UNPRECEDENTED INTERDEPENDENCIES … BUT STILL CONTRASTED NATIONAL WAYS OUT OF THE CRISIS

1. UNPRECEDENTED INTERDEPENDENCIES …BUT STILL CONTRASTED NATIONAL WAYS OUT OF THE CRISIS Robert Boyer Visiting Professor at International Center for Business and Politics, Copenhagen Business School Keynote address to the conference “Reforming the Bretton Woods Institutions” organized by the Danish Institute for International Studies, Copenhagen, 16-17 September 2009

2. INTRODUCTION Starting from the Robert Wade’s diagnosis about the three sources of crisis • The so-called globalization has generated an unprecedented deepening of division of labour • Financial deregulation has meant an accelerated innovation and diffusion of new dangerous products • In the US and UK financialisation has been used to compensate rising inequalities

3. Mixing these three mechanisms explain the specificity of the current crisis • The end of an historical epoch for American growth regime and the “post Bretton Woods non-system” • This is the repetition of neither the American Great Depression nor the Japanese lost decade • The diversity of capitalisms makes quite difficult a coordinated response to a structural, systemic and global crisis

4. THE LECTURE: SEVEN STEPS • How globalisation has transformed international relations? A brief retrospective • How financial innovations have finally destroyed the American finance-led growth regime. • A world wide crisis but quite contrasted institutional configurations and policy response.

5. Why governments and regulatory agencies have been so slow in learning how to cope with new financial instruments? • From new regulatory regimes to the reconstruction of viable growth patterns. • Contrasted interests and path dependent economic policy styles: a required but quasi impossible reform of the international system. • About possible scenarios.

6. HOW GLOBALISATION HAS TRANSFORMED INTERNATIONAL RELATIONS? A BRIEF RETROSPECTIVE

7. The 90s: the United States, Japan and China and the stability of the world economy • The Americans: the consumers of last resort • The Japanese: the savers of last resort • The Chinese: the manufacturers of the world

8. Figure 1 - Can two vicious circles make a world virtuous configuration?

9. The 2000s: Still another configuration for the world economy • The Americans: the consumers of last resort…and beneficiary of world excess of saving • The Japanese: a recovery in response to the dynamism of Chinese imports of equipment goods and high-tech components • The Chinese: the manufacturers … and the savers of the world

10. Figure 2 – Towards a duopoly at the world level?

11. Why the IS-LM model becomes relevant at the world level • From a closed economy model to the interaction of two national economies: the US and China • A lasting overcapacity in manufacturing in China, hence a pressure towards price wars • An upward drift of the relative prices of oils and raw materials

12. A possible explanation of the Alan Greenspan puzzle • Not any increase in long term interest rates in the US: the consequence of the excess savings of Asia • The moderation of core inflation: the definite impact of Chinese overcapacity in commodities • The surge of consumption prices: the under capacity in the production of raw materials • These are direct consequences of the America / Asia (China) duopoly

13. A contrario, a drastic challenge of neoricardian international trade theory • The mobility of frontier technologies towards China • The quasi unlimited supply of labor in China • The size of the potential Chinese market

14. The role of increasing returns to scale • Consequently, the emergence of the hypothesis that manufacturing world prices are Chinese prices

16. II. HOW FINANCIAL INNOVATIONS HAVE FINALLY DESTROYED THE AMERICAN FINANCE-LED GROWTH REGIME At the core of the crisis: the erosion of the directresponsibilityof credit decision

17. Thespilloverof all the destabilizing mechanisms not corrected during the previous crises… The endof a finance-led growth regime… An unprecedented crisis generated by financial laissez-faire…thatdiffusesto the rest of the world

18. 1. At the core of the crisis: the erosion of the direct responsibility of credit decision…. Various financial entities buy these derivatives Risk transfer Need of hedging Securitisation by investment banks Lehman Brothers Swaps against credit default AIG Externalization of the risk Mortgage financial institution Real estate buyers Credit contract Deepening of the gap between financing and risk taking Incentive to take more risk Figure 3 – The hidden origin of subprime crisis: a perverse division of labor within finance Collapse of the joint responsibility of contract Systemic crisis

19. ….Hence an explosion of subprime derivatives Figure 4 – The fast growth of credit derivatives, especially from mortgage

20. Figure 5 – The risk transfer implies a decline in the quality of assets ….With a constant deterioration of the quality of borrowers

