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 

UNITED NATIONS 

New York and Geneva, 2009 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

ii

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

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: 

– This systemic failure can only be remedied through comprehensive reform and reregulation 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 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 crisisstricken countries. 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

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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 

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Contents

Key messages ........................................................................................................................................................iii 

Foreword by the Secretary-General of UNCTAD .................................................................................................ix 

Executive summary ...............................................................................................................................................xi 

Chapter I – A crisis foretold ...................................................................................................................................1 

A. Introduction .......................................................................................................................................................1 

B. What went wrong: blind faith in the efficiency of financial markets................................................................1 

C. What made it worse: global imbalances and the absent international monetary system....................................4 

D. What should have been anticipated: the illusion of risk-free greed and profligacy ...........................................8

Chapter II – Financial regulation: fighting today’s crisis today ...........................................................................11 

A. It was not supposed to end like this .................................................................................................................11 

1. Financial efficiency and gambling ............................................................................................................12 

2. Avoiding regulatory arbitrage and the role of securitization.....................................................................13 

3. Micro and macro prudential bank regulation ............................................................................................16 

4. The need for international coordination ....................................................................................................17 

5. Financial regulation and incentives ...........................................................................................................17 

B. Lessons for developing countries.....................................................................................................................18 

1. Financial development requires more and better regulation......................................................................19 

2. There is no one-size-fits-all financial system ............................................................................................20 

C. Conclusion: closing down the casino...............................................................................................................20 

Chapter III – Managing the financialization of commodity futures trading ........................................................23 

A. Introduction: commodity markets and the financial crisis...............................................................................23 

B. The growing presence of financial investors in commodity markets..............................................................25 

C. The financialization of commodity futures trading..........................................................................................26 

D. Financialization and commodity price developments......................................................................................32 

E. The implications of increased financial investor activities for commercial users of commodity futures 

 exchanges.........................................................................................................................................................35 

F. Policy implications...........................................................................................................................................36 

1. Regulation of commodity futures exchanges ............................................................................................36 

2. International policy measures....................................................................................................................37 

G. Conclusions .....................................................................................................................................................38 

Chapter IV – Exchange rate regimes and monetary cooperation..........................................................................41 

A. Introduction: currency speculation and financial bubbles................................................................................41 

B. The history of different exchange rate regimes is of a series of failures..........................................................44 

C. Global exchange rate management, trade and investment ...............................................................................47 

D. Currency crisis prevention and resolution .......................................................................................................50 

E. A multilateral approach to global exchange rate management.........................................................................51 

F. Conclusion........................................................................................................................................................54 

Chapter V – Towards a coherent effort to overcome the systemic crisis..............................................................55 

A. More and better coordinated countercyclical action is needed ........................................................................55 

B. The State is back but national action is not sufficient......................................................................................57 

1. Preventing the competition of nations.......................................................................................................57 

2. Intervention in financial markets is indispensable.....................................................................................58 

C. No “crisis solution” by markets .......................................................................................................................59 

References ............................................................................................................................................................61 
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List of figures, tables and boxes 

Box 1.1 Is Greenspan’s monetary policy to blame? 

Figure 1.1 Household savings, 1980–2009 

Figure 1.2 Global current-account balance, 1990–2008 

Box 1.2 Is the savings glut responsible? 

Figure 2.1 Leverage of top 10 United States financial firms by sector 

Figure 2.2 The shadow banking system, 2007, Q2 

Figure 2.3 Outstanding credit default swaps, gross and net notional amount 

Figure 2.4 Equity market dollar returns, 2008 

Figure 2.5 Emerging market spread, January 2007–December 2008 

Figure 3.1 Commodity price changes, 2002–2008 

Figure 3.2 Futures and options contracts outstanding on commodity exchanges, December 

1993–December 2008 

Figure 3.3 Notional amount of outstanding over-the-counter commodity derivatives, 

December 1998–June 2008 

Figure 3.4 Correlations between the exchange rates of selected countries and equity and 

commodity price indices, June 2008–December 2008 

Table 3.1 Commodity futures trading behaviour: traditional speculators, managed funds and 

index traders 

Table 3.2 Futures and options market positions, by trader group, selected agricultural 

commodities, January 2006–December 2008 

Figure 3.5 Commodity futures prices and financial positions, selected commodities, January 

2002–December 2008 

Figure 4.1 Yen-carry trade on Icelandic krona and the Brazilian real since 2005, overlapping 

quarterly returns 

Box 4.1 Fixed exchange rate regimes and the overvaluation trap 

Box 4.1 figure B.1 Experiences with fixed exchange rate regimes, selected economies, 1994–2006 

Box 4.2 figure B.2 Overvaluation trap and current account effects in Argentina 

Figure 4.2 Volatility of REER, PEER and NEER changes, selected country groups, simple 

averages, 1993–2008 

Figure 4.3 Interest rates, selected countries, January 2007–December 2008 

Figure 4.4 Example of a currency system with “planets” and “satellites” 
Report by the UNCTAD Secretariat Task Force on Systemic Issues and Economic Cooperation 

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Abbreviations

BIS Bank for International Settlements 

CBOT Chicago Board of Trade 

CDO collateralized debt obligations 

CDS Credit Default Swaps 

CEA Commodity Exchange Act 

CEBS Committee of European Banking Supervisors 

CESR Committee of European Securities Regulators 

CITs commodity index traders 

CFTC Commodity Futures Trading Commission 

COT Commitments of Traders 

DJ-AIGCI Dow Jones-American International Group Commodity Index 

ECB European Central Bank 

FED Federal Reserve System 

FSA Financial Services Authority 

GDP gross domestic product 

ICE Intercontinental Exchange 

IMF International Monetary Fund 

LTCM Long-term Capital Management 

OTC over-the-counter 

NEER nominal effective exchange rate 

PEER price component of REER (PEER=NEER/REER) 

PPP purchasing power parity 

REER real effective exchange rate 

RMBS residential mortgage-backed securities 

SIVs Structured Investment Vehicles 

S&P GSCI Standard & Poor’s Goldman Sachs Commodity Index 

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

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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-theboard financial deregulation and liberalization have contributed to 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 

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

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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 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 riskfree, 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 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 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

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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 

large movements in the absolute advantages or the level of overall competitiveness of countries vis-àvis 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 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 
Report by the UNCTAD Secretariat Task Force on Systemic Issues and Economic Cooperation 

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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 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 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:

3⁄4 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; 

3⁄4 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; 

3⁄4 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; 

3⁄4 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 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

xiv

everything else fails, back-up policies, such as market-friendly capital controls, can limit risk 

accumulation in good times; 

3⁄4 Developing countries regulators should develop their financial sectors gradually in order to 

avoid the boom-and-bust cycle; 

3⁄4 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: 

3⁄4 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; 

3⁄4 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”; 

3⁄4 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; 

3⁄4 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 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. 
1

Chapter I 

A crisis foretold 

A. Introduction 

The global economic crisis, which first emerged as a financial crisis in one country, has now 

fully installed itself with no bottom yet in sight. The world economy is in a deep recession, and the 

danger of falling into a deflationary trap cannot be dismissed for many important countries. 

Firefighting remains the order of the day, but the urgent search for means to prevent the global 

economy from falling over the precipice must not be at the expense of a sober analysis of the reasons 

for the crisis, even in the short term. 

The following chapters highlight three specific areas in which the global economy 

experienced systemic failure. 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. This report investigates three interrelated issues of importance to developed and 

developing countries alike, and proposes measures to address the systemic failures they have entailed: 

(a) how the ideology of financial deregulation within and across nations allowed the build-up of 

pressures whose unwinding has damaged the credibility and functioning of the market-based 

models that have underpinned financial development throughout the world; 

(b) how the growing role of large-scale financial investors on commodities futures markets has 

affected commodity price volatility and fed speculative bubbles; and 

(c) the role of widespread currency speculation in exacerbating global imbalances and fuelling 

the current crisis in the absence of a cooperative international system to manage exchange rate 

fluctuations to the benefit of all nations. 

B. What went wrong: blind faith in the efficiency 

of financial markets 

To be sure, the causes of the crisis are more complex than some simplistic explanations based 

on government failure suggest. For example, if it were true that “too much liquidity” as the result of 

“expansionary monetary policy in the United States” was responsible for the crisis, the attempt to 

fight the short-term crisis with a new wave of cheap liquidity would amount to throwing oil on the fire 

(see box 1.1). The same is true for individual misbehaviour. No doubt, without greed, without the 

attempt of too many agents 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. Many people, if promised 

25 per cent return on equity (or a paradise on earth) tend to believe it possible without posing critical 

questions about individual risk and much less about the risk of systemic failure. Such behaviour has 

been evident time and again in modern history and it always ended in economic downturn and crash. 

The problem is much more that policy makers forget the lessons of the past and are easily seduced by 

the idea that the economic system could care for itself. 

Mainstream economic theory of the past decades even suggested that efficient financial 

markets would smoothly and automatically solve the most complex and enduring economic problem, 

namely the transformation of today’s savings into tomorrow’s investment. It assumed that efficient 

financial markets were sufficient to convince some people to put money aside and others to invest it 

into the future despite the fact that in the real world the investor is faced by “objective uncertainty” 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

2

(Keynes, 1930) concerning the returns he can expect and despite the fact that the more people save the 

lower would be the actual returns (UNCTAD, TDR 2006, annex 2 to chapter I). 

Box 1.1 

Is Greenspan’s monetary policy to blame? 

Among the different analyses of the causes of the crisis is the assertion that too much liquidity or 

excessively cheap liquidity fuelled the United States housing market boom and the subsequent speculation 

with newly created financial products based on residential mortgage-backed securities (RMBS). 

It is certainly true that over the last decade or so the Federal Reserve System (FED) widely ignored 

warnings about inflating stock markets and house prices at the end of a long boom, and more appropriate 

macroeconomic policies might have prevented the crisis from fully unfolding. However, with its approach 

of ignoring specific prices the FED followed the almost globally accepted rule that monetary policy can and 

should only control the price level of a basket of goods. 

It is also true that very low interest rates after the collapse of the dot.com bubble in 2001 fuelled the 

prolongation of the housing boom. Increasing home ownership at affordable prices was laid down as a 

political target as in the “National Homeownership Strategy” (Whalen, 2008). Low interest rates were an 

important instrument to favour investment in fixed capital, including housing, over purely financial 

investment. Housing bubbles by themselves have been a regular by-product of expansionary economic 

policy and lasting boom phases, but this doesn’t explain the speculative excesses in their financing which 

occurred in the build-up to this financial crisis. 

Moreover, it is difficult to understand how the willingness to take on more risk by using the lever of low 

equity ratios for a given investment might have been driven by low policy interest rates. Under normal 

circumstances the opposite is more likely: low rates reduce the need for excessive risk-taking. An investor 

trying to squeeze a certain return over equity (say 25 per cent) out of an investment that yields only 5 per 

cent can use a smaller lever, i.e. a less risky strategy when policy and lending rates are low. More risktaking is called for in a situation where policy rates and the rates to be paid for additional longer-term debt 

are high. In the same vein, low interest rates do exactly the opposite of fuelling financial investment: they 

normally reduce the attraction of purely financial investment and increase the attractiveness of real 

investment. That is why the – now obsolete – monetarist school of monetary theory assumed that “too much 

money chasing too few goods” would lead to overinvestment and inflation in the goods market. Obviously, 

recent experience and evidence has shown that the real world economy is not functioning on such simple 

terms. But the opposite proposition, namely that too much money will lead to too much financial 

investment, is not convincing at all. 

Last but not least, low interest rates or too much liquidity in the United States cannot explain the infection 

of large parts of the rest of the world. With floating exchange rates, liquidity does not flow between 

countries and cannot spill over into regions were the dollar is not legal tender. Other economies, whose 

financial sector has been directly infected by the crisis, such as euro area and the United Kingdom, had a 

fully independent monetary policy after 2001, without dollar inflows and with much higher interest rates. 

Japan has had a zero interest rate policy for many years now to fight deflation, but this has not stimulated 

speculative bubbles such as those in the United States. 

Efficient financial markets are expected to overcome the uncertainty about the future and the 

frequency of crisis in these markets may be the result of the “mission impossible” that is expected 

from them. Or is their vulnerability mainly due to their scale (which nominally dwarfs the real 

economy) and their vital role for all other markets at the national and international level? Or do 

financial markets function in a different way than goods markets, perhaps in a way that systematically 

encourages the emergence of asset-price bubbles through a herding effect induced by the activity of 

large-scale investors? Obviously, there are strong arguments for all these hypotheses. However, a 

brief comparison of the logic of investment in fixed capital in a dynamic evolutionary setting (through 

traditional banking, i.e. lending money as an intermediary between central banks and savers on the 

one side and borrowers on the other) and investment in financial markets (through the now-crippled 

investment banks, for example) explains why capital markets seem bound to fail the more 
Chapter I – A crisis foretold 

3

“sophisticated” they are, whereas for the markets for goods and services efficiency can never be too 

much. 

Investment in fixed capital is profitable for the individual investor and society at large if it 

increases the future availability of goods and services. No doubt, replacing an old machine by a new 

and more productive one, or replacing an old product by a new one with higher quality or additional 

features, is risky because the investor cannot be sure that the new machine or the new product will 

meet the needs of the potential clients. If it does, the entrepreneur gains a temporary monopoly rent 

until others are in a position to copy his invention. Even if an innovation finds imitators very quickly, 

this doesn’t create a systemic problem: it may deprive the original innovator more rapidly of parts of 

his entrepreneurial rent, but for the economy as a whole the quick diffusion of an innovation is always 

positive as it increases overall welfare and income. The more efficient the market is regarding the 

diffusion of knowledge, the higher is the increase in productivity and the permanent rise in the 

standard of living - at least if institutions allow for an equitable distribution of the income gains and 

the demand that is needed to market smoothly the rising supply of products. 

However, the accrual of rents through “innovation” in a financial market is of a 

fundamentally different character. Financial markets are about the effective use of existing 

information margins concerning existing assets and not about technological advances into hitherto 

unknown territory. The temporary monopoly over certain information or the better guess of a certain 

outcome in the market of a certain asset class allows gaining a monopoly rent based on simple 

arbitrage. The more agents sense the arbitrage possibility and the quicker they are to make their 

disposals, the quicker the potential gain disappears. In this case, too society is better off, but in a oneoff, static sense. Financial efficiency may have maximized the gains of the existing combination of 

factors of production and of its resources, but it has not reached into the future through an innovation 

that shifts the productivity curve upwards and that produces a new stream of income. 

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. In other words, as 

seemingly irrefutable evidence, such as “rising Chinese and Indian demand for primary 

commodities”, is factored into the decisions of the market participants and confirmed by analysts 

presumed to be experts, the media and politicians, betting on ever rising prices seems to be rather 

riskless.

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”. Sooner or later consumers, 

producers or Governments and central banks will no longer be able to perform at the level of 

exaggerated expectations because hiking oil and food prices cut deeply into the budgets of consumers, 

appreciating currencies send current account balances into unsustainable deficit, or stock prices lose 

touch with any reasonable profit expectation. Whatever the specific reasons or shocks that trigger the 

turnaround, at a certain point of time market participants begin to understand that “if something 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

4

cannot go on forever, it will stop”, as it was once put by United States presidential advisor Herbert 

Stein.

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 deleveraging, i.e. the process of adjusting the 

level of borrowing to diminished revenues. A “debt deflation” (Fisher, 1933) 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.1

 Only Governments can step in and stabilize the system 

by “government debt inflation”. 

“Investment banking”, which became synonymous with “financial modernization”, is only a 

new term for an old phenomenon. 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. In 

fact, there was nothing new in the build-up or the unwinding of markets for the financial instruments 

that investment banks created. What was new, however, was the dimension through which private 

households, companies and banks have collectively engaged in what amounts to gambling. This can 

only be explained by the effects of massive deregulation, driven by the conviction that the freedom of 

capital flows and the efficient allocation of “savings” is the most important ingredient of successful 

economies. 

C. What made it worse: global imbalances and the absent international monetary system 

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 jobcreations, 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. 

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. The “wealth effect” of higher prices for housing or 

 

1

 Paul de Grauwe, Financial Times, 23 February 2009. 
Chapter I – A crisis foretold 

5

stocks led households in the United States and in the United Kingdom to borrow and consume far 

beyond the real incomes that they could realistically expect, given the productivity growth of the real 

economy and the dismal trends in personal income distribution. With overall household saving rates 

to close to zero (figure 1.1) consumer demand in both countries expanded rapidly but at the same time 

the growth process became increasingly fragile because it meant that many households could only 

sustain their level of consumption by further new borrowing. With open markets and increasing 

international competition in the markets for manufactures the spending spree eventually boosted 

borrowing on international markets and led to large current account deficits. 

-5

0

5

10

15

20

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

France

Germany

Japan

United Kingdom

United States

Figure 1.1

HOUSEHOLD SAVINGS, 1980–2009

(Per cent of disposable household income)

Source: OECD, Economic Outlook database.

Note: Data refer to net savings with the exception of United Kingdom where data refer to gross savings.

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-à-vis the overspending nations. In both cases international competitiveness was 

additionally tuned by temporary exchange rate depreciations fuelled by speculative capital flows 

triggered by interest rate differentials. 

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. 

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 (figure 1.2) 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” (Folkerts-Landau et al., 2004; and UNCTAD, TDR 2004). 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 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

6

financial crisis and a number of Latin American countries, but also to China and, to a certain extent, 

India. The latter two experienced financial crises at the beginning of the 1990s and devalued their 

currencies significantly before fixing it to the dollar – in the case of China – or engaging in managed 

floating – in the case of India. Increasing unilateralism around the world in dealing with the 

implications of global imbalances at the national level further aggravated the crisis (see box 1.2). 

-4 -3 -2 -1 0 1 2 3 4

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

Deficits Surpluses 

Figure 1.2

GLOBAL CURRENT-ACCOUNT BALANCE, 1990–2008

(Per cent of GDP)

Source: UCTAD secretariat calculations, based on data from Thomson DataStream.

Note: Data refer to 122 countries.
Chapter I – A crisis foretold 

7

Box 1.2 

Is the savings glut responsible? 

Many observers have pointed to the willingness of the world and some developing countries, in particular 

China, to finance American profligacy at very low interest rates, due to their abundant “savings” (Krugman, 

New York Times, 1 March 2009). In other words, the huge deficit of the United States is interpreted as 

being the result of the decision of American households to consume more than they could afford and the 

decision of the Chinese households to save much more than the country could invest domestically. 

