Jean-Claude Trichet: The global dimension of the crisis
Speech by Mr Jean-Claude Trichet, President of the European Central Bank, at the Foreign
Correspondents' Club of Japan, Tokyo, 18 April 2009.
* * *
Ladies and gentlemen,
I would like to thank Foreign Correspondents' Club of Japan for inviting me to talk about the
global financial and economic situation and outlook. It is for me a great pleasure to be in
Japan, and an opportunity to reflect about the financial crisis. Japan is indeed a striking
example on how a crisis that started in a segment of the US financial markets eventually
spread all over the world: while Japanese financial institutions' limited exposure to the US
sub-prime market allowed Japan to relatively withstand the first period of the turmoil, the
intensification of the crisis as of September 2008 also impacted significantly the Japanese
economy through multiple channels. A broadly similar pattern holds true for the euro area,
and ultimately also for the emerging market economies. In my address to you today, I will
take a global perspective on the crisis, its root causes and the policy response.
What the crisis has changed and how fast
One striking aspect of the current crisis is how quickly it has reversed some of the features of
the global economy that seemed well-performing in recent years, at least to many observers.
Let me highlight four areas were we have seen changes as being particularly abrupt. These
areas are housing, finance, trade and international capital flows. In all these areas, what
looked like an established trend that economic agents relied on has changed very quickly,
triggering a chain of reactions that few people had anticipated and leading policy makers to
take prompt and decisive action:
• First, the mortgage market meltdown in the United States disproved the previous
thesis that house prices would not fall nation-wide. Such belief was widely shared
among investors and misled them to lend abundantly to households that did not have
sufficient resources. There are of course different ways to compute the change in
house prices; according to some measures1, house prices in the United States nearly
doubled in nominal terms between the early 2000 and 2006. The subsequent fall in
US house prices (by an estimated 25% in two years) has fuelled delinquencies and
foreclosures and led to the dramatic fall in the price of asset backed securities, which,
alongside other factors, now plagues the balance sheets of so many financial
institutions.
•
Second, the major financial shock of mid-September 2008 put the world economy on
a completely different path by triggering a broad-based reappraisal of risks and a
global fall in confidence. This has led to a strong commitment by all relevant world
policy makers to no longer let any systemically relevant financial institution fail.
•
Third, international trade flows, which had grown very robustly in recent decades
thanks to waves of liberalisation, have suddenly abated towards the end of 2008 and
then strongly contracted in some areas, further propagating the effects of the crisis
across countries. According to projections by international institutions, world trade is
anticipated to shrink in 2009 for the first time since 1945.2 In the last quarter of 2008,
real exports fell by 6.5% in the United States, by 6.7% in the euro area, by 13.8% in
Japan and by an estimated 10% in China: these numbers stand in sharp contrast with
developments in the past decades. During the 1990s, world trade rose by around 7%
on average each year. In addition to the magnitude of the contraction in world trade,
its suddenness is also very noticeable as trade fell markedly in the last quarter of
2008, immediately after the intensification of the crisis in mid-September. Related to
this, the broad consensus in support of free trade, which has prevailed in past
decades, has to be preserved with reinforced determination, whilst risks of
protectionist pressures are mounting in many countries. I therefore strongly welcome
the commitment taken by the G20 to notify promptly the World Trade Organisation
(WTO) of any such measures, with the WTO then reporting publicly on adherence of
G20 members to their pledge not to repeat the historic mistakes of protectionism
made in previous eras.
•
Fourth, another type of international flows that has contracted sharply is financial
private flows to emerging economies, leading to balance of payment strains in some
of these countries. It is estimated that net private capital flows to emerging and
developing economies fell by a factor of 6 between 2007 and 2008. Again, balance of
payment strains had by many observers been dismissed as memory of the past. The
International Monetary Fund (IMF), which not long ago was facing a problem of falling
resources because fewer programs had been launched, has in most recent times
been confronted with the opposite problem - an issue also tackled by the G20, who
agreed at the London Summit to treble IMF resources.
