(picture: Franklin D. Roosevelt at London Summit 1933)
The upcoming G20 meeting where 85% of the World’s GDP will be present will take place in London where a similar meeting took place in June 1933. The question remains if this G20 meeting will meet the same fate as the former London meeting or a step away from the brink of the sharp economic downturn.
In 1933 the meeting was organized by the League of Nations . The objectives of many Nations were to re-instate the currency link to the Gold Standard, which would secure that prices and wages would fall in parallel with a downturn, and the idea was that this would stillenable foreign trade. The objective of some of the leaders – Mussolini, Hitler – was to demonstrate that nationalism and increased spending of re-armament would prove to be a way out of the crisis, while the country that was accused to put a torpedo to the London summit was USA. The new president, Franklin Roosevelt, had put his New Deal on the table back home, and this – very much like the present situation – resulted in a weakening of the Dollar because of huge deficit – in other words: US Govt paid to get out of the crisis by inflating it’s currency. This would be effectively stopped if the Gold Standard was to be reinstated. But it shouldn’t have been a surprise that FDR would work against the scheme – already in his inauguration speech, Roosevelt said:
"I shall spare no effort to restore world trade by international economic readjustment, but the emergency at home cannot wait on that accomplishment,"
This time around the agenda is almost the same -http://www.londonsummit.gov.uk/en/summit-aims/- but with the added objective to re-start the World on a path towards sustainable growth.
"The breakdown has created a political impasse. State rescues of entire banking systems are a necessary and inevitable response to the financial meltdown, but the consequence will be to try to limit banking to national units. Italian taxpayers will not want to see their money used to bail out remote eastern European debtors. The same political logic applies for fiscal stimulus packages, where voters will not want to see foreign producers in effect subsidized."
We may once more witness a situation where US will take the lead in what would this time become a new era of nationalism, disguised as regionalism. Already the rescue packages accepted by the US congress contains element of protectionism, ‘buy American’.
Others remain optimistic. See Recommendations – From Brookings - http://www.brookings.edu/reports/2009/0326_g20_summit.aspx or to quote from their list of recommendations also pointing to IMF as a potential key player:(See the full report from
“At least a tripling of resources for the IMF from currently $250 billion to $750 billion through a combination of a generalized quota increase, a sizeable SDR ($250 billion) allocation, a further authorization to borrow under the so-called “New Arrangements to Borrow” (NAB) or ad hoc borrowings from selected surplus countries— following the commitment already by Japan to $100 billion—and other measures to make the IMF a major actor in the global financial system”
The fears in US and UK are that there may not be lenders enough in the World to finance the galloping public deficits. Some UK critics have calculated that if you add the nationalized banks’ debt, this will all add up all debts ever accepted by UK Governments from 1691 to 2008!
“With the debts of the nationalised and part-nationalised banks now on the public sector balance sheet, the ratio of public sector debt to GDP in the UK exceeds that of Italy and Japan. And it is set to grow much higher. On the basis of the planned levels of borrowing, it could exceed 65 per cent of GDP in 2010-11. And at that scale of indebtedness, the Armageddon scenario most feared by the Treasury - that there will be insufficient lenders to match the planned level of borrowing - begins to look a distinct possibility.”
The UK recession clearly deepens as UK Public deficit hits all time record – but this time around so does the recession in almost all other countries. This is what gives us the hope that the G20 meeting – even if it may not solve all problems – at least will prove to be the first step on a long journey towards more global commitment and cooperation – including a greater role for the 3rd World countries. TheFinancial Ministers met 2 weeks ago and this statement was part of their end comminqué for the preparatory G20 meeting:
(Picture: Icelandic SUV's parked after the crisis - source: IMF)
According to a number of speeches from high level officers within the IMF these last few days, IMF has finally realized the magnitude of the financial crises, and at a meeting in Madrid on December 15, the managing director of the Fund, Dominique Strauss-Kahn was cited to have said that the international community would have to come up with at least 2% of the Worlds’ expected total GDP in order to combat the crisis.