However, this explanation is rooted in a brand of macroeconomic theory (where savings lead the process of 

investment and growth and not the other way round) that has been refuted by evidence in many cases in the 

past. 

If current account disequilibria are approached mainly from the side of trade flows instead of the capital 

flows, the observation that since the beginning of this century capital has been flowing “uphill”, becomes 

much less mysterious. If capital flows from poor to rich countries, while at the same time an increasing 

number of developing countries that are net capital exporters have achieved high growth rates, the 

traditional theory on which the “Chinese savings” culpability hypothesis is based loses all its persuasive 

power (UNCTAD, TDR 2008).

By contrast, explanations of the relationship between savings and investment based on the work of 

Schumpeter and Keynes focus on the role of profits in the adjustment of savings and investment. An 

implication is that most of the adjustment to new price signals or changed spending behaviour is primarily 

reflected in profit swings, which influence the investment behaviour of firms. Improvements of the current 

account are possible which are due to price changes in favour of domestic producers. By increasing 

domestic profits, higher net exports will trigger additional domestic investment, and the income effects of 

higher exports and higher investment will generate higher savings. 

In this view, an increase in savings is no longer a prerequisite for either higher investment or a currentaccount improvement and vice versa. Neither the American deficit nor the Chinese surplus in the current 

account is the result of voluntary decision of households and companies but the result of a complex 

interplay of prices, quantities and political decisions. For many reasons it is wrong to assume that a 

complex economy, with millions of agents with diverging interests, functions in a way that would be found 

in a Robinson Crusoe world. Hence, to blame “countries” for their “willingness” to provide “too much 

savings” compounds the neoclassical error of analysing the world economy based on the expected rational 

behaviour of “one representative agent”. Such an approach cannot do justice to the complexity and the 

historical uniqueness of events that may lead to phenomena like those that have come to be known as the 

global imbalances. 

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-à-vis other countries. These changes 

in the real exchange rates are clearly associated with the growing global imbalances (UNCTAD, 

TDR 2008).

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. With inward capital 

flows searching for high yield, the currencies of capital-importing countries (which were highinflation countries at the same time) appreciated in nominal and in real terms, and this led to a 

deterioration of these countries’ competitiveness. With losses of market shares and rising current 

account deficits their external position became more and more unsustainable. 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 deleverage their foreign currency positions or to default, which poses a direct 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

8

threat to the (mainly foreign) banks in these countries. A case in point is the situation that has recently 

emerged between East European debtors and their Austrian lenders. 

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. In addition to reduced export revenues, 

this correction devalues investment in equipment and infrastructure that was directly induced by the 

demand boom and mushrooming revenues of the last years. 

D. What should have been anticipated: the illusion of risk-free greed and profligacy 

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. For policy makers who should have known better than to 

continuously bet on “beating the bank” to now assert (with the benefit of hindsight) that greed ran 

amok, or that regulators were “asleep at the wheel”, is simply not credible. 

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. It is only at this point that greed and profligacy enter the stage. 

Without the economic “lifestyle” of deregulation of the last decades, and in the presence of more 

appropriate regulation, expectations on returns of purely financial instruments in the double-digit 

range would simply not have been possible (Kuttner, 2007; Davidson, 2008). 

In real economies with single-digit growth rates those expectations are misguided from the 

beginning. However, human beings tend to believe that in their generation things may happen that 

never happened before, ignoring, at least temporarily, the lessons of the past. This happened in most 

recent memory during the stock market booms of the “new economy”. Despite the dot.com crash of 

2000 a wide range of investors began to invest their funds into 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 should have been clear from the outset that everybody can’t be 

above average (Kuttner, 2007: 21) and that the capacity of the real economy to cope with exaggerated 

real estate and commodity prices or misaligned exchange rates is strictly limited, but it is only now, 

through the experience of the crisis, that this is coming to be understood by many actors and 

policymakers. 

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 wellinformed buyers and sellers and hence promised minimal risk (Davidson, 2008). 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 (Fabozzi et al., 2007), 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 
Chapter I – A crisis foretold 

9

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 (Kuttner, 2007: 21–22). 

Needless to mention, that credit-rating agencies totally failed. But it is mainly due to the 

microeconomic approach they usually take and their ignorance concerning macroeconomic and 

systemic factors on a global scale that they misunderstood the risk of so many participants playing on 

the same fragile bridge between the small real economy and a bloated financial sector. 

11

Chapter II 

Financial regulation: fighting today’s crisis today 

A. It was not supposed to end like this 

For the past two decades, 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 costs”. 2

There are certainly some elements in which the current crisis differs from previous ones. 

These new elements were 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. 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 subprime mortgage loans), but in many 

markets, the true harbinger of the crisis was the unchecked build-up of risk during the boom. 

 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 (Borio, 2008). 

The financial sector acts as the central nervous system of modern market economies. It 

distributes liquidity and mobilizes the capital necessary to finance large investment projects; it 

allocates funds to the most dynamic sectors of the economy; it provides households with the necessary 

funds to smooth consumption over time; and, through its payment system, it allows managing the 

complex web of economic relationships that are necessary for economies characterized by a high 

degree of division and specialization of labour. 

Finance is intrinsic to successful economic development, but like most powerful tools, it can 

also cause great damage. The presence of informational asymmetries and maturity mismatches that 

ensue from high-powered leverage make financial systems inherently unstable and prone to boom and 

bust cycles. As a consequence, almost every country has hundreds of pages of legislation aimed at 

regulating the domestic financial sector. 

There are, however, 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 

 

2

 Remarks by Chairman Alan Greenspan at the 2003 Conference on Bank Structure and Competition, Chicago, 

Illinois, 8 May 2003 (http://www.federalreserve.gov/boarddocs/speeches/2003/20030508/default.htm). 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

12

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”. 

1. Financial efficiency and gambling 

Financial markets can provide many different products, and they can do a decent job at 

evaluating all available information. However, if they do not contribute to long-run economic growth, 

they do not provide any social return. From a regulator’s point of view, social (or functional) 

efficiency should be the only relevant definition of financial efficiency. Inefficiencies in information 

arbitrage or fundamental valuation, such as those, which contributed to the current crisis, are of 

concern to regulators to the extent that they create social inefficiency. In discussing the status of the 

United States financial system in the early 1980s, Tobin (1984) concluded that markets were 

becoming more efficient in processing a large number of transactions at low cost but less efficient in 

terms of their contribution to growth. In his view, the United States financial market was becoming 

more and more similar to a casino, where gambling dominated activities with true social returns. 

Tobin’s early assessment is corroborated by the fact that the US financial system has had to be bailed 

out three times in three decades and has now managed to completely recapitalize itself. 

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. 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. 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 (Stiglitz, 

2009). 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. 

In some cases it will be easy to identify products, which provide no real service besides the 

ability to gamble and increase leverage. 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 (see 

following section), it becomes clear that 90 per cent of these CDS do not provide any hedging service. 

Clearly, regulatory limits are needed for the issuance of 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. 

Likewise, there are instances where weeding out these (socially) inefficient forms of finance 

will be more difficult. For instruments that provide both real and gambling services, regulators will 

need to evaluate the costs and benefits of each product and only allow instruments for which the 

benefits outweigh the costs. Others may have high potential social returns yet increase risk and 

opaqueness. Therefore, they should be properly regulated and monitored. Choices will not be easy. 

They will require value judgments and the risk to overshoot with regulatory measures. However, this 

is the case for any policy decision. The decision of not taking any action is a regulatory action in itself 
Chapter II – Financial regulation: fighting today’s crisis today 

13

and uncertainty cannot be used as an excuse for avoiding regulation. The current crisis shows that 

erring on the other side may be the most costly outcome. 

2. Avoiding regulatory arbitrage and the role of securitization 

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 per cent of risk-weighted assets. Regulation has been 

effective in increasing the measured capital ratio of commercial banks. Over the last twenty-five 

years, the ten largest United States banks substantially decreased their leverage (figure 2.1), going 

from a non-risk adjusted first-tier capital ratio of approximately 4.5 per cent (which corresponds to a 

leverage of 22) to a non-risk adjusted first-tier capital ratio of approximately 8 per cent (which 

corresponds to a leverage of 12.5).3

Since capital is costly, bank managers try to circumvent regulation by either hiding risk4 or by 

moving some leverage outside the bank. In fact, the decrease in the leverage ratio of commercial 

banks was accompanied by an increase in the leverage ratios of non-bank financial institutions (the 

dotted and dashed lines in figure 2.1). 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, 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 (figure 2.2). 

 

3

 The capital ratio plotted in figure 2.1 is not risk adjusted. United States banks try to maintain risk-adjusted 

capital ratios of approximately 10 per cent, as this is considered a safe level of capital by United States 

regulators. 

4

 It has been argued that AAA rated tranches of collateralized debt obligations (CDO) were in high demand 

because, by providing high return while demanding low capital charges, they exploited a regulatory loophole 

built into the Basel Accords (Kashyap, Rajan and Stein, 2008). 

5

10

15

20

25

30

1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

Leverage

Banks Financial services Life insurance

Figure 2.1

LEVERAGE OF TOP 10 UNITED STATES FINANCIAL FIRMS BY SECTOR 

Source: UNCTAD secretariat calculations, based on balance sheet data from Thomson Datastream.

Note: Leverage ratio measured as share of shareholders equity over total assets. Data refer to 4 quarter moving average.
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

14

Asset backed 

securities 

issuers

4.1

Brokers and 

dealers

2.9

Finance 

companies

1.9

Government 

sponsored

enterprises

7.7

0

2

4

6

8

10

12

14

16

18

Market based Bank based

$ trillion

Credit unions 0.8

Savings 

institutions

1.9

Commercial banks

10.1

Figure 2.2

THE SHADOW BANKING SYSTEM, 2007, Q2

Source: Shin (2009).

Regulators did not seem to be too worried by this shift in leverage because they assumed that, 

unlike deposit taking banks, the collapse of large non-bank institutions would not have systemic 

implications.5

 The working hypothesis was that securitization had contributed to both diversifying and 

allocating risk to sophisticated economic agents who could bear such risk. As a consequence, the 

system could now take a higher level of total risk. The experience with Structured Investment 

Vehicles (SIVs) shows the flaws with this line of reasoning (UNCTAD, 2007a). While regulation 

focused on banks, it was the collapse of the shadow banking system which kick-started the current 

crisis.

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 (Issing et al., 

2008). The build up of hidden systemic risk can be limited by designing an objective-based regulatory 

system (Lukken, 2008). All markets and providers of financial products should be overseen on the 

basis of the risk they produce. If an investment bank issues insurance contracts like CDS, this activity 

should be subject to the same regulation that applies to insurance companies. If an insurance company 

is involved into maturity transformation, it should be regulated like a bank (Congressional Oversight 

Panel, 2009). 

In 2006, the IMF (2006: 51) found that “there is growing recognition that the dispersion of 

credit risk by banks to a broader and more diverse group of investors ... has helped make the banking 

and overall financial system more resilient ... commercial banks may be less vulnerable today to 

credit or economic shocks”. It clearly did not work that way. UNCTAD (2007a) discusses several 

reasons why securitization did not deliver. The key point is that securitization offered the law of large 

numbers as a compensation mechanism for the loss of soft information built into traditional lending. 

 

5

 In fact, in 2000, the United States Congress ruled out the possibility of regulating Credit Default Swaps 

(CDSs) and in 2004, the United States Securities and Exchange Commission allowed large investment banks to 

increase their leverage (Congleton, 2009). 
Chapter II – Financial regulation: fighting today’s crisis today 

15

However, the statistical models used by the financial industry failed miserably. Some of the 

assumptions at the basis of these models were plainly wrong (some models assumed that real estate 

prices could only increase; Coval et al., 2008). Others were more subtly incorrect, but even more 

dangerous.

Among the latter was the assumption that the risk associated with each debt contract 

packaged in a collateralized Debt Obligation (CDO) is uncorrelated with the risks of the other debt 

contracts included in the same CDO. At first glance, that of uncorrelated (or idiosyncratic) risk 

appears to be a reasonable assumption, and it is probably so in normal times. However, in bad times 

things work differently because asset prices tend to collapse at the same time. In the presence of 

correlated risk, small mistakes in measuring the joint distribution of asset returns may lead to large 

errors in evaluating the risk of a CDO. These problems are compounded by the fact that all models 

used in the financial industry use historical data to assess risk. But, by definition, historical data do 

not contain information on the behaviour of new financial instruments. 

Another problem with standard models of risk is that they do not control for network and 

counterparty risk. Several financial institutions are both buyers and sellers of risk and gross exposure 

to risk is often much higher than the real underlying risk. Brunnermeier (2008) shows that even in a 

situation in which all parties are fully hedged, the presence of counterparty risk amplifies uncertainty. 

This is not just a hypothetical example. UNCTAD secretariat estimates confirm that the gross 

exposure from CDS in the United States market is about 10 times the net exposure (figure 2.3), 

demonstrating that counterparty risk played a key role in the panic that followed Lehman Brothers’ 

bankruptcy in September 2008. This is another example of instruments, which were supposed to 

diffuse risk but have increased systemic fragility (Brunnermeier, 2009). 

Figure 2.3

OUTSTANDING CREDIT DEFAULT SWAPS, GROSS AND NET NOTIONAL AMOUNT

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

October 2008 November 2008 December 2008 January 2009

$ billion

Net exposure

Gross minus

net exposure

Source: UNCTAD secretariat calculations, based on data from the Depository Trust and Clearing Corporation.

Creating a clearinghouse that would net out the various positions could increase transparency 

(Segoviano and Singh, 2008). Even better, prohibiting excessive use of CDS by preventing the gross 

national value of CDS contracts to exceed their net notional value would allow hedging but limit 

gambling (Soros, 2009).6

 

6

 For a defence of CDS, see Wallison (2009). 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

16

3. Micro and macro prudential bank regulation 

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 (Nugée and 

Persaud, 2006). It is micro-prudential but not macro-prudential. This is problematic because there are 

instances in which what is prudent for an individual institution has negative systemic implications. 

Consider the case of a bank that suffers large losses on some of its loans. The prudent choice for this 

bank is to reduce its lending activities and cut its assets to a level which is in line with its smaller 

capital base. If the bank in question is small, the system will have no problem in absorbing this 

reduction in lending. If, however, the bank in question is large, or the losses affect several banks at the 

same time, the individual bank’s attempt to rebuild its capital base will drain liquidity from the 

system. Less lending by some banks will translate into less funding to other banks, which, if other 

sources of liquidity are not found, might be forced to cut lending and thus amplify the deleveraging 

process and affect investment in fixed capital. This seems to be the rut in which large parts of the 

global credit system remain stuck through the early part of 2009. 

Another channel through which the current micro-regulatory system may have negative 

systemic implications relates to “mark-to-market” accounting, according to which banks need to value 

some assets by using their current market price. A large bank realizing losses needs to reduce its risk 

exposure. Presumably, this bank will sell some of its assets and thus depress their price. This will lead 

to “mark-to-market” losses for banks that hold the same type of assets. If these losses are large 

enough to make capital requirements binding, the affected banks will also need to reduce their 

exposure. If they start selling assets, they will amplify the deleveraging process and the debt deflation. 

As the opposite happens in boom periods, this mechanism leads to leverage cycles. 

In light of this, some of the assumptions at the basis of the Basel Accords do not make much 

sense. Risk weighted capital ratios impose high capital charges on high-risk assets and low capital 

charges on low-risk assets. This can increase systemic risk and amplify the leverage cycle because 

during good times certain assets are considered to be less risky than they actually are, and during bad 

times the same assets might be viewed as riskier than they actually are. Required capital ratios will 

end up being too low in good times and too high in bad times. 

Moreover, relatively safe assets can have very high systemic risk. In a continuum of debt 

securities, going from super-safe assets (e.g., AAA German bunds) to high-risk junk bonds, the assets 

that are more likely to be downgraded if a systemic crisis come about, are not the super safe (because 

of flight to quality), nor the high risk (because they cannot be downgraded by much). The assets that 

are most likely to be downgraded are those on the safe side of the spectrum, but not super-safe (e.g. 

AAA-rated tranches of CDOs). But these are the assets that were required by low regulatory capital 

during the boom period and, because of the downgrade, need a higher regulatory capital in the crisis 

period (Brunnermeier et al., 2009). 

Consequently, 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. The key 

consideration for macro-prudential regulation is each institution’s contribution to systemic risk. Other 

things equal, larger institutions should be subject to a heavier regulatory burden than smaller 

institutions. However, size is not a sufficient indicator because small institutions, which are subject to 

correlated risk, may have the same systemic importance as a large institution. Regulators should also 

be concerned about leverage, maturity transformation, provision of essential services (such as 

payment or market-making) and interconnectedness.7

 The time dimension of risk can be assessed by 

 

7

 New research aimed at developing CoVaR models (i.e., models that measure the value at risk of financial 

institutions conditional on other financial institutions being under distress, Adrian and Brunnermeier, 2008) can 
Chapter II – Financial regulation: fighting today’s crisis today 

17

building early warning systems and by the recognition that booms (and the subsequent crashes) are 

fuelled by imprudent lending and high leverage, both built on the misperception that risk has 

permanently lowered. 

4. The need for international coordination 

Regulatory arbitrage does encompass institutions within a jurisdiction, but it also extends 

across jurisdictions. It is therefore necessary to add an international dimension to financial regulation. 

At the least, regulators based in different countries should communicate and share information. At this 

stage, it is impossible to implement a global early warning system because there are no data on crossborder exposure among banks and on derivative products (Issing and Krahnen, 2009). Regulators 

should work together towards developing joint systems for the evaluation of cross-border systemic 

risk and should share information on liquidity and currency mismatches in the various national 

markets. Regulators should also coordinate the oversight of large international banking organizations 

and add clarity to the responsibilities of home and host countries, especially for crisis management 

(Group of 30, 2009; Issing et al., 2008). 

But international cooperation needs to go further. It needs to focus on regulatory standards 

and avoid races to the bottom in financial regulation. Without international coordination, the 

impression may arise that a country can become an international financial centre if only its financial 

markets are deregulated. In some countries there has also been reluctance to share data on crossborder exposure in the belief that an increase in transparency may have a negative effect on the 

competitiveness of the domestic financial sector (Issing and Krahnen, 2009). This position is wrong. 

