TWN Info Service on Finance and Development (Mar09/05)
26 March 2009
Third World Network

Financial deregulation at root of current global crisis
Published in SUNS #6664 dated 20 March 2009

Geneva, 19 Mar (Kanaga Raja) -- A sustained process of financial deregulation -- within countries and between countries -- led to an expanding cycle of optimism and risk-taking that is at the root of the current global crisis, the UN Conference on Trade and Development (UNCTAD) said on Thursday.

In a report, "The Global Economic Crisis: Systemic Failures and Multilateral Remedies", UNCTAD said that history indicates that financial systems are intrinsically unstable and prone to boom and bust cycles, and need to be regulated.

However, modern financial regulation is based on the assumption that "markets know best" and does not take sufficient account of the regularly repeated lesson that financial markets can fail.

The collapse in the market for sub-prime mortgages in the United States was the spark that ignited the crisis, but it is not the fundamental cause, the report said. At the root of the current crisis are the global imbalances and the underestimation of risk that led to excessive leverage in the years before the crisis. The build-up of risk could have been avoided if financial policies had been guided by a sense of pragmatism rather than by fundamentalist market ideology.

"It was the combination of financial and technological innovation in banking and credit markets, unaccompanied by adequate regulation and supervision that led to today's predicament," said the report.

Given the paramount influence of asymmetric information on economic decision-making, financial markets are different from goods market, and therefore need to be subject to stricter regulation, the report said, adding: "This is not a failure of the market system. It is a failure of financial deregulation."

The report also said that a sharp jump in food prices in 2007-2008 - and a subsequent steep drop in those prices - was driven in part by large-scale speculation by financial investors. It called for more transparency in futures markets for commodities such as food and petroleum, as well as more power for regulators to step in when such futures speculation - which is aimed at profits for arbitrage investors rather than as a hedge to protect producers against normal price swings - drives up prices for vital goods such as food.

The report further contends that exchange-rate adjustments cannot be left to the market and must be subject to multilateral oversight. Noting that the fallout from short-term currency speculation has contributed to sharp collapses in the values of some national currencies as the global economic crisis has intensified, it recommended that changes in nominal exchange rates should reflect differences in rates of inflation between trading countries.

The report was written by economists serving on UNCTAD's Secretariat Task Force on Systemic Issues and Economic Cooperation, in advance of several upcoming international conferences on the global economic crisis.

It comes just as the International Monetary Fund has reported that global activity is now projected to contract by 0.5 to one percent in 2009 on an annual average basis - the first such fall in 60 years. Another piece of grim news was highlighted in a recent study which found that private capital flows with respect to emerging markets this year is expected to be less than half of its levels in 2007, which will likely put further stress on emerging market currencies, asset markets and economies.

The study in the RGE Monitor, founded by a team of economists and political experts and headed by well-known economist Prof. Nouriel Roubini, attributed this reversal in capital inflows to de-leveraging or losses in financial markets, which it said, has been one of the most significant effects of the financial crisis on emerging market economies. The study pointed to a less-than-encouraging outlook for portfolio investments, and said that redemptions of $41.2 billion out of emerging market equity funds in 2008 have fully reversed the record $40.8 billion inflow in 2007. It said that about half of emerging market fund purchases undertaken since 2003 have now been withdrawn.

The study also cited the Institute of International Finance projecting net private capital flows to emerging markets to fall sharply to $165 billion in 2009 (from $467 billion in 2008). Net lending of international banks to emerging market economies (excluding Gulf countries) is projected to decline to $135 billion in 2009, from $401 billion in 2007 and $245 billion in 2008. The RGE Monitor cited the World Bank as estimating the total financing needs of some 104 developing countries in 2009 to be more than $1.4 trillion. The Monitor noted that emerging economies such as Iceland, Ukraine, Argentina, Indonesia and Russia have imposed controls on capital outflows as a way to manage the financial crisis.