A few days before this speech, his first deputy director, John Lipsky, addressed a conference in Steigenberger Hotel,Frankfurt via a Videoconference link from WashingtonD.C. He stressed the severity and depth of the crisis, loss of consumer confidence and the impact on the emerging economies. He said:
“In November, the IMF revised down its forecast for global growth, less than a month after the publication of its October World Economic Outlook. Based on current policies, the world economy is projected to grow by 2¼ percent in 2009, down from about 5 percent in 2007, before picking up in 2010. The major advanced economies are in recession, and activity is expected to contract by ¼ percent on an annual basis in 2009, marking the first annual contraction in the post-war period for this group of countries.”
The most interesting part of his pitch was the underpinning of the need for what he called a reform of the financial architecture:
“These include the design of financial regulation; the assessment of systemic risk; and creating mechanisms for more effective international action to reduce the risk of crises, and to address them when they occur.
Financial innovation and integration also have increased the speed and extent to which shocks are beingtransmitted across asset classes and countries, and have blurred boundaries, including between systemicnon-systemic institutions. Regulation and supervision, however, remain geared at individual financialadequately consider the systemic and international aspects ofdomestic institutions' actions. ...
The challenge, therefore, is to design new rules and institutions that reduce systemic risks, improve financial intermediation, and properly adjust the perimeter of regulation and supervision, but without imposing unnecessary burdens.”
What John Lipsky is pointing at is that one of the most important powers beyond the speed of of the crisis are the so-called financial derivatives combined with a lack of international assessment of the real risk of these ‘inventions’. He stated that the crisis has underscored the tension between globally active financial institutions and nationally bounded regulators and supervisors.
And his final sentence was:
“Enhanced information provision will also be important for improving the assessment of any build up of systemic risks. This will require reviewing transparency, disclosure and reporting rules. Information requirements will also need to cover a larger set of institutions, from insurance companies to hedge funds and to off-balance sheet entities.”
This very much reflects my own earlier remarks on the need for a complete restructuring and possible combination of IMF, G20 and the World Bank with equal voting rights also for the BRICcountries.
Dominique Strauss-Kahn’s speechin Madrid on December 15 had similar and maybe even more stressing points; the purpose of the meeting was to celebrate Spain’s 50th anniversary as member of IMF.Dominique Strauss-Kahn said that action is needed on three fronts to prevent the current recession turning into a global depression:
• Coordinated government intervention in financial markets to get credit flowing and support bank recapitalization
• Fiscal measures to offset the abrupt fall in private demand
• Liquidity support for emerging market countries to reduce the adverse effects of the widespread capital outflows triggered by the financial crisis.
In some of the starkest language he has used since the crisis erupted, Strauss-Kahn said governments around the world have endorsed this agenda, most recently at the November meeting of the Group of 20 (G-20) industrialized and emerging market countries in Washington. "Many have begun to implement it. But the actions taken so far are not enough. We need more," he said, according to the text of remarks as prepared for delivery.
According to the most recent IMF forecast, the major advanced economies are expected to contract by ¼ percent on an annual basis in 2009, marking the first annual contraction in the post-war period for this group of countries. But with the effects of the crisis spreading rapidly, IMF First Deputy Managing Director John Lipsky has said that the Fund is likely to revise downward its global forecast when it announces new numbers next month.
"We are facing an unprecedented decline in output, we have evidence of substantial uncertainty limiting the effectiveness of some fiscal policy measures, and we anticipate that the negative growth effects will last for some time. For all of these reasons we are calling for stimulus measures that are large and diversified, and that will last longer than one or two quarters," said Strauss-Kahn.
His main points were that a lot of fiscal measures can be effectively applied to maximize the multiplier effect of different fiscal measures. Actions could include support to housing and finance; transfers to low-income families, greater provision of unemployment benefits, improved tax benefits for low-wage earners, and expansion ofbenefits and spending on major projects—particularly those that are already planned and could be implemented quickly, as time is everything. But the IMF would not recommend reduction in corporate tax rates, dividends and capital gains taxes, or special incentives for businesses. "These are likely to be ineffective and difficult to reverse," Strauss-Kahn said. This is quite remarkable considering the pressure on Washington to help the troubled car makers in US. Let us look at the indications from IMF that the real problem behind the crisis might be the so-called derivatives.
Looking into the history of derivatives we find some real horrors – not least in the reason for why they were created in the first place. Of course neither IMF nor any of the heavy weights in the Financial Sector had warned (sufficiently) or earlier against these derivatives, except a few remarkable persons, which I will come back to.