Investors want transparency and proper regulation; a race to the bottom may end up being a negative 

sum game and reduce the efficiency and size of the world’s financial system (Stiglitz, 2009). 

Cooperation among regulators should converge towards a homogenous application and enforcement 

of regulatory standards (Group of 30, 2009) and should focus on closing regulatory gaps, especially in 

offshore centres. 

However, there is no one size that fits all. Regulatory systems, just like policies, have to be 

adapted to the different institutional conditions prevailing in different countries. Allowing countries to 

pursue alternative regulatory approaches can also provide regulators with a better understanding of the 

trade-offs implied by different regulatory models (Pistor, 2009). A better appreciation for these 

different needs and approaches could be achieved by increasing the participation of developing 

countries in the various standard setting bodies and international agencies in charge of guaranteeing 

international financial stability. 

5. Financial regulation and incentives 

In many countries financial deregulation rested on the idea that bank managers would not do 

anything that would prejudice the long-term value of their firms (e.g., Greenspan, 2008). It is now 

clear that this idea is fundamentally flawed. Economists and policymakers have always been aware 

that managers’ incentives are not aligned with those of shareholders, but they operated under the 

assumption that, because of their reputation capital, long-lived institutions can be trusted to monitor 

themselves. However, large corporations are composed of individuals who always respond to their 

own private incentives, and those who are in charge of risk control are often subject to the same type 

of incentives that dictate the behaviour of investment officers (Acemoglu, 2009). 

In fact, even self-interested individuals who spot potential profit opportunities driven by an 

episode of collective market irrationality may find it difficult to swim against the tide. If an episode of 

“irrational exuberance” lasts too long, any investment manager who goes against the trend will 

 

help regulators in measuring risk spillovers and thus assessing the systemic importance of individual 

institutions. 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

18

underperform and be likely to lose his clients and job. Lamont and Thaler (2003) have shown that the 

presence of long-lasting deviations from fundamental asset values is made possible by the fact that 

very few investors try to fight the trend. It is not surprising that one of the mottos of the financial 

industry is: “the trend is your friend”. 

The list of distorted incentives at the basis of the current crisis is long, but executive 

remuneration in the financial industry and the regulatory role of credit rating agencies are paramount. 

With respect to executive pay, regulatory reform should aim at promoting remuneration structures that 

reduce incentives for excessive risk-taking. Greater transparency and the design of remuneration 

structures that do not focus on yearly returns may be a positive step in this direction. Problems related 

to credit rating inflation could instead be addressed by subjecting rating agencies to regulatory 

oversight (UNCTAD, 2007a; Congressional Oversight Panel, 2009) and by regularly publishing rating 

performance (Issing et al., 2008). 

B. Lessons for developing countries 

Developing countries are paying a steep economic price for a crisis that originated at the 

centre of the world’s financial system. They need to consider how they can protect themselves from 

external financial shocks. Moreover, most developing countries are rightly trying to build deeper and 

more (functionally) efficient financial systems, and this crisis should be seized as an opportunity to 

expose the hidden risks of financial development and how more sophisticated financial systems 

require more, and not less, regulation. 

During 2008, the United States stock market lost about 35 per cent of its value. Compared 

with other industrial countries and with the largest emerging markets, it did relatively well. All large 

emerging markets had dollar returns which were well below those of the United States (figure 2.4). 

Sovereign spreads tripled in the second half of 2008 (figure 2.5) and private capital flows to emerging 

economies collapsed by 80 per cent with respect to 2007. At the same time, interest rates on United 

States Treasuries are at historically low levels. There seems to be a flight to quality in the country at 

the centre of the crisis. So much for decoupling! Contagion is not purely financial. The most recent 

estimates show a sudden drop of GDP growth in both transition and developing economies. 

Figure 2.4

EQUITY MARKET DOLLAR RETURNS, 2008

-80 -70 -60 -50 -40 -30 -20 -10 0

Russian Federation

Turkey

China

India

Indonesia

Republic of Korea

Brazil

Argentina

Philippines

Emerging markets

United Kingdom

Hong Kong, China

South Africa

France

Germany

Malaysia

Mexico

G-5 (average)

Colombia

United States

Japan

Dollar return (per cent)

Source: UNCTAD secretariat calculations, based on stocks and markets data from Thomson Datastream.
Chapter II – Financial regulation: fighting today’s crisis today 

19

Figure 2.5

EMERGING MARKET SPREAD, JANUARY 2007–DECEMBER 2008

100

200

300

400

500

600

700

800

02/01/07 02/03/07 02/05/07 02/07/07 02/09/07 02/11/07 02/01/08 02/03/08 02/05/08 02/07/08 02/09/08 02/11/08

Basis points

Source: Thomson Datastream.

1. Financial development requires more and better regulation 

Developing countries tend to have financial systems that are less functionally efficient than 

those of the advanced economies. Given the importance of finance for investment in fixed capital and 

growth, several developing countries adopted ambitious structural reform programs aimed at 

modernizing and improving their own financial systems. However, there are serious doubts as to 

whether these pro-market policies were successful in their aim of increasing the social efficiency of 

their financial sectors (UNCTAD, TDR 2008, chapter IV). 

Developing countries are often characterized by a non-competitive financial system in which 

banks make good profits by paying low interest on deposits and charging high interest rates on loans, 

which they only extend to super-safe borrowers. Shareholders and bank managers are content with 

rents arising from limited competition, but the financial system is hardly conducive to investment in 

fixed capital and to economic development. Credit will be limited and unlikely to flow to potentially 

high-return investment projects in the productive sector. If the country decides to reform its financial 

system and if policymakers are well aware that the reform process should target functional efficiency, 

the task is not an easy one. Even if policymakers know that financial instruments that may have high 

social returns in a more developed country may not be appropriate for their less developed economy 

and try to target the reform process to the real needs of their country, financial regulators will soon 

start facing new problems. By reducing bank margins, the reform process leads to a whole new set of 

incentive problems. 

The old system was inefficient but relatively easy to control. A more competitive 

environment alters the incentive structure of bank managers in two ways (Rajan, 2005). First, as their 

compensation now depends on returns to investment, bank managers will face more upside risktaking. This is problematic if bank officers are used to operating under the “3-6-3 risk management 

rule” (borrow at 3 per cent, lend at 6 per cent, and be on the golf course by 3 PM) and end up 

assuming risk that they do not understand. Along similar lines, regulators used to an inefficient but 

stable banking system may not understand the new risks and vulnerabilities. Second, since bank 

managers know that they are evaluated against their peers, they have incentives to herd and take 

hidden tail risk. Detecting this behaviour, which has the potential for generating large systemic 

shocks, requires sophisticated regulators. 

On the investment bank side, the loss of stable income from brokerage activities may provide 

incentives for increasing leverage and entering into activities that involve maturity transformation; in 

other words, for the creation of a shadow banking system. But, again, regulators may not be ready for 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

20

this new structure of the financial system and still work under the assumption that only commercial 

banks have systemic importance. 

This example shows that one perverse outcome of otherwise successful financial reforms is 

that, by reducing margins, they may induce bankers to take more risk than they are prepared to absorb 

or than regulators are able to understand. This does not mean that developing countries should not try 

to improve the functional efficiency of their financial system. However, the process needs to be 

gradual and accompanied by a stronger and more comprehensive regulatory apparatus. 

2. There is no one-size-fits-all financial system 

Developing countries face a difficult trade-off regarding the design and regulation of their 

financial systems. On the one hand, access to finance is necessary for economic development. On the 

other hand, as seen above, a more sophisticated financial sector is also likely to lead to an increase in 

total risk. If the second effect dominates the first, financial development may lead to an increase of 

systemic risk. Until recently it was believed that good financial regulation could be a solution to this 

trade-off and most countries could build financial systems that are both sophisticated and stable. The 

current crisis suggests that this objective may not be within the reach of most developing countries, at 

least in the near future. In choosing where to position themselves in the continuum between financial 

sophistication and stability, developing countries should recognize that there is no model that is right 

for all countries or at all times. Each country needs to find the model, which is most appropriate for its 

current level of development, needs, and institutional capacity. 

Countries with stronger regulatory and institutional capacity may want to adopt a more 

aggressive process of financial liberalization and embrace a more market-based financial system. 

Other countries may want to be more cautious and stick to traditional banking. Some countries may 

find that their regulatory capacities do not even allow the proper working of private banks and may 

decide to rely more on State-owned banks. If they decide do to so, they should not be discouraged by 

the claim that “State ownership tends to stunt financial sector development, thereby contributing to 

slower growth” (World Bank, 2001). Many examples in developed economies have shown that the 

prejudice against State-owned banking is not justified and that “sophisticated” financial systems may 

badly fail. After all, the current crisis shows that once the chips are down and all bets are off, all banks 

are public.

C. Conclusion: closing down the casino 

It is often argued that financial regulators should not fight the last crisis. And yet, this is 

exactly what agencies in charge of air traffic safety do with considerable success. Some argue that 

things are different for finance, as the principles of physics that keep airplanes in the air do not 

respond to regulatory changes, but financial markets, designed and operated by human beings, do. 

Financial innovation, the argument goes, is viral and reacts to regulation by producing more complex 

and opaque financial instruments. Hence, the argument continues, each financial crisis is different 

from the previous and is thus unpredictable. According to this view, nothing can be learned and new 

regulation can only do more harm. This line of reasoning is certainly true for the particular 

instruments, which are the proximate cause of any financial crisis. In 1637 it was tulip bulbs, in 1720 

it was stocks of the South Sea Company, and in the current crisis it is mortgage-backed securities. 

Nobody knows which financial instrument will be at the centre of the next crisis, most likely not

mortgage-backed securities. Probably this instrument has not yet been invented. 

However, the mechanism that leads to the crisis is always the same: a positive shock 

generates a wave of optimism which feeds into lower risk aversion, greater leverage and higher asset 

prices which then feed back into even more optimism, leverage and higher asset prices. Sceptics will 

claim that asset prices cannot grow forever at such a high rate but the enthusiasts will answer that this 

time it is different. If the boom lasts long enough, even some of the sceptics will end up believing that 
Chapter II – Financial regulation: fighting today’s crisis today 

21

this time, it is indeed different. Those who remain sceptical will be marginalized. Of course, things 

are never that different. At some point the asset bubble will burst, the deleveraging process, the debt 

deflation and economic crisis will begin. A regulatory framework that takes this mechanism into 

account could have prevented some of the excesses that led to the current crisis. 

The problem is that after a crisis there is widespread political support for regulation, and this 

may lead to overregulation. However, after a long period of stability, characterized by small nonsystemic crises, policymakers forget the lessons of the previous crisis and no longer understand the 

rationale for the existing regulatory apparatus. This is when the deregulatory process starts and it may 

be fuelled, as it was this time, by the general belief in free markets and unfettered competition and it 

tends to overshoot. A possible solution to this regulatory cycle is to follow the example of air safety 

regulators who, besides learning from relatively rare airplane crashes, also put a great deal of attention 

on near misses. For instance, there was much to be learned from the Long-term Capital Management 

(LTCM) collapse of 1998, from the Asian crisis in the second half of the 1990s and the Argentinean 

crisis at the beginning of the century. A proper regulatory response at the national and international 

level would have played an important role in limiting the built-up and the consequences of the current 

crisis.

Regulators around the world must be chastened by what has befallen global finance, but 

equally determined to draw the lessons and be up to the reform tasks that lay ahead. A Herculean 

effort will be called for not only as penance for what has already occurred but as proof that the system 

can be fixed and can deliver the functional/social efficiency expected of it. Therefore, the most 

important task is to ensure that financial efficiency is defined as the sector’s ability to stimulate longrun economic growth. Transaction costs, the number of available instruments, or the overall size of 

the financial system are only relevant if they contribute to increasing social welfare, they should not 

be objectives per se. 

Financial markets in many advanced economies have come to function like giant casinos, 

where the house almost always wins (or gets bailed out) and everybody else loses. Twenty-five years 

ago, Tobin (1984) argued that there may be something wrong with an incentive structure, which leads 

the brightest and most talented graduates to engage into financial activities “remote from the 

production of goods and services”, and that the private rewards of financial intermediation might be 

much higher than its social reward. More recently, Rodrik (2008) asked, without finding a convincing 

answer, “What are some of the ways in which financial innovation has made our lives measurably and 

unambiguously better”. The key objective of financial regulatory reform must be to devise a system 

that allows weeding out of financial instruments whose functional/social efficiency is dubious - 

effectively taking the wagering (betting on uncertain outcomes) out of modern finance. 

In concluding, the collapse in the market for subprime mortgages in the United State was the 

spark that ignited the crisis, but it is not the fundamental cause. 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 market fundamentalist ideology. 

However, it would be far-fetched to interpret the crisis as challenging the basic functioning of 

all capitalist markets. 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. Certainly, policymakers were remiss in not accounting for human greed in evaluating 

the risks of financial deregulation or new instruments as they were invented. In 1983, the financial 

sector generated 5 per cent of the United States’ GDP and accounted for 7.5 per cent of total corporate 

profits. In 2007, the United States financial sector generated 8 per cent of GDP and accounted for 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

22

40 per cent of total corporate profits.8

 Policymakers should have wondered about an industry that 

constantly expects to generate double digit returns in an economy that grows at a much slower rate 

(UNCTAD, 2007a), especially if there are strong indications that this “industry” does not contribute 

much to overall productivity and needs to be bailed out every decade or so. 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. This is not a failure of the 

market system. It is a failure of financial deregulation. 

More finance and more financial products are not always better. Financial markets may be 

efficient in the sense that they produce many different instruments and have low transaction costs, but 

their contribution to social welfare is nil in good times and negative in bad times. Social efficiency is 

the only definition of financial efficiency that should be relevant for policymakers. Financial 

regulation should be aimed at reducing the proliferation of such instruments, which seem to be more 

efficient at masking the risk to investors than in minimizing it. International coordination along this 

dimension is of utmost importance. 

Finally, there is a fundamental flaw with a regulatory apparatus based on the assumption that 

protecting individual institutions will automatically protect the whole system. This is partially a 

reflection of the same theoretical mindset that assumes that the rational behaviour of one economic 

agent can be an accurate model or guide for the expected behaviour of a free, perfect financial system 

grouping countless agents. There are cases in which actions that are good and prudent for individual 

financial institutions have negative implications for the system as a whole. It is thus necessary to 

develop a macro-prudential regulatory system based on countercyclical capital provisioning and to 

develop institutions for the supervision of all the different financial markets that are focusing systemic 

risk and nothing else. 

 

8

 The data for 1983 are from Tobin (1984) and the data for 2007 are from Wolf (2009) and the United States 

Bureau of Economic Analysis. 
23

Chapter III 

Managing the financialization of commodity 

futures trading 

A. Introduction: commodity markets and the financial crisis 

The build-up and eruption of crisis in the financial system was paralleled by an unusually 

sharp increase and subsequent strong reversal of the prices of internationally traded primary 

commodities. The recent development of commodity prices has been exceptional in many ways. The 

price boom between 2002 and mid-2008 was the most pronounced in several decades in its 

magnitude, duration and breadth. The price decline since mid-2008 stands out for its sharpness and 

number of commodity groups affected. The price hike for a number of commodities put a heavy 

burden on many developing countries relying on imports of food and energy commodities, and 

contributed to food crises in a number of countries in 2007–2008, while the slump of commodity 

prices in the second half of 2008 was one of the main channels through which the dramatic slowdown 

of economic and financial activity in the major industrialized countries was transmitted to the 

developing world. 

The strong and sustained increase in primary commodity prices between 2002 and mid-2008 

was accompanied by a growing presence of financial investors on commodity futures exchanges. This 

“financialization” of commodity markets has raised concern that much of the recent commodity price 

developments – and especially the steep increase in 2007–2008 and the subsequent strong reversal – 

was largely driven by financial investors’ use of commodities as an asset class. 

Over the 78 months from early-2002 to mid-2008 the IMF’s overall commodity price index 

rose steadily and nominal prices more than quadrupled. During the same period, UNCTAD’s non-fuel 

commodity index tripled in nominal terms and increased by about 50 per cent in real terms. Since 

peaking in July 2008, oil prices have dropped by about 70 per cent, while non-fuel prices have 

declined by about 35 per cent from their peak in April 2008. This reversal is considerable; however, it 

corresponds only to about one seventh of the previous 6-year increase, so that commodity prices 

remain well above their levels of the first half of this decade. While the timing differed from 

commodity to commodity, both the surge in prices and their subsequent sharp correction affected all 

major commodity categories, and they affected both exchange-traded commodities and those that are 

either not traded on commodity exchanges or not included in the major commodity indices 

(figure 3.1). It is this latter category that many financial investors use for their investment in 

commodities. 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

24

Figure 3.1 

COMMODITY PRICE CHANGES, 2002–2008 

0 50 100 150 200 250 300 350 400 450 500 550 600 650 700 750 800 850 900 950

Rhodium

Cadmium

Manganese

Cobalt

Iron ore

Rice

Crude petroleum

Tin

Copper

Silver

Nickel

Lead

Maize

Zinc

Aluminium

A. JUNE 2008 VS. JANUARY 2002

(Percentage change)

-100 -90 -80 -70 -60 -50 -40 -30 -20 -10 0 10

Manganese

Iron ore

Rice

Cobalt

Cadmium

Rhodium

Silver

Zinc

Maize

Lead

Tin

Aluminium

Nickel

Copper

Crude petroleum

B. DECEMBER 2008 VS. JUNE 2008

(Percentage change)

Exchange-traded commodities

Commodities either not traded on commodity exchanges or not 

included in the major commodity indices

Source: UNCTAD secretariat calculations, based on Metal Bulletin; and UNCTAD Commodity Price Bulletin.

