


of trends into the future. This way, speculation on excessively


high returns can support itself – for a while. Many agents


disposing of large amounts of (frequently borrowed) money bet on


the same “plausible” outcome (such as steadily rising prices of


real estate, oil, stocks or currencies). As expectations are


confirmed by the media, so-called analysts and policymakers,


betting on ever rising prices appears rather risk-free, not reckless.


Contrary to the mainstream view in the theoretical


literature in economics, speculation of this kind is not stabilizing;


on the contrary, it destabilizes prices. As the “true” price cannot


possibly be known in a world characterized by objective


uncertainty, the key condition for stabilizing speculation is not


fulfilled. Uniform, but wrong, expectations about long-term price


trends must sooner or later hit the wall of reality, because funds


have not been invested in the productive capacity of the real


economy, where they could have generated increases in real


income. When the enthusiasm of financial markets meets the


reality of the – relatively slow-growing – real economy, an


adjustment of exaggerated expectations of actors in financial


markets becomes inevitable.


In this situation, the performance of the real economy is


largely determined by the amount of outstanding debt: the more


economic agents have been directly involved in speculative


activities leveraged with borrowed funds, the greater the pain of


deleveraging, i.e. the process of adjusting the level of borrowing to


diminished revenues. As debtors try to improve their financial


situation by selling assets and cutting expenditures, they drive


asset prices further down, cutting deeply into profits of companies


and forcing new “debt-deflation” elsewhere. This can lead to


deflation of prices of goods and services as it constrains the ability


to consume and to invest in the economy as a whole. Thus, the


attempts of some actors to service their debts make it more




Report by the UNCTAD Secretariat Task Force on Systemic Issues and


Economic Cooperation: Executive summary


3


difficult for others to service their debts. The only way out is


government intervention to stabilize the system by “government


debt inflation”.


* * *


It is instructive to recall the end of the Bretton Woods


system, under which the world had enjoyed two decades of


prosperity and monetary stability. Since then, the frequency and


size of imbalances and of financial crises in the world economy


have dramatically increased, culminating in the present one. Since


current-account imbalances are mirrored by capital account


imbalances, they serve to spread quickly the financial crisis across


countries. Countries with a current-account surplus have to credit


the difference between their export revenue and their import


expenditure to deficit countries, in one form or another. The


dramatic increase of debtor–creditor relations between countries


also has to do with the way in which developing economies


emerging from financial crises since the mid-1990s tried to shelter


against the cold winds of global capital markets.


Financial losses in the deficit countries or the inability to


repay borrowed funds then directly feed back to the surplus


countries and imperil their financial system. This channel of


contagion has particularly great potency in today’s world, with its


glaring lack of governance of international monetary and financial


relations. Another important reason for growing imbalances is


movements of relative prices in traded goods as a result of


speculation in currency and financial markets, which leads to


considerable misalignments of exchange rates. Speculation in


currency markets due to interest rate differentials has led to


overspending in the capital-receiving countries that is now


unwinding. With inward capital flows searching for high yield, the


currencies of capital-receiving countries (with higher inflation and


interest rates) appreciated in nominal and in real terms, leading to




The Global Economic Crisis: Systemic Failures and Multilateral Remedies


4


large movements in the absolute advantages or the level of overall


competitiveness of countries vis-à-vis other countries.


The growing disconnection of the movements of nominal


exchange rates with the “fundamentals” (mainly the inflation


differential between countries) has been a main cause of the


growing global imbalances. For rising economic welfare to be


sustainable, it has to be shared without altering the relative


competitive positions of countries. Companies gaining market


shares at the expense of other companies are an essential


ingredient of the market system. But if nations gain at the expense


of other nations because of their superior competitive positions,


dilemmas can hardly be avoided. If the “winning” nations are not


willing to allow a full rebalancing of competitive positions over


the long run, they force the “loser” nations into default. This is a


phenomenon that J. M. Keynes some 80 years ago called the


“transfer problem”; its logic is still valid.