But these days the papers and blogs are filled of stories like this one:
Jesse Essinger has a fine description of what compared to these 58 Trillions $ elephant in a room:
“The history behind the derivatives seems to be an invention by a team of JP Morgan’s top economists around 1995 at a time when Morgan’s books were under pressure; they had reached the practical maximum of guarantees to private companies, and if they extended these credit lines, they would very soon run the risk of crossing the line of solvency according to standard regulation terms.
So the idea that the team came up with was derivatives”
The idea behind the construction is that if you can sell somebody a lottery ticket that the guarantees you issue to a third party company and that other wise should have been shown on your books, now gives you the opportunity to keep your guarantees and credit lines to lenders out of the books, and in this way leverage your equity way beyond what the normal national financial rules would allow. And as you sell these lottery tickets all over the World in a global sweepstake, other financial institutions can make additional lotteries out of the original lottery making it completely impossible to estimate the real risk. The 58 Trillion Dollars is probably on the low side.
As early as in 1998 Long Term Capital Management (“LTCM”) encountered financial difficulties that required a bailout by banks, orchestrated by the Federal Bank of New York. LTCM is now forgotten and the lessons were forgotten surprisingly quickly.
Also this link contains the story of Amaranth: (Edited by Satyajit Das, the author of ‘Traders, Guns & Money’ Buy his book here:
“Amaranth was a multi-strategy hedge fund. Amaranth Advisors started life as a convertible arbitrage fund (a relatively low risk trading activity). The fund was a recent entrant into energy trading – an infinitely more volatile activity. Just before it blew up, the hedge fund had assets of $9.2 billion. Amaranth's investor base is believed to include funds of funds at major investors such as Goldman Sachs, Morgan Stanley, Credit Suisse, Bank of New York, Deutsche Bank and Man Group. Amusingly, Amaranth claimed to have “best-practice” risk management.
Risk Models – Nick Maounis after the losses surfaced, noted: “Although the size of our natural gas exposure was large, we believed, based on input from both our trading desk and the stress testing performed by our energy risk team, that the risk capital ascribed to the natural gas portfolio was sufficient”. It is questionable that the risk models used were appropriate. For example, correlation risk (one of the main risks in relative value trading) is not generally well captured in traditional risk models. A cursory review of the events shows the inherent limitations of the risk models used. Amaranth took approximately 80 trading days to make $ 2 billion through the end of April and approximately 20 trading days to lose $ 1 billion in May 2006. Amaranth also took twelve trading days to lose a reported $4.44 billion through September 18th or a daily average of close to $ 370 million. Further, when the sale of the energy book was announced on Wednesday, 20 September, the losses were approximately $6 billion and the average daily loss for September expanded to $ 420 million per trading day.”
The story of derivatives also contains other names of interest – Robert Reoch and Blythe Masters seem to be the most notorious:
Blythe MastersCalled:'Thewoman that invented the Weapon of financial Mass Destruction'
As the story goes: “In 1997, she and a team developed many of the credit derivatives that were intended to remove risk from companies' balance sheets. The idea was to separate the default risk on loans from the loans themselves. The risk would be moved into an off-balance sheet vehicle. The product was called Bistro, otherwise known as broad index secured trust offering.
In a guide to understanding the instruments she had created, Masters sung their praises: "In bypassing barriers between different classes, maturities, rating categories, debt seniority levels and so on, credit derivatives are creating enormous opportunities to exploit and profit from associated discontinuities in the pricing of credit risk."
The banks argued that by trading credit derivatives of the kind pioneered by Masters, they had spread their risk elsewhere and therefore needed lower reserves to protect against loan defaults. Regulators rolled over and the banks loaned ever more. It was a huge success and the market for credit derivatives grew rapidly.”
It is fantastic to read Blythe Masters comment on her invention: “By enhancing liquidity, credit derivatives achieve the financial equivalent of a free lunch, whereby both buyers and sellers of risk benefit from the associated efficiency gains.
