The collapse of financial markets in the last two years has been a cataclysmic event, heralded by some as the end of the capitalistic market economy. While such claims now look overblown, the loss of financial wealth has been enormous, and the consequences unprecedented for the economies of the world.
Financial wealth over recent decades has become the clearest sign of economic advancement. But its loss is likely to usher in an era of a much more sedate and controlled financial system subject to stricter rules, at least in the core countries of the global financial system.
The loss of capital value of financial assets world wide may have reached $50 trillion in 2008, and could increase in 2009. The loss in the financial capital stock has been around one year of total world GDP. The decline reflects the reduced capitalization of stock markets, loss in the value of bonds supported by mortgages and other assets, and the depreciation of many currencies against the US dollar, although these trends seem to be reversing.
There has been no loss of physical capital, and this bodes well in terms of the productive capacity of the world economy to recover from the worst economic crisis since the 1930s. But the loss of financial wealth will have lasting effects on aggregate demand, even as governments intervene massively to sustain their economies.
This article describes how financial markets rose rapidly until their recent collapse. It then describes the main factors that affected the rise and fall, and how different regions have fared during the period. The article concludes with a discussion of the possible future developments, as well as some policy implications, and the expected impact of these traumatic events on economic performance.
Financial sector development
Between 2002 and 2007 the value of financial assets rose 125% while GDP grew by 70%, entailing an increase in the ratio of financial assets from 33% of GDP to 440% by the end of 2007. Capital markets deepened, but at the same time they formed the base of the speculative bubble that erupted in late 2007. During the period, the ratio of financial assets to GDP in advanced economies rose by 35%. In developing Asia the ratio rose by 60%, and in Latin America by 75%.
The pace of financial asset accumulation came to an abrupt halt in 2008, when the ratio to GDP declined by 18% in response to the crisis, and 10% in nominal terms, notwithstanding the massive global injection of liquidity by central banks and governments alike. When these increases in liquidity are subtracted, the loss of financial wealth at a worldwide level amounted to $56 trillion through the first quarter of 2009 – more than a year’s worth of GDP (although this was reversed in the second quarter of 2009 with a gain of $22 trillion).
Sources of change in financial assets
The rise in financial assets in the period through 2007 reflects the general accumulation of savings, a new level of prosperity, and partly the imbalances in the world economy during the earlier part of the decade.
Chart 1 provides estimates of gains (stock market valuation changes; exchange rate movements; changes in spreads and movements in non-performing loans).
Table 2 provides detailed information of the changes in valuation during the period. It incorporates a stylized calculation of the possible losses arising from the crisis through the end of 2008, with quarterly estimates presented subsequently. The table estimates the decline in stock prices, the loss of value of private and public debt, and the effect of depreciation on debt and bank assets. The estimate does not include the loss in the value of assets held by local investors abroad, an issue discussed below.
The estimated losses are very large – almost $60 trillion in the second half of 2008 and the first quarter of 2009, reversing to a large extent the gains of previous years.
Chart 2 shows the main sources of explained changes during the period under study. Clearly, the main change is in the stock market, with more limited changes in the debt and bank assets. Only in 2003, when financial markets were recovering from serious prior weaknesses, and in 2008, when financial markets collapsed, were other items affected in a significant way.
Chart 3 shows the changes on the basis of their source – the valuation of the stock markets, changes in exchange rates, spreads and in the ratios of non-performing loans. The most notable factors explaining the 2008 losses in markets are related to the quality of the portfolio (non-performing loans and spreads), which had been of negligible importance in previous years.
Exchange rate effects are more the reflection of imbalances among regions and not overall systemic problems, although the two coincided in 2006–08. The imbalances experienced by the US explain the depreciation of the US dollar before 2008, while the changed perception of relative risks explains the US dollar appreciation in the last quarter of 2008 and early 2009.
Decoupling theory misplaced
All regions of the world have suffered the consequences of the crisis, showing again that the decoupling theory that had been prevalent during earlier years was misplaced. The integration of the world economy was a major factor in explaining the process of transmission.
Chart 4 shows that declines are particularly large in the case of developing Asia, Latin America, and the European Union.
The unfolding of a drama:
2007–2009
Chart 6 shows the synchronization of the fall in values in the second half of 2008, and the first quarter of 2009 (with the exception of developing Asia and Latin America during the quarter) and the subsequent recovery in the second quarter. The massive loss of wealth hit all regions of the world, although the bubble appears to have started to burst in Asia and the US early in 2008, as the US economy had started to decelerate and entered into recession.