In addition to all these factors, overshooting of commodity


prices led to the emergence of – partly very large – current-


account surpluses in commodity-exporting countries over the past


five years. When the “correction” came, however, the situation of


many commodity producers in the poorer and smaller developing


countries rapidly deteriorated. There is growing evidence that


financialization of commodities futures markets played an


important role in the scale and degree of market volatility. Prices


in many physical markets for commodities can be driven up by the


mere fact that everybody expects higher prices, an expectation that


may itself be the result of futures prices that are driven up by shifts


of speculative power between financial markets, commodity


futures and currency markets.


* * *


The global financial crisis arose amidst the failure of the


international community to give the globalized economy credible


global rules, especially with regard to international financial




Report by the UNCTAD Secretariat Task Force on Systemic Issues and


Economic Cooperation: Executive summary


5


relations and macroeconomic policies. The speculative bubbles,


starting with the United States housing price bubble, were made


possible by an active policy of deregulating financial markets on a


global scale, widely endorsed by Governments around the world.


The spreading of risk and the severing of risk – and the


information about it – were promoted by the use of


“securitization” through instruments such as residential


mortgages-backed securities that seemed to satisfy investors’


hunger for double-digit profits. It is only at this point that greed


and profligacy enter the stage. In the presence of more appropriate


regulation, expectations on returns of purely financial instruments


in the double-digit range would not have been possible.


With real economic growth in most developed countries at


under 5 per cent, such expectations are misguided from the


beginning. It may be human nature to suppress frustrations of the


past, but experts, credit rating agencies, regulators and policy


advisors know that everybody cannot gain above average and that


the capacity of the real economy to cope with incomes earned


from exaggerated real estate and commodity prices or misaligned


exchange rates is strictly limited. The experience with the stock


market booms of the “new economy” should have delivered that


lesson, but instead a large number of financial market actors began


to invest their funds in hedge funds and “innovative financial


instruments”. These funds needed to ever increase their risk


exposure for the sake of higher yields, with more sophisticated


computer models searching for the best bets, which actually added


to the opaqueness of many instruments. It is only now, through the


experience of the crisis, that the relevance of real economic


growth and its necessary link to the possible return on capital is


slowly coming to be understood by many actors and policymakers.


The crisis has made it all too clear that globalization of


trade and finance calls for global cooperation and global


regulation. But resolving this crisis and avoiding similar events in


the future has implications beyond the realm of banking and




The Global Economic Crisis: Systemic Failures and Multilateral Remedies


6


financial regulation, going to the heart of the question of how to


revive and extend multilateralism in a globalizing world.


* * *


In financial markets, the similarity of the behaviour of


many financial market participants and the limited amount of


information that guides their behaviour justify considerably


greater government intervention. Contrary to atomistic goods and


services markets and the colossal quantity of independent data that


help form prices, most of the information that determines the


behaviour of speculators and hedgers is publicly accessible and the


interpretation of these data follows some rather simple explanatory


patterns. Neither market participants nor Governments can know


equilibrium prices in financial markets. But this is not a valid


argument against intervention, as we have learnt now that


financial market participants not only have no idea about the


equilibrium, but their behaviour tends to drive financial prices


systematically away from equilibrium. Governments do not know


the equilibrium either, but at some point they are the best


positioned to judge when the market is in disequilibrium,


especially if functional/social efficiency is to be the overriding


criterion of regulation.


If the failure of financial markets has shattered the naïve


belief that unfettered financial liberalization and deliberate non-


intervention of Governments will maximize welfare, the crisis


offers an opportunity to be seized. Governments, supervisory


bodies and international institutions have a vital role, allowing


society at large to reap the potential benefits of a market system


with decentralized decision-making. To ensure that atomistic


markets for goods and for services can function efficiently,


consistent and forceful intervention in financial markets is


necessary by institutions with knowledge about systemic risk that


requires quite a different perspective than the assessment of an


individual investor’s risk. Market fundamentalist laissez-faire of




Report by the UNCTAD Secretariat Task Force on Systemic Issues and


Economic Cooperation: Executive summary


7


the last 20 years has dramatically failed the test. A new start in


financial market regulation needs to recognize inescapable lessons


from the crisis, such as:


