Commodity Speculators The Villains Behind The Global Financial Crisis


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Analysis of the catalyst leading to global financial crisis.

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Commodity Speculators The Villains Behind The Global Financial Crisis

  1. 1. Commodity Speculators – The Villains Behind The Global Financial Crisis. When the economic history of the early part of the 21st century is written, and an assessment is made of the factors that led to the world’s greatest ever financial crisis; commodity speculators will be singled out as being one of the prime culprits behind the events. The attractiveness of commodities to speculators increased steadily during the last 7-8 years, driven by the belief that strong demand from rapidly growing emerging economies such as China, India, Brazil and others would be sustained over the medium to longer term and that this would mean continuous upward pressure on key commodity prices. This was particularly the case with oil. An analysis of the oil market highlights the intense level of speculative activity that has occurred over the past two years. The analysis shows that the increase in prices in 2007- 2008 was not driven by any significant imbalances between supply and demand for oil. The surge in prices from around $60 to around $150 in July 2008 was driven almost exclusively by frenzied speculative activity. The graph shows movements in total world supply and demand for oil from 2007 Q1- 2008 Q4 and compares this with the price of crude oil over the same period. All three time series have been rebased for comparative purposes, to start at a level of 100 in 2007 Q1. It is clear from this analysis that there was no significant imbalance between total world demand and supply of oil over this period, yet the price of oil soared until about the end of 2008 Q3, when the speculative bubble burst in dramatic fashion. Total World Oil Supply & Demand & Crude Pices 2007-2008 250.00 200.00 150.00 Total World Supply Total World Demand Crude Oil Price 100.00 50.00 0.00 2007 2008 1. Rebased to index =100 in 2007 Q1 Source: Energy Information Administration – Official Energy Statistics from The US Government 1
  2. 2. The combination of strong global demand for commodities, and the additional pressure on prices resulting from speculative activity, resulted in accelerating inflation, particularly in the world’s largest economy, the US. The key driver of this price pressure though, was the skyrocketing price of oil. To counter the inflationary threat, monetary authorities in the US and other developed economies, resorted to raising interest rates sharply. In hindsight, this was a colossal policy error for two reasons. • Firstly, it failed to recognise the fact that the increase in commodity prices, (the fundamental cause of the inflationary pressure) was a classic speculative bubble that was bound to burst sooner rather than later. • Secondly, it failed to adequately take into account the disastrous impact which higher interest rates would have initially on the global financial system but ultimately on the real economy. After more than a decade of cheap money, individuals and institutions had accumulated large amounts of borrowings. Banks, particularly in the US competed aggressively with each other to lend billions of dollars to house buyers, with little or no vetting of borrowers in terms of ability to sustain interest payments. The consequence of this was that even small increases in rates had the effect of tipping a vast swathe of borrowers over the edge. This in turn created a tsunami of ‘toxic assets’ crashing onto the balance sheets of major financial institutions across the globe. This was the trigger which led to the global melt down of the financial system. The graph below plots the relationship between US interest rates and US mortgage foreclosures over the period since 2004. The data shows how rates rose sharply from mid 2004 reaching a peak at the start of 2007 and staying high during 2007. As already noted, the economic logic for this was the need to contain rapidly building inflationary pressure, driven mainly by the steep rise in the price of oil and other key commodities and by expectations that these trends would continue. For example, many leading oil market analysts were confidently predicting that the oil price would hit $200 per barrel before the end of 2008! US Interest Rates & Mortgage Foreclosures 2004-20081 350.0 300.0 250.0 200.0 US Mortgage foreclosures US Bank Prime Loan Rate 150.0 100.0 50.0 0.0 2 04 05 06 07 80 20 20 20 20 20 1. Rebased to index =100 in 2004 Q1 Sources: 1. EconStats, 2. Mortgage Bankers Association
  3. 3. As a result of the more than doubling of interest rates in the space of two years, millions of already hard pressed borrowers were forced to pay for the speculative feeding frenzy in commodity markets. This in turn resulted in a massive rise in the rate of mortgage defaults as can be seen in the graph. This was the catalyst for the global credit crunch that we have witnessed. There are a multitude of lessons to be learned from the events of the last few months. No doubt economists and policy makers will research these exhaustively for years to come and the current crisis will be studied as intensely as was the Great Depression of 1929. However there are some immediate and obvious lessons which emerge from even a cursory analysis of events. Firstly, there is an urgent requirement for a global tightening of the regulatory system surrounding the banking and financial services industry to ensure that never again is there such a dramatic and catastrophic loss of confidence in the banking and financial system. Secondly, there is a strong case for concerted international action to limit or even ban speculation in certain key commodity markets, in particular oil. Whilst markets should be allowed to operate freely and to respond to changes in the fundamental economics of supply and demand, the destructive impact of intense speculative activity in key commodities must be recognised. As we have seen, speculation in such commodities has the potential to unleash powerful inflationary pressures in the world economy and to sow the seeds of economic chaos and recession. Thirdly, governments and economic policy makers need to seriously enhance their understanding of how markets operate and to increase the level of sophistication of policy responses to economic events. The global financial crisis is a dramatic and painful lesson about the consequences of: • failing to properly understand the key drivers of the inflationary pressure, and of, • misusing interest rate policy to address an inflationary problem which required a fundamentally different policy response. There is no doubt that the policy of raising interest rates without due consideration being given to the consequences of such action, or to understanding the fundamental causes of the inflationary pressure, greatly exacerbated the problem. We now see governments around the world taking emergency action to, reverse their earlier blunders, by lowering interest rates dramatically to try and prevent a global economic slump. Unfortunately, this is like closing the barn door after the horse has bolted! The damage has been done and it will take a lot more than simply lowering interest rates to return the global economy to its growth trajectory. Stephen Neill 3 Partner VBM Consulting