“At stake is the unfathomable $56 trillion notional value of derivatives contracts between U.S. commercial banks and counterparties, measured by the Office of the Comptroller of the Currency at the end of 2002. The entire market, around the world, is estimated at over $100 trillion. But such notional amounts--the face amount of the underlying security--are rarely realized”
But also Alan Greenspan:did what he could to let the derivatives go on the run: In 1994, a bi-partisan bill was introduced in Congress to tighten the supervision of the complex and growing derivatives in the banking industry. The bill would have had the regulatory agencies establish standards for capital requirements, disclosure, accounting and examinations and audits. As expected, the banks argued that no new laws were needed. Greenspan sealed the legislation's defeat by testifying that the Fed had the powers it needed and that a taxpayer bailout caused by derivatives was remote.
Read the comments on Forbes here. (“The great Derivatives Melt down”)
As a closing conclusion on these ‘Weapons of Mass Destruction’ (More real than some other WMD) – a PDF from the originator, JP Morgan’s Guide:
“The use of credit derivatives has grown exponentially since the beginning of the decade. Transaction volumes have picked up from the occasional tens of millions of dollars to regular weekly volumes measured in hundreds of millions, if not billions, of dollars. Banks remain among the most active participants, but the end-user base is expanding rapidly to include a broad range of broker-dealers, institutional investors, money managers, hedge funds, insurers, and re-insurers, as well as corporates. Growth in participation and market volume is likely to continue at its current rapid pace, based on the unequivocal contribution credit derivatives are making to efficient risk management, rational credit pricing, and ultimately systemic liquidity. Credit derivatives can offer both the buyer and seller of risk considerable advantages over traditional alternatives and, both as an asset class and a risk management tool, represent an important innovation for global financial markets with the potential to revolutionise the way that credit risk is originated, distributed, measured, and managed.”
As the crisis that started in August with the market for US sub prime loan collapsing now has gathered a momentum that hasn’t been seen for many decades, a lot of observers and experts have expressed a multitude of suggestions and remedies while financial leaders, regulators and politicians have been working around the clock to try to stem the harsh tides. (See: The Fuel that fed the Subprime Meltdown)
And as the traces have now spread to almost all countries and sectors of the economy it is obvious that new approaches, indeed more than a New Deal is needed. As all major European and Western economies are now more or less in recession, the price of oil has dropped to as low as one third of the price during July, the Bloomberg’s Metals Index likewise down to 1/3 of July, prices for food have dropped to 50% of an all-time high. Stock value of most of the Worlds leading companies down to 50% or below, with a threatening overcapacity in industries like transportation, tourism and an automotive industry on the verge of collapsing, it is about time to stop and wonder how this could happen so fast and with an impact of this enormous magnitude.
There are some obvious and some maybe more hidden reasons why this could happen: Firstly, the Globalization is the direct reason for the rapid spread of the problems; the first wave due to the Financial derivatives being traded on a World Wide basis much alike re-insurance made the sub-prime loans felt in almost all major financial institutions. (See: Gambling on Derivatives) Secondly, most of the financial regulatory system – especially, but not only the US ‘Greenspan’ system – has been based on a long, steady period of growth, and has not been geared to any kind of massive drop in values and stock prices; this meant for instance that because of rules on Pension Funds protecting their core capital, they had to sell off bonds or stock in the beginning of the downturn, putting additional pressure on the market. Thirdly the Globalization now means that all major industries spread the value chain across the continents leading to direct and fast reactions in supplier markets. Add to this the inefficiency of supra national regulatory and supporting systems. We have seen the G7 gather quickly, but before their decisions, some countries were already trying to implement their own strategies, and even if a somewhat concerted effort was indeed agreed upon, it was still implemented in lots of different ways. And then you could argue, that as OECD has pointed out that only 20% of the Global Economic Growth from 2005 to 2009 comes from the advanced economies, G7 should have been enlarged to, well G20 (See declaration on G20 meeting in Nov. 2008), with lots of negotiation power plus obligations put on the BRIC-countries and developing economies, that still has a promise of positive economic growth in the next couple of years. Looking at the IMF, this institution has only once during the last 10 years being called upon by a Western Country – namely Iceland. So IMF and it’s traditional mission, remedies and requirements before putting any substantial credits on the table, it is hardly a toolbox that is fitted to the complicated advanced economies, that are now suffering. And likewise, the World Bank has other objectives, to help developing countries. (Figure: IMF: Real Economic Growth by Market Type, 1997-2013 %)
So what is really wrong and why doesn’t the funds but to the disposal of the financial institutions do the trick? Why isn’t the drop of interest rates in most countries helping us? One of the reasons I expect is imbedded in the psychology of the intervention packages: As Government officers are now being put in charge of banking operations, we are coming from a situation with lots of risky business with lots of willingness in the financial market to finance risk by spreading it around to a situation now where absolutely NO risk is tolerated; it may be that basic international trading business and associated payments are financed, but funding for new start-ups are likely to disappear completely. The next phase of the downturn will be that Government tax revenue will start to drop as income drops and the unemployment starts to rise.