The sometimes extreme scale of changes in recent commodity price developments and the 

fact that prices had increased and subsequently declined across all major categories commodities 

suggests that, beyond the specific functioning of commodity markets, broader macroeconomic and 

financial factors which operate across a large number of markets need to be considered to fully 

understand recent commodity price developments. The depreciation of the dollar clearly was one such 

general cause for the surge in commodity prices. But a major new element in commodity trading over 

the past few years is the greater weight on commodity futures exchanges of financial investors that 

consider commodities as an asset class. Their possible role in exacerbating price movements away 

from fundamentals at certain moments and for certain commodities is the focus of the following 

sections.
Chapter III – Managing the financialization of commodity futures trading 

25

B. The growing presence of financial investors 

in commodity markets 

Financial investors have been active in commodities since the early 1990s. Initially, they 

mainly comprised hedge funds that have short-term investment horizons and often rely on technical 

analysis. The involvement of financial investors took on new proportions in the aftermath of the dotcom crash in 2000 and started a meteoric rise in early 2005. Most of this financial investment in 

commodities uses swap agreements to take long-term positions in commodity indexes. Two common 

indexes are the Standard & Poor’s Goldman Sachs Commodity Index (S&P GSCI) and the Dow 

Jones-American International Group Commodity Index (DJ-AIGCI), which are composites of 

weighted prices of a broad range of commodities, including energy products, agricultural products, 

and metals.9

Investors in commodity indexes aim at diversifying portfolios through exposure to 

commodities as an asset class. Index investors gain exposure in commodities by entering into a swap 

agreement with a bank which, in turn, hedges its swap exposure through an offsetting futures contract 

on a commodity exchange. All index fund transactions relate to forward positions – no physical 

ownership of commodities is involved. Index funds buy forward positions, which they sell as expiry 

approaches and use the proceeds from this sale to buy forward again. This process – known as 

“rolling” – is profitable when the prices of futures contracts with a long maturity are below the 

prevailing price of the futures contract with a remaining maturity of one month (i.e. in a 

“backwardated” market) and negative when the prices of futures contracts with longer maturities are 

higher (i.e. in a “contango” market). 

Trading volumes on commodity exchanges strongly increased during the recent period of 

substantial commodity price increases. The number of futures and options contracts outstanding on 

commodity exchanges worldwide increased more than fivefold between 2002 and mid-2008 and, 

during the same period, the notional value of over-the-counter (OTC) commodity derivatives has 

increased more than 20-fold, to $13 trillion (figures 3.2 and 3.3).10 But financial investment sharply 

declined starting in mid-2008. This parallel development of commodity prices and financial 

investment on commodity futures markets is a first indicator for the role of large-scale speculative 

activity in driving commodity prices first up and then down. 

 

9

 In the DJ-AIGCI, weights are limited to 15 per cent for individual commodities and to one third for entire 

sectors, while in the S&P GSCI weights depend on relative world production quantities, with energy products 

currently accounting for about two thirds of the total index. 10 The Bank for International Settlements (BIS) is the only source that provides publicly available information 

about OTC commodity markets. However, these data do not allow for commodity-specific disaggregation. 

Notional amount refers to the value of the underlying commodity. However, traders in derivatives markets do 

not own or purchase the underlying commodity. Hence, notional value is merely a reference point based on 

underlying prices. 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

26

0

5

10

15

20

25

30

35

40

45

50

Dec.

1993

Dec.

1995

Dec.

1997

Dec.

1999

Dec.

2001

Dec.

2003

Dec.

2005

Dec.

2007

Source: BIS, Quarterly Review , March 2009, table 23B.

Figure 3.2

FUTURES AND OPTIONS CONTRACTS 

OUTSTANDING ON COMMODITY EXCHANGES, 

DECEMBER 1993–DECEMBER 2008 

(Number of contracts, millions)

0

2

4

6

8

10

12

14

Dec.

1998

Dec.

2000

Dec.

2002

Dec.

2004

Dec.

2006

June

2008

Other commodities

Other precious metals

Gold

Source: BIS, Quarterly Review , December 2008, table 19.

Figure 3.3

NOTIONAL AMOUNT OF OUTSTANDING OVERTHE-COUNTER COMMODITY DERIVATIVES, 

DECEMBER 1998 – JUNE 2008 

(Trillions of dollars)

C. The financialization of commodity futures trading 

Among economists there is, however, scepticism with regard to the link between speculation 

and commodity price developments. This scepticism is based on the efficient market hypothesis. 

According to this view, prices in a freely operating market perfectly and instantaneously incorporate 

all relevant information available. Thus, if speculators were driving market prices above fundamental 

levels, consumers would demand less than producers are supplying. The resulting excess supply must 

appear in inventories. For example, Krugman (2008) argues that no inventory accumulation could be 

observed during the sharp increase in oil prices in 2007–2008 so that speculation cannot have played a 

role in the oil price run-up. 

However, the short-term price elasticity of many physical markets for commodities like oil 

and food is low. Prices can be driven up by the mere fact that everybody expects higher prices, which 

in itself may be driven by rising futures prices following rising demand for futures by financial 

speculators. If producers increase prices consumers do not have many means to hold up. If no 

substitutes are quickly available they have to accept for a time higher prices. No inventories appear, 

the market is cleared but prices are much higher than without speculative activity. The efficient 

market hypothesis fails on commodity markets because the number of counterparties (especially those 

with an interest in physical commodities) and the size of their positions are less than perfectly elastic. 

Hence, large orders may face short-term liquidity constraints and cause significant price shifts. This 

implies the possibility of a “weight-of-money” effect: position changes that are large relative to the 

size of the total market have a temporary, or even a persistent, price impact. 

There is at least one other reason why the efficient market hypothesis may fail on commodity 

markets. Changes in market positions may result from the behaviour of a certain group of market 

participants who respond to factors other than information about market fundamentals. Huge amounts 

of uninformed traders may misinterpret certain pieces of information as a genuine price signal and, by 

incorporating this signal into their trading strategy, perpetuate the “informational” value of this signal 

across the market. Given that uninformed traders often use similar trend extraction techniques, they 

run the risk that collectively they will generate the trends that they then individually identify and 

follow.
Chapter III – Managing the financialization of commodity futures trading 

27

In addition, available inventory data are incomplete. For example, market participants may 

want to accumulate inventories but do not succeed because of tight supply. In such a situation, mere 

attempts to accumulate inventories may push up prices without any actual increase in physical 

inventories. Moreover, a large part of inventories is not included in published data. In the case of 

some non-ferrous metals for instance, official inventories have strongly increased since mid-2008 

despite declining prices. This is likely to reflect a massive de-stocking of private inventories by 

market participants who had accumulated commodities when prices were rising and the ready 

availability of physical commodities could provide significant extra benefits and are now depositing 

their products in official warehouses in exchange for cash. Thus, developments of official inventory 

data are not reliable indicators in the debate on the relative impact on commodity prices of financial 

investors and of fundamentals. 

Uninformed trading combined with herd behaviour relates to those managed funds that use 

technical-analysis tools (trend identification and extrapolation, algorithmic trading) for position 

taking. This can result in increased short-term price volatility, as well as the overshooting of price 

peaks and troughs. Moreover, if traders react to changes in non-commodity markets and the price 

changes stemming from their position changes feed into the trading strategies of uninformed traders, 

commodity markets will become exposed to spillover effects from other asset markets. Uninformed 

trading on commodity markets is not a new phenomenon. However, the sustained trend towards 

greater financialization of commodity trading is likely to have increased the number and relative size 

of price changes that per se are unrelated to fundamental conditions. 

A strong indication for the role of uninformed trading in price setting on commodity markets 

is the strong correlation between the unwinding of speculation in different markets that should be 

uncorrelated. Figure 3.4 shows that there are phases of speculative activity where currencies, even 

those of small countries like Iceland, and commodity prices are clearly driven by factors beyond 

fundamentals because the fundamentals underlying the different prices cannot go into the same 

direction. Obviously, all participants react to the same kind of information, to the same “news” by 

winding or unwinding their exposure to risky assets. 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

28

Figure 3.4 

CORRELATIONS BETWEEN THE EXCHANGE RATES OF SELECTED COUNTRIES AND 

EQUITY AND COMMODITY PRICE INDICES, JUNE 2008–DECEMBER 2008 

y = -1E-05x + 0.0463

R2

 = 0.9561

0.014

0.016

0.018

0.020

0.022

0.024

0.026

0.028

1723 1923 2123 2323 2523 2723 2923

Reuters Commodities Price Index

Exchange rate

y = -2E-05x + 0.0443

R2

 = 0.9222

0.014

0.016

0.018

0.020

0.022

0.024

0.026

0.028

752 952 1152 1352

S&P 500 Composite Equity Price Index

Exchange rate

y = -7E-06x + 0.0325

R2 = 0.9576

0.012

0.013

0.014

0.015

0.016

0.017

0.018

0.019

0.020

1723 1923 2123 2323 2523 2723 2923

Reuters Commodities Price Index

Exchange rate

y = -1E-05x + 0.031

R2 = 0.9057

0.012

0.013

0.014

0.015

0.016

0.017

0.018

0.019

0.020

752 952 1152 1352

S&P 500 Composite Equity Price Index

Exchange rate

y = -0.0007x + 2.6671

R2

 = 0.9008

0.70

0.80

0.90

1.00

1.10

1.20

1.30

1.40

1.50

1723 1923 2123 2323 2523 2723 2923

Reuters Commodities Price Index

Exchange rate

y = -0.0014x + 2.5932

R2 = 0.9235

0.70

0.80

0.90

1.00

1.10

1.20

1.30

1.40

1.50

752 952 1152 1352

S&P 500 Composite Equity Price Index

Exchange rate

y = -0.0324x + 235.19

R2 = 0.8346

141

146

151

156

161

166

171

176

181

186

191

1723 1923 2123 2323 2523 2723 2923

Reuters Commodities Price Index

Exchange rate

y = -0.065x + 230.92

R2

 = 0.8355

141

146

151

156

161

166

171

176

181

186

191

752 952 1152 1352

S&P 500 Composite Equity Price Index

Exchange rate

A. BRAZILIAN REAL TO JAPANESE YEN

B. NEW ZEALAND DOLLAR TO JAPANESE YEN

C. ICELANDIC KRONA TO JAPANESE YEN

D. HUNGARIAN FORINT TO JAPANESE YEN

Source: Thomson Datastream database. 
Chapter III – Managing the financialization of commodity futures trading 

29

The weight-of-money effect relates primarily to index-based investment, which allocates 

positions across many commodities in proportions that depend on the weighting formula of the 

particular index. As a result, index-based investment generates price pressure in the same direction 

across a broad range of commodities. Moreover, index-based investment positions can be large 

relative to the size of the entire markets, as shown below. 

Making this analytical distinction between informed, uninformed and noise traders is 

straightforward in principle (table 3.1), but in practice making this separation is not easy. The 

Commodity Futures Trading Commission (CFTC) – the institution mandated to regulate and oversee 

commodity futures trading in the United States – publishes trading positions in anonymous and 

summary form in the weekly Commitments of Traders (COT) report. The CFTC classifies market 

participants as “commercial” if they are hedging an existing exposure and “non-commercial” if they 

are not. It is widely perceived that, as a consequence of the increased diversity of futures markets 

participants and the increased complexity of their activities, the COT data may fail to fully represent 

futures market activity (CFTC, 2006a). Many institutions reporting positions as hedges, and which 

therefore are classified as commercial, are held by commodity swap dealers to offset financial 

positions which, if held directly as commodity futures, would be counted as non-commercial. 

Responding to these concerns, the CFTC started in 2007 to issue supplementary data on positions of 

commodity index traders (CITs) for selected agricultural commodities (CFTC, 2006b). According to 

the CFTC (2009), CITs generally replicate a commodity index but may come from either the 

commercial or non-commercial categories. 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

30

Table 3.1 

Commodity futures trading behaviour: traditional speculators, 

managed funds and index traders 

Traditional speculators Managed funds Index traders 

General 

market

position

Active positions on both 

sides of market; able to 

benefit in both rising 

and declining markets 

Active, often large positions on both 

sides of market; able to benefit in both 

rising and declining markets; relatively 

opaque positions 

Passive, large and long-only 

positions in swap agreements with 

banks which, in turn, hold futures 

contracts to offset their short 

positions; able to benefit only in 

rising or backwardated (spot 

price>forward price) markets; 

transparent positions 

Position

taking

behaviour

React to changes in 

commodity market 

fundamentals (supply, 

demand, inventories); 

mostly trade in one or 

two commodities on 

which they have 

intimate knowledge; 

leveraged positions 

Some (e.g. hedge funds) conduct 

some fundamentals research and thus 

react to changes in commodity market 

fundamentals. Others (e.g. commodity 

trading advisors) mostly use technical 

analyses (trend identification and 

extrapolation, algorithmic trading), 

which extract information from price 

movements, thereby risking to 

misinterpret noise trader position 

taking for genuine price information, to 

engage in herding behaviour and to 

cause snowball effects; leveraged 

positions

Not interested in fundamentals of 

specific commodity markets but 

may take views on commodities 

as a whole; relative size of 

positions in individual commodity 

determined by index weighting 

formula; idiosyncratic position 

taking such as rolling at 

predetermined dates; position 

changes relatively easy to predict; 

fully collateralized positions 

Impact on 

liquidity 

Improve liquidity Active, large positions can improve 

liquidity and make hedging easier for 

large commercial users. In periods of 

rapid and sharp price changes, large 

positions are a “liquidity sponge”, 

making it difficult for hedgers with 

commercial interests to place orders 

Passive, large positions act as 

“liquidity sponge” 

Reaction to 

sharp price 

changes

May be taken by 

surprise if price 

changes are unrelated 

to fundamentals; can be 

forced out of market if 

insufficient liquidity to 

meet margin calls 

triggered by sharp price 

increases

Taking and closing positions often 

automatically triggered by computer 

programmes; risk of causing snowball 

effect

Different price developments for 

individual commodities require 

recomposition of relative 

investment positions to preserve 

predetermined index weight 

pattern; sharp price declines may 

cause disinvestment 

Reaction to 

changes on 

other

markets

Operate only in 

commodity markets; 

normally concentrate on 

one or a few 

commodities and, thus, 

react little to 

developments in other 

markets

Operate across different asset 

classes. Commodities tend to have a 

fixed weight in managed fund 

portfolios so that price movements in 

other markets can lead to position 

changes in commodity markets 

Operate across different asset 

classes. Potentially strong links 

between commodity futures 

market activity and development 

on equity and bond markets, in 

two dimensions: (i) risk-return 

combinations in other asset 

classes can become more 

attractive, causing a withdrawal 

from commodity markets; (ii) 

margin calls on other investments 

can trigger closing of positions in 

commodities and accelerate 

contagion across asset classes 

Classification 

in CFTC 

Commitment

of Traders 

Reports

Non-commercial user 

category 

Mostly in non-commercial user 

category 

Mostly in commercial user 

category 

Source: UNCTAD secretariat. 
Chapter III – Managing the financialization of commodity futures trading 

31

A primary concern often expressed with respect to the financialization of commodity trading 

relates to the magnitude of index trader activity combined with the fact that they tend to take only 

long positions. Table 3.2 provides evidence on the relative share of both long and short positions held 

by different trader categories in those agricultural markets for which the CFTC has published 

disaggregated data starting in January 2006. The data clearly show that index funds are present almost 

exclusively in long positions and that they account for a large portion of the open interest in some 

food commodity markets. Indeed, over the period 2006–2008, the net long positions of index traders 

in cotton, live cattle, feeder cattle, lean hogs and wheat were significantly larger than the respective 

positions of commercial traders, while they were roughly of equal size for maize, soybeans and 

soybean oil. 

While the number of index traders is relatively small, their average long position is very large 

(middle panel of table 3.2), sometimes more than ten times the size of an average long position held 

by either commercial or non-commercial traders. Positions of this order are likely to have sufficiently 

high financial power to drive prices (Capuano, 2006). As a result, speculative bubbles may form and 

price changes can no longer be interpreted as reflecting fundamental supply and demand signals. All 

of this can have an extremely detrimental effect on normal trading activities and the efficiency of the 

market, despite the existence of speculative position limits. 

In fact index traders actually exceeded speculative position limits in wheat contracts on the 

Chicago Board of Trade (CBOT) and for other commodities they came much closer to these limits 

than did the other trader categories (right-hand panel of table 3.2). This is legal as index traders are 

mostly classified as commercial traders and, therefore, are not subject to speculative position limits. 

But as noted by Sanders, Irwin and Merrin (2008: 8) “it does provide some indirect evidence that 

speculators or investors are able to use ... [existing] instruments and commercial hedge exemptions to 

surpass speculative limits”. 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

32

Table 3.2 

Futures and options market positions, by trader group, 

 selected agricultural commodities, January 2006–December 2008 

(Per cent and number of contracts) 

 Long positions 

 

Percentage share in total positions Average position size 

Speculative

limits

Commodity

NonCommercial 

Commercial Index Nonreporting

NonCommercial 

Commercial Index 

 

Maize 42.4 23.4 22.8 11.3 1134 1499 16260 22000 

Soybeans 42.1 20.4 25.2 12.2 590 1052 6024 10000 

Soybean oil 38.0 28.4 23.8 9.8 790 1719 4418 6500 

Wheat CBOT 39.0 12.3 41.1 7.5 553 964 8326 6500 

Wheat KCBOT 38.1 23.4 21.0 17.5 680 632 1816 6500 

Cotton 41.0 20.1 30.7 8.3 363 1010 4095 5000 

Live cattle 39.3 12.0 39.7 9.0 580 409 4743 5150 

Feeder cattle 42.5 15.7 24.6 17.2 258 162 469 1000 

Lean hogs 36.3 8.7 43.8 11.3 419 712 3983 4100 

Short positions 

Percentage share in total positions Average position size 

Speculative

limits

Commodity

NonCommercial 

Commercial IndexNonreporting

NonCommercial 

Commercial Index 

 

Maize 34.7 47.2 1.2 16.9 618 2469 1579 22000 

Soybeans 36.4 44.6 1.2 17.8 365 1696 736 10000 

Soybean oil 29.1 63.2 0.9 6.7 512 3385 720 6500 

Wheat CBOT 41.7 42.3 3.0 12.9 554 2124 1218 6500 

Wheat KCBOT 20.4 56.0 0.5 23.1 378 1123 221 6500 

Cotton 39.8 54.1 1.0 5.1 380 2706 496 5000 

Live cattle 34.5 43.8 0.7 21.0 456 879 487 5150 

Feeder cattle 34.0 20.9 1.0 44.2 166 150 213 1000 

Lean hogs 38.3 43.1 0.8 17.9 405 1952 353 4100 

Source: UNCTAD secretariat calculations, based on data from CFTC; speculative limits from Sanders, Irwin and Merrin (2008: 25). 

Note: Following the methodology applied by Sanders, Irwin and Merrin (2008), spread positions were added to both long and short 

positions for the percentage shares in total positions. Average size of spread position is not reported here. 

