Bucket and Spoon

Anyone telling you when and where the next earthquake is going to happen should be disbelieved and treated with contempt. The same applies to anyone telling you when and where recovery from the current global crisis is going to happen. Maybe the green shoots are already here, in Europe and/or the US. Maybe in China end-2009 and 2010. Maybe globally in 10 years time. We are sailing in uncharted waters and nobody can speak with any acceptable degree of confidence and credibility.

The current global financial crisis is unprecedented. It is not due to an exogenous shock (like the oil shock of 1974) but it is an endogenous, systemic crisis, due to the unregulated degeneration of financial institutions, banks and non-bank intermediaries, the result of twenty years of hyper-liberalism. In August 2007 USA sub-primes acted as trigger, but the process was amplified by their securitisation and repackaging in structured bonds, as part of a much larger bubble in the derivatives market. According to the Basel-based Bank of International Settlements, the global outstanding derivatives – bets on the value of assets, and bets on those bets – have been growing exponentially and reached 1.14 quadrillion dollars. More precisely: $548 trillion in Exchange Traded Derivatives[1] plus $596 trillion in notional Over-The-Counter[2] derivatives. By comparison, the gross domestic product of all the countries in the world is only 60 trillion dollars. What was supposed to be an instrument to distribute risk has turned into a multiplication of risk.

Ultimately the problem with derivatives is that they represent bets that are only marginally covered. If those bets had to be 100% covered – and therefore losses constrained by a ceiling – at the time a transaction takes place, the size of the derivatives markets would be only a fraction of its present size, and counterparty defaults would not occur. With uncovered bets, mostly laid down on credit, when the value of underlying assets falls the whole pyramid collapses. In 2006 there were no bank failures in the USA; these were 3 in 2007, 25 in 2008, 23 in the first quarter of 2009.

The crisis is synchronised throughout the world, thus offering no geographical or sectoral shelter.
It spreads fast moving from the financial sector to the real economy, from one country to the other thanks to the globalisation of trade and capital movements, and in turn tends to de-globalise the world economy.

It is a deep crisis: for the first time since 1945 world income is falling, on average by 2% in 2009, accordingly to the IMF. World exports (obviously by definition equal to world imports), after growing steadily from 7% of world income in 1970 to 27% in 2007 are now falling, and at a rate much faster than income: minus 9% in 2009 according to the IMF, minus 13% according to the WTO. This brings down the world exports/income ratio, which is the most common and reliable index of globalisation. Labour unemployment has been growing fast. According to OECD forecasts Europe unemployment will rise by 20 million in 2009.

Such an unprecedented occurrence appears to have brought about, first, a re-thinking of the need for supervision and regulation of financial markets, and more generally for corporate governance in financial institutions and also in production, nationally and globally; second, an attempt to achieve a co-ordinated effort by at least the major countries and international financial institutions, for monetary expansion, as well as additional large scale fiscal stimulation. But there are considerable obstacles and doubts about both the actual implementation of such policies and their likely success.

The United States are unwilling to negotiate financial regulations internationally. They have injected large scale liquidity in the rescue of financial institutions, a process rightly criticised by Joseph Stiglitz as collectivisation of losses – directly, under Paulson and Bush, indirectly via government guarantees, under Geithner and Obama – after past profits have been privatised and salted away by shareholders and overpaid managers. Millionaire bonuses for managers of failing companies have been taking some cuts, through tax and ceilings, which have been criticised as improper interferences with “the market for managerial talent” – as if the medieval corporative practice of managers’ salaries being decided by other managers with a vested interest in inflationary settlements had anything to do with a competitive market. But by and large managers have kept their ill-gotten gains.

The effectiveness of monetary expansion, in any case, is limited by the current low level of interest rates, and by the liquidity preference that the public exhibits at such low rates (as we should all know very well from the experience with Japan’s monetary policy).

Fiscal expansion – Keynes resurrected and rehabilitated – on a world scale makes infinitely more sense than unilateral fiscal expansion by a single country. But many governments are already heavily indebted and feel they do not have much of what the World Bank calls “fiscal space” for sustaining larger deficits. The US have contributed fairly generously, however Gordon Brown himself, after posing as world saviour by promoting coordinated fiscal stimulation, had to trim his own sails and failed to do in the UK what he preached abroad. And there is the great temptation for governments (e.g. Italy) to benefit as free riders without contributing to the common effort.

In general, the size of the combined world-wide monetary and fiscal stimulus is at best a couple of percentage points of the size of the derivatives markets. Emptying water from the sinking ship with a spoon is not enough.

[1] ETD, traded via specialized exchanges or other exchanges acting as an intermediary, taking an initial margin from both sides of the trade to act as a guarantee.
[2] Over The Counter, privately negotiated and traded directly between two parties, without going through an exchange or other intermediary.