More bleak news emerged at a high-level meeting at the WTO on Wednesday of some 30 experts representing international financial institutions, regional development banks, export credit agencies and private banks to discuss problems associated with trade finance -- viewed as the lifeline of trade. The meeting found that despite the rapid decrease of trade flows, the shortage of trade finance is still a problem and that the liquidity gap between demand and supply has widened substantially. There is also a rapid deterioration in the trade finance situation in emerging markets. Trade officials said, after the high level meeting, that the liquidity gap in trade finance has increased three- or four-fold from the previous estimate of about $25 billion, made in November 2008.

At a media briefing on Wednesday to launch the report, UNCTAD Secretary-General Dr Supachai Panitchpakdi said that UNCTAD is deeply concerned that international discourses on the crisis have not paid enough attention to the impact on developing economies. They will suffer more due to the fact that the liquidity crunch will hit them the hardest, particularly in the area of trade financing. When developing countries ask for assistance, they should be given assistance in a way that would not be reflective of the past pro-cyclical conditionalities that came along with the assistance, which did more to damage those developing economies, he said.

Asked what he wanted to see coming out of the upcoming G20 leaders' summit in early April, the UNCTAD head said that if global stimulus is undertaken, it should not just take into account the most advanced economies but should also take into account the rest of the global economy. In addition, the G20 has to establish the fact that there is also the need for trade, and for it to be rehabilitated, either through the Doha Development Agenda or trade financing.

Mr Heiner Flassbeck, Director of UNCTAD's Division on Globalization and Development Strategies, said that urgent action is needed. He pointed to the need for policy space for all countries to adopt counter-cyclical policies and not be forced to undertake pro-cyclical policies. He noted that the conditionality of the IMF is still pro-cyclical.

Asked if the monetary polices of former US Federal Reserve Chairman Alan Greenspan were to blame for the current crisis, he said that Greenspan could not be blamed for his macroeconomic policy because monetary policy cannot decide what individual agents do with the money that they issue. What monetary policy does is try to stimulate the economy at a certain point in time. But he did blame Greenspan for his deregulation stance. "There, he is clearly to blame. Besides his monetary policy, he was always in favour of the highly sophisticated and efficient markets, and there he really got it wrong."

The UNCTAD report said: "The United Nations must play a central role in the 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."

The report said that excessive speculative financial activity should be tackled as a whole. Establishing national regulations to prevent housing bubbles and the creation of risky financial instruments alone would only intensify speculation in other areas such as stock markets. And preventing currency speculation through a global monetary system with automatically adjusted exchange rates might simply redirect speculators searching for quick profits into commodities futures markets, thus increasing volatility there. The same is true for regional steps to fight speculation that might only make other regions the focus of speculators.

"Nothing short of closing down the big casino will provide a lasting solution," said the report.

The report found that the fatal flaw in financial innovation that leads to crises and collapse of the whole system is demonstrated whenever herds of agents on the financial markets "discover" that rather stable price trends in different markets (which are originally driven by events and developments in the real sector) allow for "dynamic arbitrage", which entails investing in the probability of a continuation of the existing trend. As 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) they acquire the market power to move these prices far beyond sustainable levels.

Contrary to the mainstream view in the theoretical literature in economics, speculation of this kind is not stabilizing, but rather destabilizes prices on the targeted markets. As the equilibrium price or the "true" price simply cannot be known in an environment characterized by objective uncertainty, that main condition for stabilizing speculation is not realized. Hence, the majority of the market participants just extrapolate the actual price trend as long as "convincing" information that justifies the hike allows for a certain degree of self-delusion.

The bandwagon created by uniform, but wrong, expectations about price trends inevitably hit the wall of reality because funds have not been invested in the productive base of the real economy where they could have generated higher real income. Rather, it has only created the short-term illusion of continuously high returns and a "money-for-nothing mentality", said the report.