21. … This deterioration of quality is permanent of MBS from 2003 to 2007 Graph 1 Source : Yuliya Demyanyk, Otto Van Hemert (2008), p. 1

22. … This is not simply the outcome of low documentation mortgages Graph 2 Source : Yuliya Demyanyk, Otto Van Hemert (2008), p. 1

23. The spillover of all the destabilizing mechanisms not corrected during the previous crises… Figure 6 – The origins of subprimes crisis Excessive reliance upon theoretical models (LTCM, collapse 1987) Last Resort Lender and tutor of the financial system Strong incentives for Wall Street and CEO to adopt these financial instruments with respect to their remuneration (Enron) Primacy of investment bank, large leverage / fair value (Northern Rock) CENTRAL BANK Low interest rate Financial stability policy The Central Bank cannot detect nor prevent speculative bubbles Collusion of financiers with politicians in order not to regulate derivatives (Enron, subprimes)

24. Figure 7 – A transposition of Irving Fisher debt deflation theory ….Hence a general deflation of financial assets

25. ….A quasi-complete freezing of inter-bank credit Source : Artus Patrick (2008), « La finance peut-elle seule conduire à une crise grave ? », Flash économie, n° 429, 2 Octobre, Natixis, Paris, p. 2 et 3.

26. An unprecedented crisis generated by financial laissez-faire… • Securitization and subprime have been generating a large overproduction in the real estate sector Source : Artus Patrick (2008), « La finance peut-elle seule conduire à une crise grave ? », Flash économie, n° 429, 2 Octobre, Natixis, Paris, p. 4 et 6.

27. Graph 8 – The public institutions governing the mortgage market collapse • A systemic financial crisis: collapse, bankruptcy, distrust against banks, creeping public control

28. The end of a credit led household consumption boom Source : Artus Patrick (2008), « Plaidoyer pour la création « d’acheteurs d’actifs risqués en dernier ressort », Flash économie, n° 416, 23 septembre, Natixis, Paris, p. 6 et« La finance peut-elle seule conduire à une crise grave ? », Flash économie, n° 429, 2 Octobre, Natixis, Paris, p. 3.

29. Thus finance will finally destabilize the real economy, even if non financial corporations were more careful in debt management Source : Artus Patrick (2008), « Trois méthodes pour réduire le levier d’endettement », Flash économie, n° 414, 23 Septembre, Natixis, Paris, p. 2.

30. III. A WORLD WIDE CRISIS BUT QUITE CONTRASTED INSTITUTIONAL CONFIGURATIONS AND POLICY RESPONSE

31. THE EYE OF THE HURRICANE: THE UNITED STATES: A typicalreal estatebubble Asystemicfinancial collapse An inducedrecession/depression And variousspill overamong the three sources of crisis … ….. Hence a quiteuncertainprofile of the way out of the crisis

32. Figure 8 – Three self reinforcing debt deflation-depression spill over along Irving FISHER’s model keynesian countervailing programs

33. 2.THREE TRANSMISSION MECHANISMS FROM THE US ECONOMY TO THE REST OF THE WORLD The diffusion of the finance led growth model to other OECD countries : mimicking the American crisis Financial globalization implies a brusque assessment of risk and this severely hits all the countries that relied upon the permanent inflow of foreign capital The collapse of the world trade, consequence of the freeze of inter-bank credit, is spreading the crisis even to the high performing and virtuous economies

34. 3. AN UNPRECEDENTED DEGREE OFINTER-DEPENDENCE WHATEVER THEDIVERSITYOF REGULATION MODES

35. C1 : The good pupils of financiarization : A systemic crisis with a freeze of credit : UK and Ireland Table 2 – The difference between producers and buyers of toxic derivatives Depreciations of financial assets by banks (Mds de $)

36. C2 : The Asian crisis is repeating itself in Europe : the danger of a large debt in foreign currency. Hungary, Estonia, Latvia, Lithuania et Ukraine. Tableau 3 – Europe 2008 : the excess of borrowing in foreign currency

37. C3 : The victims of the very success of an export and innovation led growth regime Sweden, Netherland, Germany and Japan Table 4 – Countries at the technological frontier Source : Artus Patrick (2009) : « Se limiter à règlementer la finance ne résoudra rien », Flash Economie, n° 156, 3 avril, Natixis, Paris, p. 10.