D. Financialization and commodity price developments 

To gauge the link between changes in trading positions and price changes figure 3.5 shows 

for the period 2002–2008 net long non-commercial positions for crude oil, copper, wheat, maize, 

soybeans and soybean oil, as well as the net long index-trader positions for those commodities (wheat, 

maize, soybean and soybean oil) for which the CFTC has published data separately starting in 2006. 

A first finding from this figure is that index trader positions are overwhelmingly taken by market 

participants included in the commercial category, as already indicated in the evidence presented in 

table 3.2. 

However, figure 3.5 provides only scant evidence for a correlation between speculativeposition and price developments. While there clearly are periods and commodities where positions 

and prices move together, especially during the recent downturn and occasionally during the previous 

price upturn, there are other times when positions were not rising during periods of rapid price 
Chapter III – Managing the financialization of commodity futures trading 

33

appreciation. For example, in the wheat market there was no increase in either non-commercial 

positions or index trader positions during the steep price increase from mid-2007 through the first 

quarter of 2008. By contrast, during the same period there appears to be a weak correlation between 

market positions and prices in the maize and soybean markets, while the evidence is mixed for the 

soybean oil market. For oil and copper, where separate data on index trader positions are not 

available, non-commercial positions were declining along prices in the second half of 2008. By 

contrast, evidence for the earlier price increase does not suggest a correlation between noncommercial positions and prices: non-commercial copper positions were declining during the period 

of the sharpest price increases, roughly from the beginning of 2004 through mid-2006. For oil noncommercial positions exhibited strong volatility, even as oil prices rose almost continuously from the 

beginning of 2007 through the second quarter of 2008, by which time net oil positions had dropped 

roughly to zero. 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

34

Figure 3.5 

COMMODITY FUTURES PRICES AND FINANCIAL POSITIONS, SELECTED COMMODITIES, 

JANUARY 2002–DECEMBER 2008 

Crude oil

-80

-60

-40

-20

0

20

40

60

80

100

120

140

01/01/2002 06/01/2004 03/01/2006 01/01/2008

0

20

40

60

80

100

120

140

160

Net long non-commercial positions,

'000 futures contracts (left scale)

Price, $/barrel (right scale)

Copper

-30

-20

-10

0

10

20

30

40

50

60

01/01/2002 06/01/2004 03/01/2006 01/01/2008

0

50

100

150

200

250

300

350

400

450

Net long non-commercial positions,

'000 futures contracts (left scale)

Price, cents/lb (right scale)

Wheat

-100

-50

0

50

100

150

200

250

01/01/2002 06/01/2004 03/01/2006 01/01/2008

0

200

400

600

800

1000

1200

1400

Maize

-200

-100

0

100

200

300

400

500

01/01/2002 06/01/2004 03/01/2006 01/01/2008

0

100

200

300

400

500

600

700

800

Soybeans

-100

-50

0

50

100

150

200

250

01/01/2002 06/01/2004 03/01/2006 01/01/2008

0

200

400

600

800

1000

1200

1400

1600

1800

Net long non-commercial positions, '000

contracts, left scale

Net long non-commercial positions excl. CIT,

'000 contracts, left scale

Net long CIT positions, '000 contracts, left

scale

Price, cents/bushel, right scale

Soybean oil

-60

-40

-20

0

20

40

60

80

100

01/01/2002 06/01/2004 03/01/2006 01/01/2008

0

10

20

30

40

50

60

70

80

Net long non-commercial positions, '000

contracts, left scale

Net long non-commercial positions excl. CIT,

'000 contracts, left scale

Net long CIT positions, '000 contracts, left

scale

Price, cents/lb, right scale

Source: UNCTAD secretariat calculations, based on data from Thomson Datastream and CFTC. 
Chapter III – Managing the financialization of commodity futures trading 

35

Short-term price effects resulting from index traders’ position changes may be misinterpreted 

by other traders as incorporating new market information. More importantly, in the presence of 

uninformed traders that use technical analyses such as trend extrapolation to determine their position 

taking, such short-run effects may well give rise to “explosive extrapolative behaviour” that causes 

speculative bubbles (Gilbert, 2008a, b).11

Such behaviour has been found for the market of non-ferrous metals prices over the period 

February 2003 to August 2008, during which ten months with explosive behaviour were detected 

(Gilbert, 2008a). Similar results were obtained for Chicago grain markets and the period 2006–2008, 

including numerous instances of explosive behaviour of soybean oil (Gilbert, 2008b). The finding of 

explosive behaviour of soybean and soybean oil prices is of particular importance because of the 

pivotal role of soybeans, which are substitutes of wheat and maize in production, of other vegetable 

oils and animal feedstuffs in consumption, and of crude oil in energy. Taken together these results 

indicate that explosive extrapolative behaviour is widespread in commodity futures markets, and that 

this may have contributed to price volatility over recent years. The evidence also suggests “that the 

efficient markets view that uninformed speculation has no effect on market prices and volatility 

should be rejected” (Gilbert, 2008a: 21). 

E. The implications of increased financial investor activities for commercial 

users of commodity futures exchanges 

If the financialization of commodity trading causes futures market quotations to be driven 

more by the speculative activities of financial investors and less by fundamental supply and demand 

factors, hedging against commodity price risk becomes more complex and long-term hedging by 

commercial users may be discouraged. 

To the extent that financial investors increase price volatility, hedging becomes more 

expensive, and perhaps unaffordable to developing country users, as they may no longer be able to 

finance margin calls. For example, during the period January 2003–December 2008 margin levels as a 

percent of contract value increased by 142 per cent in maize, 79 per cent in wheat and 175 per cent in 

soybean on the Chicago Board of Trade (CME, 2008: 17–18). In early 2007, the LME raised its 

margin requirement by 500 percent over the space of a few months (Doyle, Hill and Jack, 2007). 

Larger, well-capitalized firms can afford these increases, but smaller participants may need to reduce 

the number of contracts they hold. This could itself reduce liquidity, add to volatility and discourage 

more conservative investors. Hedging food commodity exposure may become particularly risky 

because of the typically long-term nature of such hedges, corresponding to harvest cycles. Evidence 

reported by the Kansas City Board of Trade (2008) indeed points to a reduction in long-term hedging 

by commercial users at the beginning of 2008, caused by higher market volatility. 

Moreover, since 2006, there have been numerous instances of a lack of price convergence 

between spot markets and futures contracts during delivery for maize, soybean and wheat. The price 

of a futures contract that calls for delivery may differ from the current cash price of the underlying 

commodity, but these prices should very closely match when the futures contract expires. The 

difference between the futures and the cash price (also called “basis”) will tend to widen when storage 

facilities are scarce and shrink when physical supply becomes tight. If, in an otherwise balanced 

market, prices diverge by more than the cost of storage and delivery, arbitrageurs would usually act to 

 

11 Gilbert (2008a, b) argues that commodity prices are subject to explosive extrapolative behaviour if the current 

price is related to the past price through an auto-regressive relationship with an auto-regressive factor slightly in 

excess of unity and if this slight excess prevails only for short periods of time. More formally, tests for explosive 

extrapolative behaviour are based on the following equation: lnft = Į + ȕlnft-1 + İt, where ft and ft-1 are the current 

and past prices, respectively, ȕ is the autoregressive factor, and İ is an error term. 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

36

make the prices converge eventually. Failure to do so causes increased uncertainty about the 

reliability of signals emanating from the commodity exchanges with respect to making storage 

decisions and managing the risk of market positions. This could eventually result in decreased 

hedging, as commercial users seek alternative mechanisms for transferring and managing price risk 

(Irwin et al., 2008). The use of commodity exchanges by commercial users could also decline 

because, in addition to increased uncertainty, the non-convergence of futures and spot prices increase 

the cost of hedging (Conceição and Marone, 2008: 56–57). 

F. Policy implications 

Open-market price discovery and price risk management have traditionally been seen as the 

main benefits that commodity futures exchanges would provide to developing country users. By 

reducing price risk, hedging on commodity futures exchanges was also seen by some as an alternative 

to supply management under international commodity agreements. Meanwhile, commodity exchanges 

have come to assume a broader developmental role as their utility for developing countries has 

increasingly been seen as removing or reducing the high transaction costs faced by entities along the 

commodity supply chains (UNCTAD, 2007b). Given that the financialization of commodity futures 

trading has made the functioning of commodity exchanges increasingly controversial, the question 

that the current financial crisis poses is how the functioning of commodity futures exchanges can be 

improved in such a way that they can fulfil their developmental role. In trying to answer this question, 

it is useful to look at regulatory issues regarding commodity futures exchanges per se, before 

addressing broader international policy measures. 

1. Regulation of commodity futures exchanges 

Most commodity futures trading is executed on exchanges located in the United States, the 

regulation of which is mandated to the CFTC. Commodity exchange regulation has to find a 

reasonable compromise between overly restrictive limitations on speculative position holdings, which 

could impair market liquidity and reduce the hedging and price discovery functions of commodity 

exchanges, and overly lax surveillance and regulation, which would allow prices to move away from 

levels warranted by fundamental supply and demand conditions and, thus, equally impair the hedging 

and price discovery functions of the exchanges. Abuse of futures trading by speculators is addressed 

through the concept of “excessive speculation” defined as trading that results in “sudden or 

unreasonable fluctuations or unwarranted changes in the price” of commodities underlying futures 

transactions (section 4a of the Commodity Exchange Act (CEA)). To limit the amount of speculative 

trading, the CFTC has set speculative position limits, which define the maximum position, either net 

long or net short, in one commodity futures (or options) contract, or in all futures (or options) 

contracts of one commodity combined, that may be held or controlled by one person other than a 

person eligible for a hedge exemption. 

While it is often held that commodity exchanges have generally functioned well, the recent 

very sizeable price changes, occurring sometimes within a single trading day, have given rise to 

greater controversy regarding the appropriateness of regulation. This controversy relates to concerns 

of both the adequacy of information that the CFTC is mandated to collect and the restrictiveness of 

regulation regarding financial investors relative to that imposed on participants with genuine 

commercial interests. The need for tighter regulation has been discussed mainly under the “swap 

dealer loophole”. 

The “swap dealer loophole” has played a particularly important role in the current debate on 

regulatory changes of the CFTC’s regulatory mandates. This is because the greater involvement of 

financial investors in commodity futures trading has significantly increased the positions that swap 

dealers hold in commodity futures contracts. Swap dealers typically sell over-the-counter swaps to 

their customers (such as pension funds buying commodity index funds) and hedge their price 

exposures with long futures positions in commodities. Swap dealers are generally included in the 
Chapter III – Managing the financialization of commodity futures trading 

37

category “commercial traders” as they use commodity exchanges for hedging purposes. This has 

allowed them to be exempted from regulation regarding speculative position limits. But contrary to 

traditional commercial traders, who hedge physical positions, swap dealers hedge financial positions. 

Several proposals have been advanced on how to close the swap dealer loophole. For 

example, the Kansas City Board of Trade (2008) proposes addressing the index fund hedge 

exemptions by limiting their total direct or indirect futures hedge position to a percentage maximum 

in the contracts with a remaining maturity of one or two months, thus creating an incentive to spread 

the total position across several months and ease position concentration. It also suggested changes to 

the definition of a bona fide hedger and a related bifurcation in margin requirements between those 

that have true commercial hedge positions and those that hedge financial positions, as well as to 

alleviate strains to finance margins by accepting commercial agricultural collateral (warehouse 

receipts, etc). Particularly these last two changes would tend to improve the functioning of commodity 

exchanges with respect to participants with truly commercial interest. 

Given the global character of commodity futures trading and the fact that through trading 

arbitrage some contracts involve the jurisdiction of regulatory authorities in more than one country, 

international collaboration of regulatory agencies is required. Such collaboration would involve not 

only the sharing and publishing of information, some of which is already in place, but also more 

enhanced cooperation and greater harmonization in trading supervision.12 It would appear particularly 

urgent that exchanges whose legal basis is London provide data on positions by trader categories 

similarly to those that the CFTC has made publicly available for some agricultural products through 

its COT supplementary reports. Moreover, the product coverage of these supplementary reports would 

need to be enlarged. Product coverage has remained limited because for many commodities traded on 

US-exchanges look-alike contracts can be traded in London. As a result, data on positions on USexchanges provide only a partial picture of the total positions of traders that are active on both the 

United States and London exchanges. Moreover, it would appear that in the absence of such data for 

energy products, legislation enacted in the United States to address the London loophole will fail to be 

effective unless similar data on positions taken on (Intercontinental Exchange) ICE will be available. 

2. International policy measures 

In addition to regulatory issues, the financialization of commodity futures trading confronts 

the international community with the question as to how supply-side measures can address excessive 

commodity price volatility. This issue is of particular importance for food commodities because 

current grain and oilseed stocks are at historic lows so that any sudden increase in demand, or a major 

shortfall in production, or both, will rapidly cause significant price increase. Hence, physical stocks in 

food commodities need to be rebuilt urgently and adequately sized to moderate temporary shortages 

and to buffer sharp price movements and to make speculation much more risky and expensive. 

Holding large inventories around the world has often been judged economically inefficient. In the 

light of the crisis and the role of financial “investors” this position is no longer convincing.

 

12 The Financial Services Authority (FSA), which monitors commodity markets in the United Kingdom, has 

looked at commodity markets as specialised markets which are dominated by professional participants and 

hence require less regulatory attention than equity and bond markets. It supervises firms active in commodity 

markets with a view to ensuring financial stability of market participants such that contract settlement can take 

place on time and without default of any party, and it mandates commodity exchanges to regulate their own 

markets with a view to providing clearly defined contract terms and ensuring freedom of manipulation. In their 

advice on the European Commission’s review of commodity business, the Committee of European Securities 

Regulators (CESR) and the Committee of European Banking Supervisors (CEBS) (CESR, 2008) pointed to 

potential concerns regarding low levels of transparency in OTC commodity derivatives markets, as well as 

regarding the current client categorisation rules and transaction reporting requirements, but concluded that there 

was not much benefit to be gained by mandating through legislation greater pre- and post-trade transparency in 

commodity derivatives markets and that the current practice of how regulated markets report trading was 

sufficient. 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

38

Obviously, the world needs a new global institutional arrangement consisting of a minimum 

physical grain reserve to stabilize markets, to respond effectively to emergency cases and 

humanitarian crisis and an intervention mechanism. Intervention in the futures markets should be 

envisaged as soon as an existing global institution or a “global intelligence unit” (von Braun and 

Torero, 2008) 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” 

(Davidson, 2008). Needless to say, adopting such a mechanism would commit a public agency to 

second-guess market developments and as the agency would need to bet against the positions of hedge 

funds it could itself become a target for speculators, considerations which would have to be addressed 

in its eventual design. 

If a virtual reserve and intervention mechanism could be made to work satisfactorily it would 

not make more physical commodities available on markets, except for emergency situations. Given 

that the historically low level of inventories was one determinant of the abrupt price hike of food 

commodities in early 2008, the question remains how incentives to increase production and 

productivity could be fostered in developing countries, particularly in food commodities, including 

through a reduction in trade barriers and domestic support measures in developed countries. 

G. Conclusions 

Commodity futures exchanges do not function in accordance with the efficient market view. 

There are an increasing number of market participants with sometimes very large positions that do not 

trade on the basis of fundamental supply and demand relationships in commodity markets. The 

evidence to support the view that the recent wide fluctuations of commodity prices have been driven 

by the financialization of commodity markets far beyond the equilibrium prices is credible. Various 

studies find that financial investors have accelerated and amplified price movements at least for some 

commodities and some periods of time. Some of these effects may have been substantial and some 

persistent, but the non-transparency of existing data and lack of a comprehensive breakdown of data 

by trader categories make it difficult to examine the link between speculation and commodity price 

developments directly. The strongest evidence is found in the high correlation between commodity 

prices and the prices on other markets that are clearly dominated by speculative activity. 

These effects of the financialization of commodity futures trading have made the functioning 

of commodity exchanges increasingly contentious. They tend to reduce the participation of 

commercial users, including from developing countries, because commodity price risk hedging 

becomes more complex and because there is greater uncertainty about the reliability of signals 

emanating from the commodity exchanges with respect to making storage decisions and managing the 

price risk of market positions. 

It is unclear whether financial investors will continue considering commodities as an 

attractive asset class. The trading strategy of index investors has proven to be strongly dependent on 

specific conditions (rising or backwardated markets) to be profitable, and it has been fairly 

predictable so that other market participants may make sizeable profits by trading against index 

investors. Hence, financial investors are likely to move away from investing passively in indexes 

towards a more active trading behaviour either by more flexibly determining how and when to roll 

forward positions or by concentrating on other investment vehicles, such as commodity exchange 

traded funds.13 This implies that the distinction between short-term oriented managed funds and other 

financial investors will become less clear. How this affects commodity prices will mainly depend on 

the extent to which such a shift in financial investors’ trading strategy will imply a greater 

 

13 Commodity exchange traded funds are listed securities backed by a physical commodity or a commodity 

futures contract. 
Chapter III – Managing the financialization of commodity futures trading 

39

concentration on specific commodities, instead of commodities as an aggregate asset class. But such a 

potential shift in financial investors’ trading behaviour is unlikely to reduce the relative size of their 

positions which will continue to be able to amplify price movements at least for short periods of time, 

especially if investors concentrate on individual commodities. 

Better regulation of these markets and direct intervention in case of destabilizing speculation 

is needed more than ever before. 

However, the ability of any regulator to understand what is moving prices and to intervene 

effectively depends upon its ability to understand the market and to collect the required data. Such 

data is currently not available. Trading on regulated commodity exchanges and off-exchange 

derivatives trading have become increasingly interdependent. This calls for comprehensive OTC 

reporting and record keeping in order to examine trading information about sizeable transactions in 

look-alike contracts that could impact regulated markets. 

Enhanced regulation of commodity futures markets also entails closing the swap dealer 

loophole to enable regulators to counter unwarranted impacts from OTC-markets on commodity 

exchanges. At present, banks that hold futures contracts on commodity exchanges to offset their short 

positions in OTC swap agreements vis-à-vis index traders fall under the hedge exemption and thus are 

not subject to speculative position limits. Therefore, regulators are currently unable to intervene 

effectively even though swap dealer positions frequently exceed such limits and may represent 

“excessive speculation”. 