At this point, the harsh reality of a slowly growing real economy catches up with the insistent enthusiasm of financial markets such that an adjustment of expectations becomes inevitable. Hence, the short-term development of the economy is largely hostage to the amount of outstanding debt. The more households, businesses, banks, and other economic agents are directly involved in speculative activities with borrowed funds, the greater the pain of de-leveraging, i. e. the process of adjusting the level of borrowing to diminished revenues. A "debt deflation" sets in that fuels further painful adjustment because debtors try to improve their financial situation by selling assets and cutting expenditure, thereby driving asset prices further down, cutting deep into profits of companies and forcing new debt deflation elsewhere.

The result of debt deflation, if not stopped early on, will be deflation of prices of goods and services as it constrains the ability to consume and to invest for the economy as a whole. Thus, in a debt deflation, the attempts of some to service their debts makes it more difficult for others to service their debts. Only Governments can step in and stabilize the system by "government debt inflation", the report stressed. It also noted that the contribution of investment banks to real economic growth was mostly of the zero sum game type and not productive at all for society at large.

Much of "investment banking" was unrelated to investment in real productive capacity; rather, it masked the true, speculative character of the activity and presented what appeared to be an innovation in finance.

Analysis of the economic crisis which first erupted in the developed economies has to begin by recalling the end of the global system of "Bretton Woods", which had rendered possible two decades of rather consistent global prosperity and monetary stability. Since then, it has become possible to identify an "Anglo-Saxon" part of the global economy on the one hand, where economic policy since the beginning of the 1980s was comparatively successful in stimulating growth and job creations, and a Euro-Japanese component, where growth remained sluggish and economic policy wavered with no clear or consistent view on how to use the greater monetary autonomy that the end of the global monetary system had made possible.

That the crisis originated in the Anglo-Saxon part of the developed countries was the logical outcome of the full swing towards unrestricted capital flows and unlimited freedom to exploit any opportunity to realize short-term profits. The financial crisis has demonstrated the damaging impact of this "short-termism" on long-term growth. But at the same time it has been the major driving force of the world economy in the last three decades. Without the high level of consumption in the United States, today most of the developed world and many emerging-market economies would have much lower standards of living, and unemployment would be much higher, said the report. Indeed, the consumption boom in the United States since the beginning of the 1990s was not well funded from real domestic sources. To a significant degree, it was fuelled by the speculative bubbles that inflated housing and stock markets.

Juxtaposed against the current account deficits and overspending in the Anglo-Saxon economies was thrift elsewhere. Parts of continental Europe, in particular Germany, and Japan engaged in belt-tightening exercises that resulted in slow or no wage growth and sluggish consumption. But, since this policy stance also implied increased cost competitiveness, it yielded excessive export growth and ballooning surpluses in current accounts, thereby piling up huge net asset positions vis-a-vis the overspending nations.

These global imbalances served to spread quickly the financial crisis that originated in the United States to many other countries, because current-account imbalances are mirrored by capital account imbalances: the country with a current-account surplus has to credit the difference between its export revenue and its import expenditure to deficit countries. 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.

The report said that this channel of contagion has even greater potency owing to the lack of governance in financial relations between countries trading with one another in the globalized economy. The dramatic increase of debtor-creditor relations between countries goes far beyond the fallout from the Anglo-Saxon spending spree and has to do with a phenomenon that is sometimes called "Bretton Woods II". The report said that Bretton Woods II refers to how developing economies emerging from financial crises since the mid-1990s tried to shelter against the cold winds of global capital markets. For these economies, the only way to combine sufficient stability of the exchange rate with domestic capacity to handle trade and financial shocks and with successful trade performance was to unilaterally stabilize the exchange rate at an undervalued level. This applies to most of the Asian countries that were directly involved in the Asian financial crisis and a number of Latin American countries, but also to China and, to a certain extent, India.

[The "Bretton Woods II" terminology is however being widely used, in relation to the current G-20 centered processes, and the moves under way in the UN, for reforms and restructuring the global financial architecture.]