38. Germany and Japan benfit from the growth of NPI markets Tableau 5 –Exportations vers l’ensemble des émergents (*) Source : Artus Patrick (2008) : « Quels vont être les pays qui seront le plus en difficulté après la crise », Flash Economie, n° 477, 22 octobres, Natixis, Paris, p. 8.

39. C4 : Rentier economies do continue to exhibit quite specific macroeconomic regimes Saudi Arabia, Russia and Venezuela C5 : Continental economies : the potentiality of a very large domestic market India, Brazil, China C6 : Hybrid economies discomposed by their international insertion Latin America (Argentina, Mexico) C7 : The victims from the disconnection with respect to the world markets Most African countries

40. 4.TOWARDS MORE COMPLEMENTARITY THAN COMPETITION AMONG THESE INSTITUTIONAL CONFIGURATIONS Between finance led economies and continental powers : complementarity for saving and trade Between continental economies and rentier countries: complementarity of trade. Between innovation and export led regimes and other configurations: complementarity of specialization

41. Figure 9 – How the seven regulation modes interact and coexist C3 Innovation / export led Germany, Japan C2 Financial external dependency Hungary, Iceland, Ireland Trade Trading sophisticated goods C5 Continental powers China, India, Brazil Capital flows Capital, Mass produced goods Primary resources Saving Primary resources C1 Financial hegemony US, UK C4 Rentier Russia, Venezuela, Saudi Arabia Capital flows and trade C6 Hybrid and disarticulated by international insertion Argentina, Mexico Competition more than complementarity C7 Disconnection from the world market Africa

42. FACING SUCH A DIVERSITY, INTERNATIONAL COORDINATION OF NATIONAL STRATEGIES FOR OVERCOMING THE CRISIS IS QUITE PROBLEMATIC AND UNLIKELY The industrialist models against loose controls of financial hegemony NPI against the old industrialized countries. Rentier regimes as unexpected referees in anticipation of raw material scarcity

43. IV. WHY GOVERNMENTS AND REGULATORY AGENCIES HAVE BEEN SO SLOW IN LEARNING HOW TO COPE WITH NEW FINANCIAL INSTRUMENTS?

44. The same sequence repeating itself in history A financier invents a new product with promising profitability.. for him! … Followers are eager to imitate this strategy : they create a boom... Uniformed individuals enter the market and trigger a bubble… …So extreme that the speculation is bound to burst and can even trigger a major economic crisis …Then public authorities have to intervene to restore the viability of the economy The private innovation is either banned or reordered via a public control in order to convert it into a viable financial tool

45. Figure 10 – A typical sequencing of financial crises Viability of the regulated innovation Regulation by the government New cycle Lender as a last resort Entry in the zone of financial fragility Success / High profit Private innovation Rapid adoption No public intervention: collapse of the innovation

46. Computer trading:the October 19th, 1987 Wall Street crash, a first example Modern portfolio management leads to the diffusion of computer software for traders… …This generates a synchronization of selling orders… …Hence a collapse of the stock market, but rapid reaction of the Central Bank A continuing boom, not at all the repetition of October 24th 1929 crash

47. The LTCM collapse: a second example The invention of new methods in order to get high rate of returns while limiting risk… …A highly leveraged hedge fund without any regulation or prudential assessment… …An impressive boom and a brusque collapse facing an unexpected event

48. Figure 11 - The collapse of Long Term Capital Management: financial reorganization under the aegis of the FED but no new regulations A new speculative boom starts But no new surveillance mechanism No prudential regulations for Hedge Funds Extracting relevant information from past regularities Very large leverage effects But low « value at risk » according to the model New portfolio management techniques Unprecedented rate of returns Explosion of turnover LTCM collapse A highly unlikely event Abyssal losses Systemic crisis threat Bailing out by Bear Sterns Quick FED intervention

49. The ENRON story: a third example The boom of this market reaches its limits, the reversal of confidence challenges macroeconomic stability… …And again the Central Bank is the rescuer of last resort in order to preserve the viability of the financial system

50. The ENRON story Figure 12 – A third example: energy derivatives Energy derivatives Unprecedented profit Creative accounting Bankruptcy Prevention from any public control by lobbying Potential for new crisis New rules of accountability for CEO and CFO But not any reform of accountability principles A structural weakness