Another key regulatory aspect regards extending the product coverage of the CFTC’s COT 

supplementary reports and requiring non-United States, particularly London-based, exchanges that 

trade look-alike contracts to collect similar data. The availability of such data would provide 

regulators with early warning signals and allow them to recognize emerging commodity price 

bubbles. Related stepped-up regulatory authority would allow them to prevent bubble-creating trading 

behaviour from having adverse consequences for the functioning of commodity futures trading. 

To the extent relevant in each case, developing country commodity exchanges may consider 

taking similar measures, though their trading tends to be determined more by local commercial 

conditions than be subject to sizeable involvement of internationally operating financial investors. 

41

Chapter IV 

Exchange rate regimes and monetary cooperation 

A. Introduction: currency speculation and financial bubbles 

The fact that the global financial crisis originated in a relatively obscure corner of the United 

States housing credit system means that it cannot be analysed adequately by just looking at this 

segment of the market while ignoring the huge asset-price bubbles that arose elsewhere seemingly 

independently. These burst almost simultaneously because the subprime credit collapse was the kind 

of idiosyncratic shock that highlighted the exposure to risk in many areas and triggered the sudden 

unwinding of speculative positions in the stock markets, the commodities market and in the market 

for currencies.

In an environment of generally weak national financial regulation and in the absence of a 

rule-based international monetary system, the crisis quickly spread. In this way the uncertainty 

associated with the subprime crisis generated an initial speculative unwinding of open currency 

positions in summer 2007 already resulting in a strong appreciation of the Japanese yen. Since August 

2008 the unwinding of speculative currency positions has led to large depreciations of former highyielding currencies of developed economies (Australia, Iceland, New Zealand), a few emerging 

market economies (Brazil, Turkey, South Africa, Republic of Korea) as well as several transition 

economies (Hungary, Ukraine, Romania) and has put those countries into the spotlight of financial 

markets were currencies are fixed (Bulgaria and the Baltic States). As a result, in November and 

December two economies with formerly fast appreciating currencies and large external imbalances, 

Hungary and Iceland, called for IMF stand-by loans in face of their mounting currency and banking 

crises (IMF, 2008a, b). Likewise, Latvia, whose currency is pegged to the Euro, faced increasing 

interest-rate spreads due to uncertainty about its current account deficit and the mounting foreigncurrency indebtedness, asked for an IMF stand-by arrangement at the end of December 2008 (IMF, 

2008c). Several other countries reached similar agreements, among them Ukraine and Pakistan, and 

many others are expected to come. 

While these currency movements are the result of the unwinding of speculative positions and 

deleveraging of the financial sector at large, currency speculation contributed independently to the 

build-up of the financial crisis. It was encouraged by short-sighted domestic policies as well as by an 

unregulated international financial system that attracts financial investors to leverage the short-term 

opportunities provided by divergent monetary policies in different countries. Indeed, the typical 

configuration of interaction between incoherent global economic policies and private investors has 

been the blueprint for most recent financial crises and financial fragility in emerging market 

economies. 

In this way, large interest rate differentials, typically associated with large inflation 

differentials, create the expectation of high nominal returns for financial investors. The latter are not 

concerned about inflation rates and other real fundamentals as long as they do not constitute a 

perceivable threat to currency stability and therefore to their expected profits over a short period of 

time. The interest rate differential is a plausible starting point for this kind of interest arbitrage 

because short-term interest rates are rather stable as central banks in both countries determine them 

according to actual national inflation and national inflation targets. Moreover, the capital inflows 

induced by nominal interest rates spreads, coupled with an exchange rate that is perceived either as 

being stable or as appreciating on average (even the expectation of depreciation may allow for 

sufficient returns), can have a cumulative effect on the currency market. This effect drives exchange 

rates away from what is traditionally considered by the Purchasing Power and Interest Rate Parity 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

42

theories as market equilibrium and a real exchange rate (the most comprehensive measure of 

competitiveness between countries) that is rather stable. 

Whereas, under a fixed exchange rate or crawling peg regime, hot money inflows may boost 

money creation and credit expansion, a regime of floating exchange rates may induce nominal 

appreciation as well as reserve increases to the extent that the central bank, openly or implicitly, acts 

to contain exchange rate volatility. A nominal appreciation may restrain inflation by reducing import 

prices of intermediate and final goods. But an appreciated real exchange rate penalizes exports, 

deteriorates competitiveness and fosters import growth. 

 In the same vein, speculative flows induced by differentials in returns on assets denominated 

in different currencies, generate unsustainable currency mismatches in the balance sheets of firms, 

banks and even households. While foreign speculators enjoy the larger returns by borrowing in a low 

yielding currency and lending in a high-yielding currency, domestic players access cheap credit in 

foreign low-yielding currencies and invest in higher-return financial, real estate and other speculative 

assets. This may work for a while to the benefit of all players. But those capital inflows lead to real 

appreciation of domestic currencies either via nominal appreciation, price inflation or both and seed 

the sows of the collapse by destroying the competitiveness of enterprises in the capital receiving 

country. Once the loss of competitiveness shows up in huge and rising current account deficits or 

large losses of market shares, devaluation is unavoidable but extremely costly given the widespread 

currency mismatch and the mushrooming debt burden for domestic companies and households (see 

UNCTAD, 2007c; UNCTAD, TDR 2007; and UNCTAD, TDR 2008).

The left panel of figure 4.1 shows the historical carry trade potentials driven by the nominal 

exchange-rate dynamics and the interest rate differentials between the Japanese yen and the Icelandic 

krona. The thick line represents a 3-month interest rate differential between a krona- and a yendenominated asset; the thin line is the exchange-rate change of the krona vis-à-vis the yen for the 

same period. Their sum (the shaded area) is the return on a 3-month (uncovered) lending in the 

Icelandic market by borrowing in Japan in local currencies. Since this return carries the risk of 

exchange-rate changes, it is called “uncovered interest return”. The same logic applies to some 

emerging market economies that have experienced steady appreciations of their currencies despite 

fairly high inflation rates. For instance, the right panel of figure 4.1 makes the case of the Brazilian 

real where real appreciation induced by large interest rate differentials vis-à-vis the Japanese yen 

allowed large speculative gains between 2005 and 2008 (the shaded area). 
Chapter IV – Exchange rate regimes and monetary cooperation 

43

Figure 4.1 

YEN-CARRY TRADE ON THE ICELANDIC KRONA AND THE BRAZILIAN REAL SINCE 2005, 

OVERLAPPING QUARTERLY RETURNS 

Krona

-10

-8

-6

-4

-2

0

2

4

6

8

10

12

123456789101121234567891011212345678910112123456789

2005 2006 2007 2008

Per cent

Uncovered interest return

Nominal exchange-rate change

Interest rate differential

Real

-10

-8

-6

-4

-2

0

2

4

6

8

10

12

12345678910111212345678910112123456789101112123456789

2005 2006 2007 2008

Per cent

Uncovered interest return

Nominal exchange-rate change

Interest rate differential

Source: UNCTAD secretariat calculations, based on data from IMF, International Financial Statistics database; and national sources. Japan 

Interbank (offshore) 3-month, offer rate; Iceland 90-day CB notes, middle rate. Brazil CDB (up to 30 days), middle rate. Data refers to 

overlapping quarterly return. 

Note: A positive change in the exchange rate indicates an appreciation of the currency concerned. For an explanation of differentials, see 

text. 

In the last two decades, currency speculation of the carry trade type has been a recurrent 

phenomenon often associated with banking and financial crises at country and regional levels. The 

Argentinean and Chilean crisis in the 1980s, Mexico in 1994, East Asia in 1997–1998, the Russian 

Federation in 1998, Brazil in 1999, and Argentina in 2001–2002, all culminated in currency attacks 

and found their origins in the build up of financially fragile positions via currency speculation and/or 

widening external imbalances due to unsustainable pegs. Despite some political rhetoric about 

creating a “new international financial architecture”, carry trade has substantially contributed to the 

widening of the global imbalances since the end of the Latin American crisis. For instance, between 

2004 and 2008 the Icelandic krona, the Australian and New Zealand dollars, the Brazilian real, the 

Turkish lira, the South African rand and the Korean won as well as the currencies of some transition 

economies such as Hungary or Romania have experienced persistent trends of appreciation despite 

relatively high inflation rates.14 The carry trade funding currencies, such as the Japanese yen, the 

Swiss franc and the United States dollar, were driven in the opposite direction, depreciation, despite 

very low inflation rates or even deflation as in the case of Japan.

The unwinding of carry trade positions has been typically triggered by changes in 

“conventional focal points” such as the external balance or expected GDP growth, or by the fear of an 

interest rate correction and an exchange rate jump caused, for example, by changing inflation 

prospects of the funding currency. The heightened uncertainty and risk of the new global financial 

climate and the increased fragility of many speculative positions sparked off the most recent period of 

unwinding of carry trade operations. The growing importance of speculation in the process of 

appreciation of exchange rates in countries with relatively “bad” fundamentals reflects the general 

trend of building up of risky leveraged positions in the “search for double digit yields of financial 

investment”. The subsequent “flight to quality” and “the deleveraging fever” is, in the same way as 

 

14 In fact what these economies needed was currency devaluation to compensate for the loss of competitiveness 

associated with the inferior inflation performance. 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

44

for stocks or commodities, just the result of the recognition that the system as a whole could not 

deliver what too many players expected. 

B. The history of different exchange rate regimes 

is of a series of failures 

The dismal experience with floating rates or managed but floating rates in the current 

financial crisis shows, once again, one of the striking inconsistencies of global economic governance. 

On the one hand, a stable exchange rate at an appropriate level is crucial for a successful trade 

performance, growth, employment and the catching-up of developing countries. Sharp exchange rate 

fluctuations have a significant distorting impact on relative output prices, affecting directly trade 

performance. Unforeseen and volatile exchange rate changes represent shifts in the external value of 

money and disrupt the functioning of the global goods markets in the same way as do unforeseen and 

volatile national inflation rates (changes in the internal value of money). On the other hand, most 

attempts to stabilize exchange rates unilaterally have also failed. 

In fact, the adoption of pegged exchange rate regimes is considered to be one of the core 

causes of financial crisis in emerging countries during the 1990s. During the last decade, Argentina, 

Brazil, Indonesia, Mexico, the Republic of Korea, the Russian Federation and Thailand pegged 

unilaterally their exchange rate to an anchor currency, the United States dollar. The goal of the 

unilateral anchoring was to stabilize the external value of money and to force domestic inflation down 

through the channel of competitive pressure on domestic producers through cheap imports. However, 

the latter part of the strategy implied an overvaluation of the home currency even if the country 

succeeded in bringing inflation down (see box 4.1). This overvaluation normally resulted in a loss of 

international market shares and a deterioration of the current account balances. 
Chapter IV – Exchange rate regimes and monetary cooperation 

45

Box 4.1 

Fixed exchange rate regimes and the overvaluation trap 

Regimes of fixed exchange rates or “anchoring” have often been used to stabilize domestic inflation rates. While 

the reduction of domestic inflation has been achieved in many cases, the solution has not proved to be 

sustainable and has ended in crisis very often. Why? This is mainly due to accumulated losses in 

competitiveness or an appreciation (increase) of the real exchange rate. In fact, since the real exchange rate is 

defined as the nominal exchange rate adjusted for the inflation rates in the anchoring and in the anchor economy, 

fixing the nominal exchange rate leads to a situation where the real exchange rate is only driven by changes in 

the price differences. Therefore, even if the country succeeds in reducing its inflation rate gradually, the 

convergence process implies for most of the time positive inflation differentials between the anchoring country 

and the anchor country. This imbalance between the internal and external value of money is reflected in a 

continuous appreciation of the real exchange rate. 

Figure B.1 shows the examples of Ecuador and Lithuania. In both cases, since the beginning of the peg (in the 

case of Lithuania in 1994) and the dollarization (in the case of Ecuador in 2000), the real exchange rate 

continuously appreciates while the inflation rate steadily decreases. The decrease in the inflation rate of the 

anchoring country looks like a domestic success but its price is an external overvaluation. 

Figure B.1 

Experiences with fixed exchange rate regimes, selected economies, 1994–2006 

Ecuador

0

20

40

60

80

100

120

140

1994 1997 2000 2003 2006

REER

0

20

40

60

80

100

Inflation (per cent)

REER Inflation United States Inflation Ecuador

Begin of the dollarization 

process

Lithuania

0

30

60

90

120

1994 1997 2000 2003 2006

Exchange rates

-10

10

30

50

70

90

Inflation (per cent)

REER NER

Inflation United States Inflation Lithuania

Source: UNCTAD secretariat calculations, based on UNCTAD Handbook of Statistics database; and IMF, International Financial Statistics 

database. 

Note: REER is the real effective exchange rate (Index numbers, 2000 = 100). NER is the bilateral nominal exchange rate, calculated as

foreign currency per national currency. The value is scaled, using 0.25 = 40 for Lithuania. In 1994, Lithuania established an exchange 

rate of 0.25 litas per US$1 and switched from the dollar to the euro on February 2002. 

As time passes by, the effects of the overvaluation trap on the anchoring economy become more and more 

visible. The real appreciation leads to an unsustainable situation because the prices of large amounts of goods of 

the anchoring country are higher in international currency than the goods of the anchor country and the former 

constantly loses market shares.15 The unavoidable reduction of exports and the increase in imports eventually 

affects the trade balance and current account. Sooner or later the rising current account deficit accompanied by a 

real appreciation will be interpreted by the capital markets as an indicator for non-sustainability (UNCTAD, 

 

15 The concept of price elasticity of the demand is important to determinate businesses and consumers respond 

to exchange rate fluctuations. 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

46

TDR 2007: 14) and may trigger speculative flows. Therefore, mostly episodes of real exchange rate appreciation 

are followed by abrupt nominal (and eventually real) exchange rate devaluation and the consequent abandoning 

of the peg.

Argentina has been the classical case (figure B.2). In April 1991, Argentina’s currency board established a fixed 

pegging of one-to-one parity between the peso and the U.S. dollar. Its main achievement was to bring inflation 

down from more than 3,000 per cent in 1989 to 3.4 per cent in 1995. However, the real appreciation, which in 

the last stage was fuelled additionally by depreciations of important trading partners like Brazil, had severe 

consequences for the Argentinean economy and its export performance. The system led the economy to a point 

were the peg was no longer sustainable and the national currency had to be depreciated. However, the final 

correction is very costly in terms of output and employment (UNCTAD, TDR 2007: XV). 

Figure B.2 

Overvaluation trap and current account effects in Argentina 

b. Real effective exchange rate and current 

account balances

0

20

40

60

80

100

120

1991 1993 1995 1997 1999 2001 2003 2005 2007

-6

-4

-2

0

2

4

6

8

10

REER (Index numbers, 2000 = 100)

Current account balance in per cent of GDP (right scale)

a. Exchange rates and inflation

0

20

40

60

80

100

120

1992 1994 1996 1998 2000 2002 2004 2006

-5

0

5

10

15

20

25

30

REER (Index numbers, 2000 = 100)

NER

Inflation (right scale)

Source: UNCTAD secretariat calculations, based on UNCTAD Handbook of Statistics database and IMF, International Financial Statistics 

database. 

Note: NER is the bilateral nominal exchange rate, calculated as foreign currency per national currency. The value is scaled, using 1 = 80. 

Any external or political shock could trigger a loss of confidence in the regime and set off an 

avalanche of speculative capital outflows in such a situation. The flight of short-term capital would 

sooner or later mark the collapse of the exchange rate regime, as the monetary authorities trying to 

fend off the attack on the currency have to use precious foreign exchange to buy their own currency. 

However, the reserves of foreign exchange are limited and experienced market participants anticipate 

the depletion of reserves and the final surrender of the Government in the country with the currency 

under pressure to depreciate. That is why the accumulation of foreign exchange reserves is rarely 

sufficient for Governments and central banks to prevail over speculative attacks, even if the amount of 

reserves is huge like in the Russian Federation. 

The global imbalances that have plagued the world for so many years reflect vital systemic 

deficiencies, especially the lack of a viable multilateral financial system that balances the symmetric 

obligations of surplus and deficit countries. These deficiencies in the global economic order did not 

led to deflation earlier owing mainly to the flexibility and pragmatism of United States 

macroeconomic management. Meanwhile, more and more developing countries have followed a 

similar path of adjustment by stabilizing their exchange rate at a relatively low level, running sizeable 

current-account surpluses and accumulating huge dollar reserves. 

While this practice is widely suspected to be sub-optimal, in many respects it represents the 

only feasible way in which developing countries can successfully adapt to the absence of symmetric 
Chapter IV – Exchange rate regimes and monetary cooperation 

47

obligations of surplus and deficit countries. It is no surprise that the “undervaluation-cum-intervention

strategy” (UNCTAD, TDR 2006, chapter I: 10) is especially prevalent among developing countries 

that have gone through currency crises in the wake of liberalization of their financial systems and 

capital accounts. Having learned the hard way that reliance on supposedly benign capital inflows 

rarely pays off as a sustainable development strategy, a growing number of developing countries have 

shifted to an alternative approach that relies on trade surpluses as their engine for investment and 

growth. This strategy presupposes that at least one country in the global economy can afford to run 

the corresponding trade deficit. 

The problem is that the United States became overburdened by having played the lead role as 

global growth engine for so long. It could largely ignore its external imbalance because it created no 

serious conflict with sustaining full employment and price stability. Now the turning point has to be 

found under extremely difficult circumstances, with the world facing a deep recession and the threat 

of global deflation. However, the main reason for the increasingly unmanageable global burden of the 

United States was not the rising numbers of developing countries running current-account surpluses 

per se. Rather, the failure of other key industrial countries, such as Japan and Germany, to do more to 

contribute to the reduction of the global imbalances lies at the heart of the matter. Their huge external 

surpluses, based on improved competitive positions, suggest that the required competitiveness gains 

of the United States needed to reduce global imbalances should mainly come at their expense. This 

recovery process would be greatly eased if it were to occur in the context of buoyant domestic 

demand in these economies. 