These examples illustrate how massive the problems were, which were building up under the
surface of the global economy. One key word here is synchronisation. I have mentioned how
quickly trade and financial flows, which used to act as powerful drivers of globalization, have
abated at the end of last year, further propagating the effect of the crisis across borders.
What was remarkable in the "boom" period between 2004 and 2007 is not only the fact that a
large number of economies was growing very fast, but also the fact that virtually no country
was left behind: all systemically important economies registered positive growth rates.
Similarly, in this crisis, all regions are affected, albeit, again, to a different extent, and all
economies are going through one of their most difficult episodes in decades.
The root causes of the crisis
Let me now turn to the root causes of the crisis. The present crisis cannot be easily
explained by one or two factors; rather, a combination of micro and macro factors has been
at play.
Micro factors, related to insufficient financial oversight and massive underestimation of risk,
are the immediate cause of the financial crisis as I have already stressed on earlier
occasions. I will argue, however, that macro factors are important for explaining the
emergence of the crisis, as they have created the preconditions for micro factors to unfold.
Structural factors, global imbalances and risk premia
Generally, the macro root causes of the financial crisis can be associated with two
measurable developments: low risk premia and the accumulation of global imbalances. I will
argue that there is an interplay between these two developments that help us to understand
the relationship between macro fundamentals and the emergence of the financial crisis.
The first measurable development relates to the price side and is reflected, as I mentioned
before, by exceptionally low risk premia in virtually all markets. Of course, one could
provide specific explanations to any particular market that could rationalize the decline in
individual risk premia. One striking feature has been, however, the persistent and
synchronized decline in risk premia across all markets. Estimated risk premia in the
stock market before the intensification of the crisis in September 2008 were one third and
two thirds below their values at the beginning of the 1980s, in the euro area and the US
respectively. Term premia in bond markets had lost before the crisis three fourth of their
estimated value at the middle of the 1990s. The premium for investments in houses has
followed a similar trend in particular in the United States. Finally, the cost of corporate
borrowing in excess of a riskless rate, which remunerates credit risk, had also decreased
significantly in both economies. Obviously, we observed the same movements across all
markets.
Facts common to multiple markets suggest the existence of a common factor: one of
these common factors, I will argue, was the lack of sufficient medium-term orientation
of global macro policies.
A second measurable macro development on the quantity side is the accumulation of "global
imbalances". The expression "global imbalances" refers to saving-investment imbalances
within - and external imbalances among - a number of systemically relevant countries,
which were unsustainable over a medium- to long-term perspective.
Conceptually, it is helpful to separate the drivers of global imbalances into structural and
cyclical components.3
Structural issues have been at play in the development of imbalances in advanced
economies. While main distortions were to find at the micro level, they had important
macroeconomic implications. As argued before, insufficient oversight of financial markets
in advanced economies, which ultimately allowed for the originate-and-distribute banking
model to develop, led to a separation of those holding credit risks from those monitoring and
managing them. The resulting excessive focus on near-term returns led to a misjudgement of
the underlying risk, and created wrong incentives for originators. Such an environment
created the conditions for the observed herding behaviour, in which risk control easily
became a secondary issue. At the same time, rapid financial innovation and the emergence
of new, non-standardised structural products made the risk assessment difficult for rating
agencies, leading to considerable underpricing of the embedded unit of risk and to biased
expectations about the evolution of asset wealth. Ultimately, at the macro level, this
system led to an inefficient allocation of capital and resulted in very low savings rates
in some systematically important advanced economies.
Structural factors have dominated the emergence of excess savings in emerging Asia.
The latter happened in a context of quickly rising incomes, growing productivity and
commodity prices in emerging economies, and was partly attributable to structural factors
such as:
•
the propensity of residents to accumulate precautionary savings due to lacking
welfare provisions; and
•
relative financial underdevelopment.
