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In 1997 some observers feared an impending global recession as result of the headwinds stemming from the Asian Financial Crisis.  However, within two years, those fears had dissipated and were replaced with new concerns of irrational exuberance. 

By contrast, the U.S. economic downturn beginning in 2008 initially appeared to be relatively benign.  Most observers believed that a moderation in U.S. economic growth was essential to prevent an over-heating of the global economy.  It was further believed that the problems confronting the U.S. economy were of its own making and would have little effect on global economic growth.  

To be sure, some economists did forecast a U.S. recession in 2008 as a result of mounting home foreclosures. Such forecasts were however widely dismissed as being unduly alarmist during the first quarter of 2008.

It is essential for policy makers to understand the key differences between the 1997 Asian Financial Crisis and the 2008 Global Recession. 

First, during the Asian Crisis, the prices of commodities, particularly oil, declined as a result of falling demand. In fact, the price of oil plummeted to nearly US$10.00.

Second, global policy makers preemptively stimulated their economies, through monetary easing, in order to mitigate the downside risks stemming from the Asian Crisis.

By contrast, in 2008 the prices of commodities skyrocketed during the midst of the U.S. economic downturn.  That is, prices increased as global demand weakened, which can only be described as irrational market behavior. The resulting commodity bubble fueled worldwide inflation concerns.   

Further, global policy makers in 2008 were compelled to restrict the growth of their economies, through monetary tightening, in order to mitigate the downside risks of inflation.

To be sure, were it not for the irrational behavior of commodity prices, global policy makers would likely have stimulated their economies in 2008 to mitigate the downside risks stemming from the weakness in the U.S. economy. Moreover, lower commodity prices would have further boosted global economic growth. 

Indeed, the U.S. consumer would have demonstrated far greater resilience to the numerous headwinds confronting the U.S. economy were it not for irrational behavior of commodity prices, particularly, oil which touched $150 during the middle of 2008.

What explains the divergence in the direction of commodity price movements in 2008 relative to 1997?  In short, hedge funds.  In 1997, the prices of commodities were largely set by supply and demand forces between producers and suppliers of commodities.  However, in 2008, commodities had become asset classes which were widely available to investors through online exchange traded funds.  During the first half of 2008, market participants attempted to reduce their exposure to assets denominated in U.S. dollars by selling U.S. equities and re-investing in commodities. 

In short, the downward spiral of the U.S. economy and subsequent global recession was largely attributable to the (irrational) investment allocation decisions of market participants, particularly hedge fund managers.  Millions of jobs have been lost because market participants did not understand the wider impact of their investment decisions. 

Going forward policy makers will be well served in placing restrictions on the amount of speculative interest in commodity markets.  Perhaps hedge funds should be restricted altogether from speculation in commodity markets?  Or perhaps policy makers should set upper and lower limits for commodity prices?  To be sure, the global recession of 2008 clearly demonstrates that the unbridled self-interest of market participants can no longer go unchecked.

Raju Agarwal