Analysis of the catalyst leading to global financial crisis.

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
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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. 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
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Partner
VBM Consulting
Stephen.neill@vbm-consulting.com