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
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 years worth of GDP (although this was
reversed in the second quarter of 2009 with a gain of $22
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
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
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 200608. 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
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:
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
Chart 7 shows the cumulative gains and
losses over the period as a proportion of GDP. The key points
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
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
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
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
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
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
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