Chart 7 shows the cumulative gains and losses over the period as a proportion of GDP. The key points are:
• World gains started decelerating during the middle of 2007, when the sub-prime crisis started to be taken seriously. But they only fell with the burst of the commodity boom, and then collapsed after the paralysis of financial markets in the wake of the Lehman bankruptcy.
• Despite the large governmental packages of late 2008, the financial losses continued unabated until early 2009, when commodity prices bottomed.
• The region showing the greatest rebound, relative to end 2006, was Latin America, helped by reasonable macro-policies after decades of mismanagement. Developing Asia, reflecting the strength of China and India and the appreciation of their currencies against the dollar, has also recovered.
• The US remains the major lagging economy, still well below 2007 levels.
• Europe, which continued to see large gains, partly due to a strengthening of the euro and sterling, through mid-2008, suffered the worst collapse from its peak in mid-2008, although it has recovered subsequently.
• Japan, even with a yen appreciation, or because of it, remains almost as weak as the US.
In the end, the recovery is helping restore financial wealth. The coordinated action of central banks and fiscal authorities in support of the financial system, and the rebound from a downward overshooting in reaction of markets to the liquidity crisis explain most of the recovery. If this is the case, one can expect only modest gains in financial wealth during the rest of 2009 and 2010.
Cross-border effects of world financial losses
To what extent will the losses described so far have an effect on the wealth of other regions? Table 3 shows the stocks of net assets and liabilities held in different regions are significant but in the end are only a small proportion of total assets and liabilities. To that extent, the cross-border effect of declines in asset values has a measurable but limited impact.
The table provides an indication of the net financial position among the different areas. It is based on data provided by the IMF on foreign investment positions for individual countries. It only extends to end 2007; nevertheless it provides a good illustration of relative magnitudes.
While on a gross basis assets and liabilities may be significant, the net position tends to be small. For example, in the case of the US, it holds a net foreign liability position as a result of years of large deficits, but this position amounts to 4% of total assets in the US. In the case of Europe it is smaller, at 2%, while the net asset positions for the largest creditors, Japan and emerging Asia, amount to some 9% of total assets. The largest net (negative) position corresponds to Latin America, equivalent of 15% of total assets.
The financial impact can be considerable, to the extent that net positions may not provide the full picture. As an example, for developing Asia, the net creditor position is dominated by large levels of reserves and related assets, mostly invested in US official securities, while the FDI (foreign direct investment) position reflects a combination of large positions of assets and liabilities that may have been hit in a differential fashion by the crisis.
FDI assets may have suffered from a milder shock in advanced economies than the shock of domestic Asian conditions had on FDI liabilities held by foreign investors. This may well have reflected that economic activity suffered more domestically than abroad. (Unfortunately, data is not available about the origin and destination of financial and FDI flows in the detail that would help in this analysis, but clearly the impact is at worst moderate in magnitude.)
Pulling it all together
The loss of wealth has had serious effects on the world economy. The impact of a decline in stock market values by almost one half, and the reduction in the values of financial assets and higher spreads has a direct effect on the performance of economies worldwide.
At its simplest, both consumption and investment will decline.
Different estimates show wealth elasticities of consumption to financial wealth in the order of up to .05, and of .06 in the case of housing equity for increases in wealth. However, the association is stronger in the case of declines in wealth, likely entailing a sharper adjustment of perceived permanent income in the case of declines than for increases. On that basis, a decline in financial wealth in the order of 20% could reduce consumption by 2%.
In addition, the effect on investment would be significant on account of the perceived reduced prospects for growth in the near future because of significant existing excess capacity. Thus, the decline in activity in 2009 of about 3% a year seems consistent with the loss of wealth that this paper describes. This decline is taking place notwithstanding the significant efforts among major countries to reactivate their economies.
The implications of this loss of wealth for future economic policies are complex. It has been absolutely essential to continue supporting demand in the face of the existing collapse of private demand. However, the injection of liquidity and rapid increase in government debt has a limit, and the public will quickly develop a negative perception about the ability of government to cover the mounting debt obligation currently being incurred.
This phenomenon, associated with the more technical concept of Ricardian equivalence between debt and taxation, imposes disciplines over the longer term that economic policy-makers are not yet ready to face.
Still, to the extent that current demand policies change the perceptions about the gravity of the current crisis for the better (and a significant portion of expenditure goes toward capital formation), such expenditure will allow for a smooth transition. But this will occur only if the pace of the imbalances is corrected soon.
Otherwise, the loss of wealth already experienced may be combined with increased inflation and a loss of confidence in public debt instruments that would aggravate – rather than correct – the existing level of economic distress.
Claudio Loser is president of Centennial Group Latin America. He was assisted in this paper by Drew Arnold a student at Georgetown University and summer intern at Centennial