Going back to Economic history the situation looks almost like described in Karl Marx ‘Das Capital’. His prediction that as the competition between the capitalists is bringing down the ‘value add’, the lack of profit will lead to mass bankruptcies, take over and mergers so that the strong will get even stronger – and finally leading to the collapse of the capitalist system. Only this time we put Government officials on top of the Capitalists – but how can they become efficient bankers? Let alone efficient car makers? Is it a take over by the Proletars? Or will it just lead to more bankruptcies?
The good ol’ macro economic model for aggregate demand will have to be looked at a mega-economic level, as the best idea in the mid term run will be to stimulate demand:
D = C + I + G + (X-M)
(Demand equals Private Consumption plus Investment plus Government Expenditures + Export minus import). The sinister scenario goes like this:
Consumption: Consumers expect prices to fall and keep their money in the pocket, disposable income may come down due to lay offs, consumer credit is being stopped by risk-adverse banks, and as housing values are coming down, there is no easy way to obtain a mortgage credit to finance major items like cars, washing machines etc. Investment: Probably only most necessary re-investment programs will survive, capital equipment will begin to be worn down, and banks are not allowed to finance any kind of innovative new start ups or new development, unless the needed capital is generated by the companies themselves. Government expenditure: If Governments are facing cut in tax revenues and rising unemployment and social costs, this will create a short term deficit, but only major investment programs, new infrastructure projects (Going green? Public Transportation instead of cars?) would help. Exports are likely to drop, particularly exports to the mature western economies. It does help of course, that Import will most likely drop as well. If we take all of these factors together, we have the classical remedies for a depression spiral.
So indeed the task that the Governments are facing is enormous, the international institutions not fitted for the magnitude of the problem, the need for collaboration and mutual adjustment is immense, and the risk for potential social unrest is looming.
The dynamics of the model is based on expectation; the more likely it is that prices will fall, the more the aggregate demand will be reduced leading to a very vicious spiral. Only short term remedy could be a marked, temporary and international cut in VAT to kick consumers to go out and buy. It may only be a short term advantage, but it definitely need to be accepted internationally to avoid problems with the balance of trade in some countries.
So where is the hope for a more long range type of solution? On the institutional side we need to create a supranational regulatory body with power enough to call for collaborative funding and with benevolence enough not to strangle the countries they are helping. We also need a ‘Bretton Woods’ type of agreement on common rules and regulations for criteria to have solid banks, with well-defined products, have efficient pension fund regulations, establish a transparent market for dealing with and handling risks and international investments, trying to harmonize mortgage systems around the World - and we need to speed up the Doha round to ensure free trade and break down what may remain of restrictions and local subsidies – to food, cars, anything. We need to have an international agreement beyond Sarbanes-Oxley to ensure public insight into all sorts of major businesses, and we need some sort of international court system for fraud committed by international organisations and companies, much like the Haag International Criminal Court.
But all this require transparency and easy access to information. My point is that the more we speed up the velocity of adequate information related to international trade and finance, the more we will be able to expand commerce and trade. If you remember the old quantitative model:
M x V = P x Q
Saying that is a proportionality between the supply of Money times the velocity of Money circulation and the general Price level P times the aggregate production index, Q. The theory was in various disguises used by Milton Friedman, suggesting that in case of inflation the volume of Money in circulation should be brought down. But maybe we could reformulate this to:
(M x V(m)) x V(i) = k x (P x Q)
Suggesting that the volume of Money multiplied by the Velocity of Money multiplied by the velocity of information in a transparent economy could be stated to be proportional to P x Q, which again is a pseudonym for the National Product. The idea is that the faster the flow of information needed to exchange info business, transfer financial transactions, exchange freight and customs documents, the more transactions will be performed, and the more transactions can actually be funded by the available amount of money. In other words: Speed AND transparency. This calls for investment in updating management of value chains, updating flow of information between suppliers, manufacturers, consumers and financial institutions. It also calls for fast introduction of open standards for cross national and cross agency communication (See the EU’s Interoperability Framework!) – and first and foremost it calls for transparent semantics on all aspects of trade and finance. UN EDIFACT was just a beginning.