Recent studies show4 that the lower degree of financial development in emerging
economies, compared with mature economies, has been one important driver of capital flows
to mature economies. In fact, the lack of supply in "safe" financial assets in emerging
economies can trigger capital flows to regions that are able to produce the desired assets.
Evidence indeed confirms the large scope for emerging economies to catch up in financial
terms, while at the same time pointing to an accelerating pace of financial development since
the late 1990s in most of these countries. In particular, in the past decade the funding of
emerging economies in domestic financial markets has been increasing at a much faster
pace than in the advanced economies. As a result, in 2007 the funding of emerging
economies in domestic markets accounted for about half the ratio observed in the EU, the
US, and Japan - compared with less than one third of the ratio in 1998.
Indeed, some of these structural factors can be addressed by proper policies
implemented over sufficiently long-term horizons. For instance, the provision of public
goods in emerging economies to increase the degree of social security would reduce
uncertainty and precautionary savings motives. Similarly, further development of efficient and
liquid domestic financial markets would contribute to somewhat lower savings and better
channel them to domestic investment.
Globally, very low risk premia coupled with limited volatility created the macro preconditions
that encouraged the global "search for yield". Of course, the progressive build-up of systemic
risk via a generalised underestimation of the quantity of risk that pushed risk premia to
unsustainably low levels was in particular permitted by the inefficiencies in financial market
regulations.
The associated "underpricing of the unit of risk" fuelled the overpricing of house and financial
assets and encouraged the creation of ill-designed and not transparent structured financial
products. More generally, it led to a widespread deterioration in lending standards and credit
quality and increasing confidence in leverage activities in several mature economies.
The policy response
How have economic policies responded to the current crisis? The current crisis has shown
that there is a need for more rigorous regulation of the global financial system. Such
regulation needs to meet two fundamental requirements. First, it needs to prevent the
excessive risk taking that we have been observing in financial markets over the past years
and that led to the creation of asset price bubbles and large imbalances in the global
economy. At the same time, it needs to create an environment that is conducive to
sustainable growth for our economies in the long run. In this respect, I should remind that a
process of multilateral surveillance of global imbalance had been agreed and put in place
under the aegis of the IMF; while a clear diagnosis of the sources of these imbalances and
the necessary policy responses emerged among the relevant partners, it is clear that
engaging resolutely in the implementation of the pertinent policy prescriptions remained
extremely difficult before the crisis erupted.
The international community has swiftly reacted to the need for greater coordination of
policies and regulation of international financial markets. In this respect, it is worth coming
back to the outcome of the recent meeting of the G20 in London. Governments have agreed
to establish a new Financial Stability Board (FSB) with a strengthened mandate and enlarged
membership, as a successor to the Financial Stability Forum (FSF). New principles on
remuneration will be implemented to guarantee the sustainability of compensation schemes
and to prevent the financial market participants from focussing excessively on short term
returns. Regulation and oversight will be extended to all systemically important financial
institutions, instruments and markets. This will also embrace, for the first time, systemically
important hedge funds. The FSB will co-operate with the International Monetary Fund (IMF)
to identify systemic economic and financial risks. At the same time, the international
community has agreed to triple IMF resources to 750 billion US dollar and to support trade
finance for an amount of 250 billion US dollars. The sheer size of these commitments clearly
shows that the international community is determined to prevent a retrenchment of global
capital and trade flows and to guarantee the stability of the international financial and
economic system.
National governments have in addition undertaken an unprecedented concerted fiscal
expansion to stimulate demand and foster confidence in our economies. Governments have
also decided on a broad set of measures to support the banking sector and strengthen the
stability of the international financial system. These measures include the injection of new
capital, guarantees on bank debt and deposits, as well as large-scale schemes that aim at
coping with the issue of impaired assets. For example, governments in the euro area alone
have committed more than 2 trillion euro in the form of capital injections, liability guarantees,
impaired asset relief and funding guarantees, which altogether corresponds to around 23%
of euro area GDP.
I thank you for your attention.