In conclusion, the exchange rate must be flexible enough to prevent persistent misalignments 

that would harm the competitiveness of domestic producers and their trade performance. At the same 

time, excessive volatility of the exchange rate must be avoided, as this heightens the risks for longterm investment, increases domestic inflation and encourages financial speculation. The idea that the 

“corners” of absolute fixing or free floating offer a simple way out is flawed. Both corners are based 

on purely hypothetical and unrealistic assumptions. In the case of free floating, it is assumed that 

international financial markets smoothly adjust exchange rates to their “equilibrium” level. In the case 

of a hard peg the product, financial and labour markets would always smoothly and rapidly adjust to a 

new equilibrium at the predetermined exchange rate. In reality, however, exchange rates under a 

floating regime have proved to be highly unstable, leading to long spells of misalignment, with dire 

consequences for real economic activity. The experience with hard pegs has not been satisfactory 

either: as the exchange rate cannot be corrected in cases of external shocks or the failure of domestic 

adjustment, corrections can be extremely costly in terms of lost output, and the setbacks to the real 

sectors of the domestic economy. 

C. Global exchange rate management, trade and investment 

A long run solution for the international financial system has to start with the recognition that 

the exchange rate of any country is, by definition, a multilateral phenomenon, since any rate change in 

open economies produces externalities and multilateral repercussions. Similar to multilateral trade 

rules, a rule-based global financial system would create equal conditions to all parties involved and 

help avoid unfair competition. Avoiding competitive depreciations and other monetary distortions that 

have negative effects on the functioning of the international trading system is gaining more and more 

importance, as the world economy is getting more and more interdependent. 

The existing global economic governance system lacks the institutional arrangements to 

exercise multilateral discipline on exchange rates. Until the early 1970s under the Bretton Woods 

system, the power of markets to generate unexpected and erratic movements in exchange rates was 

constrained by capital controls and the obligation of central banks to intervene in foreign-exchange 

markets in order to maintain exchange-rate stability in normal times. This systematically limited the 

influence of short-term capital flows that were motivated by interest arbitrage. By defining narrow 

exchange-rate bands, the system also limited the ability of Governments to manipulate the exchange 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

48

rates of their currencies. This was intended to prevent beggar-thy-neighbour policies based on 

competitive depreciation, which had been one of the big and eventually damaging policy failures of 

the interwar period of the last century. The Bretton Woods system tried to ensure a balance between 

national policy autonomy on the one hand and multilateral disciplines on the other. To a certain 

extent, formal monetary autonomy was sacrificed for some stability in the financial markets and a 

balanced international trade (UNCTAD, 2007c: 47–48). 

The preceding analysis of exchange rate dynamics shows that the idea of having national 

monetary sovereignty in markets with open borders for goods and capital is an illusion and the 

exchange rate cannot be considered as a tool of domestic economic policy. There is not only, as many 

believe an impossible trinity of national monetary policy autonomy, open capital accounts and fixed 

exchange rates. There is an impossible duality: with open capital accounts national monetary policy is 

no longer autonomous since no exchange rate regime can isolate a country under these conditions. 

Therefore, multilateral or even global exchange rate arrangements are clearly necessary to achieve 

and maintain global monetary and financial stability and to combine such stability efficiently with an 

open trading system. 

An important purpose of the founding of the IMF was to avoid competitive depreciations. In a 

well-designed global monetary system, the need and the advantages of currency depreciation of one 

country would have to be balanced against the disadvantages to the others. Such a multilateral regime 

would, among other things, require countries to justify real depreciations and the dimension of 

necessary changes. If such rules were strictly applied, the real exchange rate of all the parties involved 

would remain more or less constant, as strong arguments for creating competitive advantages at the 

national level would rarely be accepted by the parties that would lose their competitiveness 

(UNCTAD, TDR 2004, chapter V). 

The strength of the case for reform of the current global non-system draws from the huge and 

distorting influence that the present monetary chaos exerts on the effectiveness of international trade. 

An exchange rate system is needed that enables companies in all countries to compete on more or less 

the same terms internationally as they do nationally. Schumpeter (1911) pointed to the importance of 

innovative investment for economic development, and Baumol (2002) argues that innovation, and the 

consequent rise in productivity, account for much of the extraordinary growth record that has occurred 

in various parts of the world since the Industrial Revolution. Both argue that market pressures force 

firms to integrate innovative investment into their routine decision processes and activities. In this 

way, markets are able to produce a stream of more efficient production processes and of products that 

better respond to consumer demand. 

At given wages, successful innovative investment will be reflected in growing market shares, 

if the investor passes on the innovation rents in form of lower prices; or it may lead to (temporary) 

monopoly profits if the investor is able to leave sales prices unchanged and to enjoy innovation rents 

from the rising revenue-cost ratio until competitors succeed to catch-up. At the international level 

very often the link between productivity gains of a single company – based on innovation – and rising 

profits or rising market shares is severed by exchange rate changes. If the exchange rate of the 

currency of a country deviates considerably from the difference of the price level in the home country 

and its trading partners, the mechanism of innovative (or creative) destruction will be distorted. 

Companies in countries with few innovations may thrive because of an undervalued exchange rate 

and vice versa. Companies that display the same cost level as their competitors in other countries may 

lose out because the currency of their country is appreciated and forces them to squeeze their profit 

margins to avoid losses in market shares. 

There is only one exchange rate/price adjustment rule that can restore the level playing field 

for all companies in international trade: nominal exchange rate changes should follow the difference 

in the price levels of the countries involved in international trade. However, nominal exchange rate 

changes appear to explain most of the real exchange rate changes; which implies that nominal 

exchange rate fluctuations do not adjust to relative price changes, in the short run. Figure 4.2 shows a 
Chapter IV – Exchange rate regimes and monetary cooperation 

49

decomposition of the variance of real effective exchange rate (REER) changes into a component that 

depends on the nominal effective exchange rate, a “NEER contribution”, and a component that 

depends on the relative price, a “PEER contribution”.16 The nominal exchange rate contribution to the 

variance of the real effective exchange rate growth is large in all four major groupings of economies, 

confirming that the volatility of the REER has been mostly driven by changes in the NEER. 

Figure 4.2 

VOLATILITY OF REER, PEER AND NEER CHANGES, SELECTED COUNTRY GROUPS, 

SIMPLE AVERAGES, 1993–2008 

0.00000

0.00005

0.00010

0.00015

0.00020

0.00025

0.00030

0.00035

0.00040

1993 1996 1999 2002 2005 2008

PEER

contribution

NEER

contribution

VAR (REER

growth)

Euro area

0.00000

0.00005

0.00010

0.00015

0.00020

0.00025

0.00030

0.00035

0.00040

1993 1996 1999 2002 2005 2008

PEER

contribution

NEER

contribution

VAR (REER

growth)

Emerging market economies in Europe 

and other transition economies

0.00000

0.00005

0.00010

0.00015

0.00020

0.00025

0.00030

0.00035

0.00040

1993 1996 1999 2002 2005 2008

PEER

contribution

NEER

contribution

VAR (REER

growth)

Emerging market (non-Europe) 

0.00000

0.00050

0.00100

0.00150

0.00200

0.00250

0.00300

0.00350

0.00400

1993 1996 1999 2002 2005 2008

PEER

contribution

NEER

contribution

VAR (REER

growth)

Other developing economies

Source: UNCTAD secretariat calculations, based on UNCTAD Handbook of Statistics database. 

Note: The 3 year overlapping variance of REER growth is broken down into two components: a variance component of the PEER growth 

and one of the NEER growth both corrected by the covariance of PEER and NEER growth. Each monthly data represents the variance 

of the growth of the variable over the preceding three years. The scale of “other developing countries” panel is ten times the scale of 

the other panels. 

 

16 The real effective exchange rate, REER, measures the relative price levels of one country vis-à-vis all trading 

partners. It is calculated as the ratio of the weighted average of foreign price indices (each multiplied by the 

relevant exchange rates) and the domestic price index. The nominal effective exchange rate, NEER, is the 

average of one country’s nominal exchange rates vis-à-vis partner countries weighted with their trade shares. 

The price component of the REER is a weighted average of trade partners’ price indices over the domestic price 

index. We can name it PEER, and it is defined as PEER=NEER/REER. 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

50

D. Currency crisis prevention and resolution 

There are four policy implications of the preceding analysis: 

x First, changes in the nominal exchange rate that are caused by “autonomous” capital flows 

(i.e. that are unrelated to the flow of goods) can – very much like protectionist measures – 

fully offset competitive advantages of firms and – likewise – increase the competitiveness of 

otherwise non-competitive companies. 

x Second, nominal exchange rate stability is not sufficient to achieve the level playing field if 

price differentials between countries still deviate.

x Third, as, over the medium or long-term the inflation rate is mainly determined by unit labour 

costs, i.e. the sum of wages that is paid to generate one unit of a product (Flassbeck and 

Spiecker, 2007: 66–70), fixing the exchange rate requires harmonizing labour market 

conditions in the countries involved. 

x Fourth, the ideal of free competition of innovative firms can be achieved in a world with 

inflation differentials and different currencies. However, with the failure of floating and of 

unilateral fixing a multilateral exchange rate framework is needed that pursues rather constant 

real exchange rates among its members. All participating countries should agree that 

competition shall take place at the micro level only and not between nations.

As important as the trade distortion effect of real exchange rate changes is the impact that a 

large deviation of nominal exchange rates from the inflation difference has on the volatility of capital 

flows and on the ability of countries to pursue a growth oriented countercyclical monetary policy. 

This is highlighted by the current crisis. The countries most exposed so far are those that combine 

high current-account deficits with a substantial build-up of foreign liabilities by the private sector and 

have been the victims of carry trade. Triggered by the subprime collapse, this currency speculation 

unwound and caused a sharp depreciation of the nominal and real exchange rates of the affected 

countries.

 While this exchange rate adjustment usually improves the overall international 

competitiveness of a country’s enterprises, which will eventually benefit their external account and 

help the real economy to recover, it entails major adverse balance-sheet effects for households and 

banks, at least in the short term. These short-term effects may cause severe stress in the domestic 

banking sector and a decline in household consumption, with serious consequences for growth and 

employment. A secondary negative impact stems from the efforts of central banks to defend the 

(depreciated) level of the currency through monetary and fiscal tightening at a certain point to contain 

the above-mentioned balance-sheet effects. But such tightening – reminiscent of the IMF-supported 

policy response to the Asian crisis – is jeopardizing their economic recovery and unnecessarily 

tightens the global policy stance now, during one of the most severe recessions of the past century. 

IMF assistance – at times combined with swap agreements or direct financial assistance from 

the EU or, recently, the United States – has helped ease the immediate pressure on the currencies and 

banking systems of the troubled countries. But the origin of the problem – speculation of the carry 

trade type – raises doubts about the adequacy of the traditional IMF approach for tackling such a 

crisis. Raising interest rates to avoid further devaluation is like the tail wagging the dog (figure 4.3) 

because traditional assistance packages or swap agreements, combined with restrictive policy 

prescriptions are clearly pro-cyclical. Indeed, countries that have been exposed to carry trade 

speculation need a real devaluation in order to restore their international competitiveness. They also 

need assistance to avoid a downward overshooting of the exchange rate, which would both hamper 

their ability to check inflation and unnecessarily distort international trade. But they do not need belttightening. Rising interest rates and falling government expenditure will only reinvite speculation and 
Chapter IV – Exchange rate regimes and monetary cooperation 

51

worsen matters in the real economy. In such situations, even countries with current account deficits 

and weak currencies need expansionary fiscal and monetary policies to compensate for the fall in 

domestic demand, as long as the expansionary effects of devaluation have failed to materialize in a 

contracting global economy. 

Figure 4.3

INTEREST RATES, SELECTED COUNTRIES, JANUARY 2007 TO DECEMBER 2008

(Per cent)

0

2

4

6

8

10

12

14

16

18

20

Jan.

07

Feb.

07

Mar.

07

Apr.

07

May.

07

Jun.

07

Jul.

07

Aug.

07

Sep.

07

Oct.

07

Nov.

07

Dec.

07

Jan.

08

Feb.

08

Mar.

08

Apr.

08

May.

08

Jun.

08

Jul.

08

Aug.

08

Sep.

08

Oct.

08

Nov.

08

Dec.

08

United States Brazil Hungary Iceland South Africa

Source: UNCTAD secretariat calculations, based on data from Thomson DataStream. 

Notes: Monthly interest rate refers to the value on the 15th day of the month. Data from December 2008 refers to the value on the 16th day of 

the month. Interest rates refers to Hungary interbank overnight (middle rate), Brazil financing overnight SELIC, Iceland interbank 1-

day, South African interbank call and US Federal funds target rate. 

Stopping an overshooting devaluation – which is the rule and not the exception – is very 

costly if attempted unilaterally, but very inexpensive if countries under pressure to devalue are joined 

in their fight against speculation by countries on the other side of the fence, namely those facing 

revaluation of their currencies. Countries that are struggling to stem the tide of devaluation are in a 

weak position, as they have to intervene with foreign currency, which is available only in limited 

amounts. If the countries with appreciating currencies engage in a symmetrical intervention to stop the 

“undershooting”, international speculation would not even attempt to challenge the intervention, 

because the appreciating currency is available in unlimited amounts: it can be printed. Multilateral or 

even global exchange rate arrangements are clearly necessary to achieve and maintain global 

monetary and financial stability and to combine such stability efficiently with an open trading system. 

E. A multilateral approach to global exchange rate management 

The preceding sections, based on historical and theoretical considerations, laid out the guiding 

principles for a global multilateral financial framework. A set of basic principles derived from the 

analysis above would make a practical implementation of the core ideas feasible and could provide 

monetary and financial stability to all participating countries while restoring the conditions for 

Schumpeterian innovation. To achieve this, a multilateral monetary framework would be based on 

rather free movement of capital and would be governed by strong global institutions. To ensure the 

functioning and the efficiency of such a framework, the following principles need to be applied 

(Flassbeck, 1988; Clarida, 1999; Bofinger, 2000; UNCTAD, TDR, various issues): 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

52

Ensure level playing field – stable real exchange rates: 

x The real exchange rate is kept constant among a group of countries (one region or more). 

Fundamental and long lasting trade imbalances are prevented since all participating countries 

maintain their level of competitiveness.

x Real exchange rates are normally kept constant by way of setting labour market institutions 

that allow steering nominal wages in a way that reflects productivity increases and the growth 

rate of inflation in each country. 

x If nominal wages fail to adjust or if inflation targets diverge, nominal exchange rates need to 

be adjusted to exactly compensate the emerging gap in competitiveness. 

Avoid currency speculation – interest rate parity:

x To avoid large speculation gains in currency markets, nominal exchange rates need to adjust 

to changes in interest rate levels of countries along the interest parity condition (relative UIP 

developments). 

x Even if inflation rates do not converge over time, the reflection of relative PPP in exchange 

rates on a regular basis (monthly or quarterly) will remove most of the incentives for shortterm speculation in currencies. 

Enduring symmetric response: 

x As unilaterally pegged exchange rate arrangements and floating are prone to speculative 

attacks, an international financial system designed to minimize speculative attacks needs to be 

built on a symmetric responsibility that commits interventions to be carried out by the central 

banks of both the depreciating and the appreciating currencies if an exchange rate comes 

under unjustified attack. 

x The country with an appreciating currency has unlimited intervention potential (since the 

means can be printed and the result of foreign exchange market interventions on the domestic 

money market can normally be sterilized). In this case the need to hold foreign exchange 

reserves to “insure” against depreciation pressures is minimal for all individual countries. 

x Symmetric response also means that cost and profits of intervention will be equally shared. 

For instance, the central bank of the appreciating currency will incur a valuation loss of its 

foreign exchange reserves in its own currency, while the central bank of the depreciating 

currency will make a valuation profit of its exchange reserves in its own currency. Likewise, 

cost of sterilization may incur on one side that need to be shared with the partner central 

banks.

Multilateral code of conduct:

x The code of conduct needs to reflect the new sprit of multilateralism in global economic 

governance based on the need to balance the advantages of one country against the 

disadvantages of other directly or indirectly affected countries. 

x The code of conduct ends the competition of nations. It is not countries that should compete 

with each other but companies on a level playing field. 

Global organization of the system: 

x The present Bretton Woods institutions have to be fundamentally redesigned or a new global 

institution with supervisory and advisory powers has to be created and has to practically 

manage the new financial system. 

x Lead currencies have to be found (“planets”); given the economic power shift away from a 

singular economic leader in the post-war financial system, several lead currencies (existing or 

artificial) should be envisaged in today’s multi-polar economic system (figure 4.4). 
Chapter IV – Exchange rate regimes and monetary cooperation 

53

x The lead currencies will be linked with each other through symmetric managed floating 

systems with exchange rates automatically adjusted by relative price differentials (relative 

PPP).

x Regional blocks can be formed (“satellites”) to be linked to one of the “planets” or a group of 

them. Alternatively, individual countries may choose to be associated as “satellites” with one 

or more of the “planets”. 

x Entry and exit criteria will need to be defined a priori and include provisions on domestic 

monetary and fiscal policy. 

Figure 4.4 

EXAMPLE OF A CURRENCY SYSTEM WITH “PLANETS” AND “SATELLITES” 

Source: UNCTAD secretariat visualization. 

The authority managing a multilateral exchange rate system needs to assume a series of 

fundamental responsibilities to ensure its efficient functioning through rules that keep the real 

exchange rate stable. An international monetary authority would need a mandate to enforce such 

regulations, including through adjustments to members’ nominal exchange rates. The surveillance 

function needs to be complemented by an enforcement capacity so as to be able to implement binding 

commitments for necessary adjustments within the system. The authority also has to assume the role 

of a lender of last resort so as to supply liquidity to the system’s members in case of crisis. A common 

currency unit could be envisaged under its surveillance, the seignorage of which would be shared 

among all members. To efficiently face stress in the financial and exchange rate system the managing 

authority will have to assign tasks and responsibilities in a symmetric fashion, i.e. through the 

involvement of the depreciating and the appreciating currencies. At the same time, the institution will 

ensure that costs and profits of symmetric interventions are shared among all parties concerned. 

Finally, the governing institution of the new exchange rate system would act as the highest authority 

for the establishment and monitoring of a true global financial multilateralism. 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

54

F. Conclusion 

In the second half of 2008 the sharp devaluation of the Icelandic krona (51 per cent against 

the United States dollar) has been followed by a larger wave of currency depreciations, such as of the 

Hungarian forint (34 per cent), the South African rand (38 per cent), the Brazilian real (34 per cent), 

the Turkish lira (33 per cent), the Mexican peso (29 per cent) and the Chilean peso (28 per cent). 