If we accept this, our supra national regulatory body and it’s steering committee (New role for G20?) should as it’s first task to finance a new global infrastructure look at financing a network, a structure and a set of standards and stewardship rules for ensuring transparency along the ideas described above.
Remember July when the oil price reached 150 $ pr. Barrel – approximately as the same time as Senator McCain stated publicly that the US economy was as strong as ever? Since then the sub-prime buble exploded and stocks plummeted. Banks went broke, and the confidence between banks simply disappeared. It didn’t help much as US Senate couldn’t get their act together and as you remember, US legislators voted No for the first round of the salvation package.
This undoubtedly worsened the global aspect of the crisis to the extent that each and every country had to find ways to secure their own financial institutions. Ireland leading by a not-so-elegant rescue package where only local Irish banks where in a position to guarantee their clients deposits.
Denmark probably was among the most constructive to put together a package involving the financial sectors themselves, but beyond that point a carte blanc for deposits not only by private investors but also by companies. The Danish interest rate was raised to a level 1% above the EURO interest rate, and slowly the funds started to flow again.
This is a bit opposed to the melt down in Iceland, which to some extent had been expected sooner or later. As the total debt of the Iceland Banks extended to 8 times the Icelandic GDP, they sort of asked for it. The neighboring Nordic countries have extended some of their funds to help Iceland, but it will never again be the same. In spite of this risky business it did come as a surprise though, that Gordon Brown (which has scored a lot of ‘Browny’ points during this crisis) acted to protect British interests as he used the UK anti-terrorist law to nationalize the deposits of the Icelandic Kaupthing Bank in UK and with the 2 Bio £ captured, actually kicked the Icelandic state over the edge.
Now after a number of terrible weeks, the stock market is down on average by 25-30%, still extremely nervous, Dollar has – amazingly – risen to an all-time high this year, and believe it or not, the oil price is down to 79-80 $ pr. Barrel.And raw material index fell at an alarming rate not seen for more than 50 years. All of this are sure signs of a recession, and not only a short term financial hiccups because of some greedy bankers in US.
Now the real question is how well the World’s leaders are avle to manage and steer their way with the long term energy crisis that is not going away, even if the oil price temporarily has fallen back, between the riscs of rising unemployment and the long term wish and plans for a better Planet by reducing dependencies on oil.
Next year we will have the United Nations Climate Conference in Copenhagen 2009. This week the EU leaders met to discuss a common position and their formerly accepted plan to reduce carbon dioxide by 20% in just 2 years from now. Initially both Poland, other former Eastern European Countries, Germany and Italy raised the opinion that EU should back off from this rather heroic plan – pressed by the upcoming elections in some countries and the fear of recession in most of them. But if one reads the results: EU Leaders meet to discuss position on climate before the UN conference in Copenhagen in 2009, everything looked fine on the surface. The problem is that the statement agreed upon requires that the EU leaders meet again and agree ‘unanimously’ on a position before the Climate Summit. So somebody kicked the ball over the side line to gain time. But no guarantees what so ever! (In spite of this statement: ‘Climate conference in Poland undeterred by current crisis’ )
It is interesting to note that both US presidential candidates seem to be in support of doing something, in spite of the US energy boards expectations this summer:
“However, unless the global economy is weaker than anticipated, EIA expects that the call on Organization of the Petroleum Exporting Countries’ (OPEC) crude oil will exceed OPEC crude oil production over the next 6 months. This market balance and the relatively low level of Organization for Economic Cooperation and Development (OECD) commercial oil inventories suggest some upward pressure on prices. However, if non-OPEC oil production increases as expected during 2009, oil price pressures would then moderate”
And it was likewise very positive to note that in the middle of the financial crisis in US,
The next few months will see if we can get more countries on the move towards an agreement in Copenhagen while at the same time handling the financial crisis.
(picture: Franklin D. Roosevelt at London Summit 1933)