Another important reason for growing imbalances is movements of relative prices in traded goods as a result of speculation in currency and financial markets ("carry trade"). The growing disconnection of the movements of exchange rates with their "fundamentals" (mainly the inflation differential between countries) has produced widespread and big movements in the absolute advantage or the level of overall competitiveness of countries vis-a-vis other countries. These changes in the real exchange rates are clearly associated with the growing global imbalances.

According to the report, speculation in currency markets due to interest rate differentials has produced a specific form of overspending that is now unwinding. In many countries, especially in Eastern Europe, but also in Iceland, New Zealand and Australia, it was profitable for private households and companies to borrow in foreign currencies with low interest rates, such as the Swiss Franc and the yen. The outbreak of the global financial crisis triggered the unwinding of these speculative positions, depreciated the currencies formerly targeted by carry trade, and forced companies and private households in the affected countries to de-leverage their foreign currency positions or to default, thus posing a direct threat to the (mainly foreign) banks in these countries.

The report also said that the global financial crisis arose amidst the neglect of international governance -- the failure of the international community to give the globalized economy credible global rules. The sudden unwinding of speculative positions in the different segments of the financial market was triggered by the bursting of the house price bubble in the United States. But all these bubbles were unsustainable and would have burst sooner or later.

"The housing price bubble itself was the result of the deregulation of 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 was promoted by the use of 'securitization' through instruments like residential mortgage-backed securities (RMBS) that seemed to satisfy investors' hunger for double-digit profits."

A more important driver of this kind of "financial innovation", however, was the naive belief in efficient market theories that did not recognize objective uncertainty but mistakenly assumed well informed buyers and sellers and hence promised minimal risk. But "securitization" of investment vehicles led to further risk concentration because it converted debtor-creditor relations (or insurer-insured relation) into capital flow transactions by packing different types of debt for onward sale to investors in form of bonds all around the world, whose interest and return of principal are based on the value of the underlying assets.

Due to the opaqueness of these complex bundled "products", many "securitized" assets found their way into instruments qualified as low-risk. A global clientele invested in these bonds because the global imbalances had intensified the global financial relations and had created the need for financial institutions located in the countries with current account surpluses to hold much of the toxic paper. In the first flush of financial liberalization, the global distribution of these papers was seen as an indication of successful risk diversification. But eventually, the opposite happened: financial "innovation" resulted in a concentration of risk since most of the "vehicles" were "securitized" by using assets that had similar default risks.

For the past two decades, said the report, financial innovation was promoted and protected with scant regard for the downside risks. The most serious financial crisis since the Great Depression, the de facto nationalization of a large fraction of the United States financial system, and the deepest global recession since World War II are now casting doubts on the assumptions that led former Chairman of the Fed, Alan Greenspan, to state: "Although the benefits and costs of derivatives remain the subject of spirited debate, the performance of the economy and the financial system in recent years suggests that those benefits have materially exceeded the cost."

There are certainly some elements in which the current crisis differs from previous ones. These new elements are exactly those supposed to increase the resilience of the financial system. They include the "originate and distribute" bank business model, financial derivatives like credit default swaps, and the creation of a "shadow banking system". There are, however, many elements that are not new. As in previous crises, the roots of the current turmoil lie in a self-reinforcing mechanism in which high growth and low volatility lead to a decrease in risk aversion. This, in turn, leads to higher liquidity and asset prices, which eventually feedback into higher profits and growth and even higher risk-taking, said the report.

"The final outcome of this process is the build-up of risk and large imbalances that, at some point, must unwind. The proximate cause for the crisis may then appear to be some idiosyncratic shock (in the current case, defaults on sub-prime mortgage loans), but in many markets, the true harbinger of the crisis was the unchecked build-up of risk during the boom."

According to the report, arguing that the current crisis has many common elements with previous ones has important implications for financial regulation today. Because of their faith in the self-discipline of the marketplace, policymakers made avoidable mistakes. For example, they disregarded the basic fact that market-based risk indicators (such has high-yield spreads or implicit volatility measures) tend to be low at the peak of the credit cycle, exactly when risk is high.