Many others are likely to follow in 2009, for instance in Eastern Europe, where the pressure on 

currency markets has been ever-increasing over recent months. Countries like Estonia, Lithuania, 

Rumania and Bulgaria are under rising distress and the region as a whole is now under serious danger 

of economic meltdown. 

But the combination of huge current-account and budget deficits, devaluation pressures, 

sometimes pegged exchange rates and diminishing foreign exchange reserves lead to the same old 

policy prescriptions of austerity again and again. It is high time to act and break this vicious cycle. 

Countercyclical macroeconomic policies – enabled and supported by a global multilateral financial 

framework – are urgently needed. 

The bold departure proposed here is needed not only to counter the adverse effects of the 

current global financial crisis, but also to prevent similar crises in the future. It is clear that vulnerable 

countries in crisis do not need assistance packages that oblige them to fiscal austerity and restrictive 

monetary policy measures. Just as the advanced economies need expansive monetary policy and fiscal 

stimulus to break the negative feedback of the financial crisis on economic activity, so do developing 

countries, transition economies and emerging markets. They all need a combination of financial 

stabilization with expansive monetary and fiscal polices. In the absence of such a policy mix more and 

more countries will quickly end up on the verge of collapse. 
55

Chapter V 

Towards a coherent effort to overcome the systemic crisis 

A. More and better coordinated countercyclical action is needed 

Despite the desperate attempts of a number of Governments to contain the fallout of the crisis, 

it has spread to many regions and sectors. In fact, the global deleveraging process cannot be easily 

stopped as the speculative positions of millions of independent entities in a number of important 

markets unwind and the brutal logic of debt deflation brings new shocks every day. In addition, the 

near meltdown of the United States financial system and beyond has deeply shaken the belief that 

business as usual will soon return to the markets. Instead, fundamentally diminished expectations 

have emerged concerning the yields that can be achieved without engaging in overly risky 

investments. 

At the beginning of 2009 the world economy is in a deep recession. The uncertainty about 

financial conditions in the near future and about the dramatic changes in relative prices of stocks and 

flows all around the world has impacted on investment in fixed capital and the demand for 

manufactured goods in a manner not seen in living memory: indeed, the world seems to face “the 

crisis of a century” (UNCTAD Policy Brief, 2008a).

 Global GDP is expected to fall in 2009. This is a dramatic setback from recent global growth 

rates, which were consistently above 3 per cent for several years. Although this is mainly owing to 

deep contractions in the developed world (-2 per cent), a considerable slowdown in growth rates in 

developing countries and transition economies (to 3 per cent) contributes to the dismal outcome. In 

Africa in particular, the consequences of the fall of commodity prices hit the real economy, whereas 

countries with a large manufacturing export sector like those in the populous East Asian region suffer 

from sluggish demand. Eastern Europe economies are trapped by their exposure to debt in foreign 

currencies and the devaluation of their own currencies. With inflation rates sharply down in most 

countries of the world and sustained downward pressure on wages, deflation, not inflation, is the main 

economic policy challenge for the years to come. Fears that “too much money” or rising government 

deficits could soon spark a new round of inflation are unjustified, misleading and could be dangerous 

in the current depressed economy. 

The decline in economic activity is unusually strong and parallel across economies. 

Obviously, the world is not witnessing the kind of cyclical decline as occurs once every few years. 

This time the downturn is driven by an unprecedented rapid deleveraging on a global scale, which 

means that billions of creditors and debtors have to adjust to fundamentally changed circumstances 

compared to their expectations. Additionally, changes in relative prices occur at a breathtaking speed. 

As many markets were overvalued at the same time, the correction is sweeping. It started with house 

prices, stocks followed, commodity prices were next and foreign exchange markets turned around in 

the unwinding of carry trade operations. 

In addition to the financial strain, the loss of a solid foundation for expectations and planning 

paralyzes investors. While from a microeconomic point of view it is useful to wait and see in such 

volatile markets, these individual holding strategies worsen macroeconomic situations by the day. To 

be sure, the deleveraging and the normalization of prices are necessary and unavoidable. In most cases 

prices will be better in line with the underlying fundamentals of supply and demand after the 

unwinding. However, the short-term effects of the gyrations in prices and exchange rates are dramatic. 

The exposure of households and enterprises to risky assets and liabilities in many cases is big enough 

to justify immediate default. 

Current public fire-fighting thus entails the difficult balancing act of letting the fire consume 

what is in any case unsalvageable, while also protecting those parts of the edifice that are most vital 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

56

and that can eventually be rebuilt (UNCTAD Policy Brief, 2008b). Therein the task of Governments is 

of a threefold nature: First, they have to restore confidence on the national and international financial 

markets to ease the flow of liquidity and credit and re-ignite global demand. This is a time-consuming 

process. It started early on in the crisis, but neither can highly unsettled credit markets be expected to 

recover overnight, nor can generous liquidity alone ensure recovery. Second, they have to apply 

pragmatic and strong countercyclical macroeconomic measures to fight the resulting global downturn. 

Third, they have to undertake the most urgent regulatory measures now to stabilize relative prices in 

the global economy by preventing new rounds of destabilizing speculation. 

In fact, in developing countries and some emerging economies, central banks have acted 

swiftly and in a rather coordinated fashion to tackle the crisis. From the start the FED did not only 

provide liquidity into the interbank market, but also slashed interest rates dramatically to provide 

monetary stimulus for the real economy. The Bank of England followed suit, in line with many other 

important central banks. Only the ECB hesitated to cut interest rates, although it provided additional 

liquidity to the system. 

As a result, the United States have no room for further interest rate cuts with virtually zero 

interest rates after the latest cut on 16 December 2008 to 0.125 per cent. The same is true for Japan 

with an interest rate of 0.1 per cent. But Europe, both the euro area and the United Kingdom, still have 

some room for manoeuvre left even as interest rates nudge downwards. By contrast, China’s scope for 

further expansionary monetary policy with a current benchmark-lending rate of 5.31 per cent is still 

substantial. Much more, China’s monetary policy draws heavily on non-interest rate based monetary 

tools such as window guidance, which can be employed in addition to further interest rate cuts. 

With the limits for further monetary easing approaching, massive fiscal stimuli are 

inescapable if global demand is to be boosted. The United States has followed up on its first fiscal 

stimulus of early-2008 with a package worth up to $800 billion in 2009 and 2010 (which amounts to 

2.5 to 3 per cent of GDP per year). Of this amount some two-thirds will go directly into public 

investment and one-third into tax cuts. Such a mixture is reasonable as tax cuts are generally less 

efficient than investment programs for companies because private households tend to save more in the 

crisis for precautionary motives. 

Countries with large current account surpluses and sluggish domestic demand must act more 

aggressively than countries with external deficits. This is particularly true for a number of economies 

in Western Europe and for Japan. In the euro area Germany is in an excellent position to use fiscal 

policies due to low deficits, low interest rates and one of the largest current account surpluses in the 

world. Recently, the Government announced a second fiscal package of up to euro 50 billion for 2009 

and 2010 (reaching a planned combined stimulus for 2009 of around 1 per cent of GDP). But more is 

needed and with a greater focus on public investment rather than tax cuts and other indirect measures 

that are likely to be saved and not spent. China, with the second largest current account surplus seems 

to be ready to capitalize on its favourable external and budgetary position by realizing a large-scale 

plan for fiscal stimuli. These plans could add up to 10 per cent of China’s GDP during the two-year 

period of 2009 and 2010. At this size it would also help to support global demand (UNDESA/UNCTAD, 2009). 

The scope for counter-cyclical policies among smaller developing countries and countries in 

transition varies greatly. Many countries with current account deficits and a weak currency are pushed 

by their creditors to lean towards pro-cyclical macroeconomic policies with high interest rates and 

fiscal conservatism. However, a departure from the traditional policy practices and policy rules is 

warranted, indeed indispensable.

As the pro-cyclical policy stance is the result of concerns over the threat of further currency 

depreciation the international community must allow these countries the room of manoeuvre to 

stabilize their real economies. This can be done best by way of creating unconditioned international 

assistance to stabilize devaluing currencies at a certain point by direct intervention of the countries 
Chapter V – Towards a coherent effort to overcome the systemic crisis 

57

with revaluing currencies. To enhance their scope for counter-cyclical responses further, 

compensatory financing, reserve swaps and additional and reliable foreign aid flows should be made 

available immediately. Only if all countries can cope with declining export earnings and reduced 

access to private capital flows the world as a whole be able to quickly overcome the global crisis. 

International coordination is indispensable to fighting the onset of global depression as well 

as to dealing with the root causes of the slump. If some countries or regions start to “free ride” on the 

attempts of other Governments to lean against the winds of recession and depression by deficit 

spending a global depression cannot be ruled out. Any kind of competitive devaluation of currencies, 

wage cuts and/or protectionist measures would be disastrous at this juncture.

B. The State is back but national action is not sufficient 

1. Preventing the competition of nations 

The involvement of many markets and of many countries shows that blaming greed and 

irresponsible behaviour of individuals is a road to nowhere. The global community has erred in the 

belief that in a highly interdependent world with financial markets closely linked by modern computer 

technologies each country can go it alone and find its way despite many pitfalls and “fallacies of 

composition”. But not all countries can improve their competitiveness, generate a current account 

surplus and gain market shares: one’s advance is another’s retreat. Competitiveness in a global 

economy is a zero sum game. 

For rising economic welfare to be sustainable, it has to be shared without altering the relative 

competitive positions of countries. Companies that gain market shares at the expense of other 

companies form an essential ingredient of the market system. If the overall efficiency of production 

rises in this process, workers who are negatively affected by corporate competition can find jobs 

elsewhere in the economy due to higher demand and higher growth. But if nations gain at the expense 

of other nations, dilemmas can hardly be avoided. If the “winning” nations are not willing to give up 

their superior position and to allow a full rebalancing of competitive positions over the long run they 

force the “loser” nations into default. This is the phenomenon that J. M. Keynes called the “Transfer 

Problem” some 80 years ago. Its logic is still valid. If it were better understood it would provide a 

reasonable path through the coming jungle of open protectionist tendencies and hidden attacks on “the 

other”, who tries to defend what he perceives as his national interest. 

Globalization of trade and finance calls for global cooperation and global regulation. To hold 

that even in the midst of the crisis, free international trade in goods and services must be preserved 

and the liberalized rules-based multilateral system must be protected while denying that is the right 

approach for global finance is incoherent and threatens to further destabilize fragile global 

imbalances. It is the failure of Governments to deliver effective global governance that is to blame 

foremost for the current global predicament. Resolving this crisis 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. 

 At the national level new concepts for economic development have to be designed that can 

better balance spending excesses in deficit countries and export excesses and long-lasting underconsumption in surplus countries. The most important rule to be followed is to use domestically 

generated productivity increases for domestic purposes through the full participation of all economic 

agents in the productivity gains. Moreover, all countries that want to share the potential benefits of 

trade and foreign direct investment have to understand that the creation of level playing fields for the 

competition of companies is a desirable target but that competition of nations is a useless and 

dangerous concept. As UNCTAD pointed out in 2007 (UNCTAD, 2007d): all countries can 

simultaneously raise productivity and wages and the level of trade to improve their overall economic 

welfare if they follow consistent rules. 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

58

To avoid the fight for market shares through manipulation of the exchange rate, wage rates, 

taxes or subsidies and to prevent financial markets from driving the competitive positions of nations 

into the wrong direction, a new code of conduct is needed regarding the overall competitiveness of 

nations. Such a code of conduct would have to balance the advantages of one country against the 

disadvantages of other directly or indirectly affected countries. For example, the effect of changes in 

the nominal exchange rate deviating from the fundamentals (inflation differentials) on trade balances 

is not much different from that of tariffs and export bounties. Consequently, such real exchange rate 

changes have to be subject of multilateral oversight, negotiations and decision-making. Only if such 

rules apply, can all trading parties avoid unjustified overall loss or gains of competitiveness and 

developing countries can systematically prevent the trap of overvaluation that has been one of the 

most important impediments to prosperity in the past. 

2. Intervention in financial markets is indispensable 

In financial markets that are in full speculative swing, nearly all participants follow the same 

pattern of expectations based on similar information. This uniformity creates manias and panics and 

huge systemic risks. In a boom phase, there are too few short sellers; and in a bust phase, too many 

(UNCTAD Policy Brief, 2008a).17 But the similarity of the behaviour of many financial market 

participants and the limited amount of information that steers them opens a gate for fully justified and 

non-distorting government intervention. Contrary to atomistic goods and services markets and the 

colossal quantity of independent data that help to form the market price there, financial markets are 

characterized by what could be called oligopolistic information sharing. 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. 

There has long been a debate in economics concerning the “equilibrium price” in these 

markets and the incompetence of Governments in identifying it and guiding the market to reach it. But 

that argument misses the point: Even if well-informed Governments and central banks do not exactly 

know the equilibrium price they usually do know when prices are in disequilibrium (Williamson and 

Subramanian, 2009). In other words, the fact that Governments have only a very rough idea about the 

equilibrium price is not a convincing argument against intervention, as we have learnt now that 

markets do not only have no idea, in fact they are systematically driving the price away from 

equilibrium. Take commodity prices: If the oil price doubles in a couple of months Governments and 

international organizations urge the oil producers to increase supply and in this way intervene in these 

markets, obviously, that means they know that the price is far beyond equilibrium. 

The same is true for many other markets. Take currencies and exchange rates: Some 

Governments criticize other Governments for intervention to keep the rate at an undervalued level; 

obviously they pretend to know a price that is closer to equilibrium. Moreover, if exchange rates 

move in the opposite direction of what is needed to restore the international competitiveness of the 

overall economy, alarm bells should ring and urge government action in both affected countries to 

stop this kind of speculation. Take housing: If for most mortgage contracts in a country to be 

serviceable house prices must rise for the next 20 years or so, Governments should know that 

something has gone wrong and will go wrong if they do not stop this speculative bubble. Take stocks: 

If the valuation of companies goes far beyond traditional valuation measures like the price earningsratio or implies exploding earnings in an environment of a cooling overall economy, Governments 

and central banks know that by intervention through interest rate increases they do less harm than 

good. Take mergers and acquisitions through private equity funds: As the business model of these 

funds is built on short-termism, namely the leveraging of returns through “equity debt swaps”, 

 

17 Schumpeter (1939: 51) put the phenomenon of the necessary “friction” in the following way: “Just as the 

physical world would be an uninhabitable chaos if the slightest difference in temperature sufficed to transfer all

heat instantaneously to the region of the minimum, so the economic world could not function if, for example, 

the slightest variation in a rate of exchange sufficed to set all gold flowing at once”. 
Chapter V – Towards a coherent effort to overcome the systemic crisis 

59

Governments should know that this business model - if used on a large scale - may dramatically 

increase the systemic vulnerability of the economy in times of stress and downturn. 

C. No “crisis solution” by markets 

The events of recent months have revealed a huge misallocation of resources and a 

destruction of enormous values driven by financial markets. The lesson is simple: macroeconomic 

prices are too important to be left to the vagaries of these markets. However, if the failure has 

shattered the naïve belief that unfettered financial liberalization and deliberate non-intervention of 

Governments will maximize welfare, or functional efficiency, the crisis offers an opportunity for a 

new start. Governments, supervisory bodies and international institutions have a vital role to play to 

allow society at large to reap the potential benefits of a system of decentralized decision makers. Only 

consistent and forceful interventions in financial markets by institutions with knowledge about 

systemic risk can transform a system of atomistic markets for goods and for services into an 

efficiently functioning entity. Market fundamentalist laissez faire of the last twenty years has 

dramatically failed the test. 

Interventions in financial markets that are part of the global economy call for cooperation and 

coordination of national institutions and for specialized institutions with a multilateral 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 over 

the coming process of reform and indeed over the fate of whole nations would seem inappropriate. 

For example, as we shown in the previous chapter, it is indispensable to stabilize exchange rates by 

direct and coordinated government intervention instead of letting the market find the bottom line and 

trying to “convince” financial markets about the credibility of the Government of the depreciating 

currency through pro-cyclical policies like public expenditure cuts or interest rate hikes. 

Once this is done, the problem of newly issued government bonds at “penalty” rates that are 

demanded by the “markets” can be tackled. The paradox that the same market participants that have 

driven Governments of many countries into a disastrous budgetary and current account situation now 

ask for “risk premia” because they do not trust these Governments any more and fear government 

default, has to be answered by the global community of Governments in a strong and clear manner. It 

is very rare that the Governments of the adversely affected countries alone are responsible for 

financial failure, while Governments of the unaffected countries are very rarely blameless in this 

regard. As Keynes (1919: 142) once put it: “In the great events of man’s history, in the unwinding of 

the complex fates of nations, justice is not so simple”. 

A global answer should follow the same principle: If everybody defaults nobody defaults. 

Only if some countries try to avail themselves of the opportunity to get cheaper credit at the expense 

of others, the “markets” have a choice and can demand a “risk premium” from the more vulnerable 

ones. If every country and every Government acknowledges that the global crisis is foremost a 

systemic crisis, i. e., due to the failure of the global community to govern the globalized economy 

properly, a truly global solution like a global bond that can be used by all countries at fixed exchange 

rates is less utopian than it sounds. 

In the same vein, a cooperative effort is needed to address all the different sorts of predatory 

speculative activities that have been responsible for the distortion in national and international price 

relations have to be tackled at the same time to avoid speculative arbitrage. The tragedy of the modern 

forms of speculation is their very short half-life: the more people on the globe concentrate on 

speculation in certain markets and the more effective they are, the quicker the results will be 

contradicted by economic reality because the real economic system can no longer bear the burden of 

largely distorted prices and exchange rates. 
The Global Economic Crisis: Systemic Failures and Multilateral Remedies 

60

That is why all the weaknesses in speculative activity have to be tackled at the same time. For 

example, dealing only with the national aspects of re-regulation to prevent housing bubbles and the 

creation of risky assets related to this area would only intensify in other areas like stocks. Preventing 

currency speculation through a new global monetary system with automatically adjusted exchange 

rates might redirect the short-term games towards commodities 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. 

It is obvious, a coherent and effective approach can only be found at the international level 

and with the inclusion of as many countries as possible. A broad international agreement about the 

distortional effects of large-scale speculation in different areas on growth and employment is 

absolutely crucial to create the framework for a globalization that has the potential to deliver rising 

living standards for all. 
61

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Key messages

National and multilateral remedies

Global economic decision-making