¾ Financial efficiency should be defined as the sector’s ability to
stimulate long-term economic growth and provide


consumption smoothing services. A key objective of


regulatory reform is to devise a system that allows weeding


out financial instruments which do not contribute to


functional, or social, efficiency;


¾ Regulatory arbitrage can only be avoided if regulators are able
to cover the whole financial system and ensure oversight of all


financial transactions on the basis of the risk they produce;


¾ Micro-prudential regulation must be complemented with
macro-prudential policies aimed at building up cushions


during good times to avoid draining liquidity during periods of


crisis;


¾ In the absence of a truly cooperative international financial
system, developing countries can increase their resilience to


external shocks by maintaining a competitive exchange rate


and limiting currency and maturity mismatches in both private


and public balance sheets. If everything else fails, back-up


policies, such as market-friendly capital controls, can limit


risk accumulation in good times;


¾ Developing countries regulators should develop their financial
sectors gradually in order to avoid the boom-and-bust cycle;


¾ Regulators based in different countries should share
information, aim at setting similar standards and avoid races to


the bottom in financial regulation.


As for the growing presence of financial investors on


commodity futures exchanges, several immediate areas are


suggested for improved regulation and global cooperation:




The Global Economic Crisis: Systemic Failures and Multilateral Remedies


8


¾ Comprehensive trading data reporting is needed in order to
monitor information about sizeable transactions in look-alike


contracts that could impact regulated markets, so that


regulators can understand what is moving prices and intervene


if certain trades look problematic;


¾ Effective regulatory reform should also close the swap dealer
loophole to enable regulators to counter unwarranted impacts


from over-the-counter markets on commodity exchanges.


Therefore, regulators should be enabled to intervene when


swap dealer positions exceed speculative position limits and


may represent “excessive speculation”;


¾ Another key regulatory aspect entails extending the product
coverage of detailed position reports of United States-based


commodity exchanges and requiring non-United States


exchanges that trade look-alike contracts to collect similar


data. Stepped-up authority would allow regulators to prevent


bubble-creating trading behaviour from having adverse


consequences for the functioning of commodity futures


trading;


¾ Renewed efforts are needed to design a global institutional
arrangement supported by all concerned nations, consisting of


a minimum physical grain reserve (to stabilize markets and to


respond to emergency cases and humanitarian crises) as well


as an intervention mechanism. Intervention in the futures


markets should be envisaged when a competent global


institution considers market prices to differ significantly from


an estimated dynamic price band based on market


fundamentals. The global mechanism should be able to bet


against the positions of hedge funds and other big market


participants, and would assume the role of “market maker”.


In a globalized economy, interventions in financial


markets call for cooperation and coordination of national


institutions, and for specialized institutions with a multilateral




Report by the UNCTAD Secretariat Task Force on Systemic Issues and


Economic Cooperation: Executive summary


9


mandate to oversee national action. In the midst of the crisis, this


is even more important than in normal times. The tendency of


many Governments to entrust to financial markets again the role


of judge or jury in the reform process – and, indeed, over the fate


of whole nations – would seem inappropriate. It is indispensable to


stabilize exchange rates by direct and coordinated government


intervention, supported by multilateral oversight, instead of letting


the market find the bottom line and trying to “convince” financial


market participants of the “credibility of policies” in the


depreciating country, which typically involves pro-cyclical


policies such as public expenditure cuts or interest rate hikes.


The problems of excessive speculative financial activity


have to be tackled in an integrated fashion. For example, dealing


only with the national aspects of re-regulation to prevent a


recurrence of housing bubbles and the creation of related risky


financial instruments assets would only intensify speculation in


other areas such as stock markets. Preventing currency speculation


through a new global monetary system with automatically


adjusted exchange rates might redirect the speculation searching


for quick gains towards commodities futures markets and increase


volatility there. The same is true for regional success in fighting


speculation, which might put other regions in the spotlight of


speculators. Nothing short of closing down the big casino will


provide a lasting solution.




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