The report points to several misconceptions regarding modern financial regulation. The most fundamental of these is the assumption that "markets know best" and that regulators should take a back seat and not try to second guess them. As is argued here, Governments and regulators can and should play an active role in monitoring and controlling markets. They are able to do so because they are privy to the same information available to market participants, but only they are in a position to detect and avoid systemic risk by understanding better than market participants the limits to and the dangers of "irrational exuberance".

A standard assumption underlying most regulatory systems is that all financial products can potentially increase social welfare and that the only problem to be dealt with is that some products may increase risk and reduce transparency. If these issues could be addressed, the argument goes, more financial innovation would always be beneficial from society's point of view.

"This argument is wrong," said UNCTAD, adding that some financial instruments can generate high private returns but have no social utility whatsoever. They are purely gambling instruments that increase risk without providing any real benefit to society. They can be efficient in the narrow sense of transactional efficiency but they are not functionally efficient.

Policymakers should not prevent and stunt financial innovation as a rule. However, they should be aware that some types of financial instruments are created with the sole objective of eluding regulation, increasing leverage and maximizing investor's profits and bankers' bonuses. Financial regulation should aim at limiting the proliferation of such dubious instruments.

The report recommended that a step in this direction could be achieved with the creation of a Financial Products Safety Commission aimed at evaluating whether new financial products can be traded or held by regulated financial institutions. Such an agency may also provide incentives to create standardized financial products, which are more easily understood by market participants, thus increasing the overall transparency of the financial market.

It also suggested that regulatory limits are needed for the issuance of credit default swaps (CDS) to reflect the amount of underlying risk. Such regulation would not be too different from laws that do not allow home-owners to over insure their houses or that prevent individuals from buying insurance contracts that make payments when an unrelated person dies. For instance, credit default swaps (CDS) are supposed to provide hedging services. But when the issuance of CDS reaches ten times the risk to be hedged, it becomes clear that 90% of these CDS do not provide any hedging service.

Poorly designed regulation can backfire and lead to regulatory arbitrage. This is what happened with banking regulation. Usually, banks take more risk by increasing leverage and modern prudential regulation revolves around the Basel Accords, which require banks with an international presence to hold a first-tier capital equal to 8% of risk-weighted assets. Since capital is costly, bank managers try to circumvent regulation by either hiding risk or by moving some leverage outside the bank. This shift of leverage created a "Shadow Banking System" consisting of over-the-counter derivatives, off-balance sheet entities, and other non-bank financial institutions such as insurance companies, hedge funds, and private equity funds.

Thanks to credit derivatives, said the report, these new players can replicate the maturity transformation role of banks, while escaping normal bank regulation. At its peak, the shadow banking system in the United States held assets of more than $16 trillion, about $4 trillion more than regulated deposit-taking banks.

In order to avoid regulatory arbitrage, banks and the capital markets need to be regulated jointly and financial institutions should be supervised on a fully consolidated basis, UNCTAD recommended, adding that the build up of hidden systemic risk can be limited by designing an objective-based regulatory system. All markets and providers of financial products should be overseen on the basis of the risk they produce.

The current regulatory framework assumes that policies aimed at guaranteeing the soundness of individual banks can also guarantee the soundness of the whole banking system. It is micro-prudential but not macro-prudential, said the report, arguing that micro-prudential regulation has to be complemented by macro-prudential regulation, which, rather than protecting depositors, has the objective of guaranteeing the stability of the system and avoid large output losses. Regulators should internalize regulatory arbitrage and be aware that both banks and non-bank financial institutions can be a source of systemic risk.

"It is thus necessary to develop a macro-prudential regulatory system based on counter-cyclical capital provisioning and to develop institutions for the supervision of all the different financial markets that are focusing systemic risk and nothing else." +