Saturday, August 13, 2011

The Recent Financial Market Volatility

A Crisis of Confidence

On Friday, August 5, 2011, the US-based rating agency Standard & Poor’s downgraded US sovereign debt from AAA status for the first time in its history.

Subsequently, the financial markets saw massive drops beginning on August 8, 2011, with 11.2% drops in value in the Dow in the US, while all European markets were also hit with major declines. The German Dax declined by 22%, the British FTSE declined by almost 15%. Likewise, in Asia, Korean and Japanese markets both tumbled by 3.7%.

Source: BBC News


Nevertheless, by Friday August 12, 2011, the markets were in stark rebound. What is happening here? Has something changed in the market fundamentals?

Change in Fundamentals? 

The main fundamental which has changed in the financial markets is the credit rating for US sovereign debt.

Change in Confidence

What really happened was a change in the way investors feel about future prospects for stability in the financial markets. Basically, we can take both the sharp downward swing and the dramatic increase in volatility as a market signal that financial stabilization measures in both the US and the EU have not really addressed the major issues. In other words, according to the market outlook, bailouts in the US have failed and the debt negotiations have also failed. The market outlook vis-à-vis the EU is that Europe’s reaction to the Greek crisis and the sovereign debt problems of the Mediterranean rim, as well as general European financial stabilization have been altogether insufficient.

The US

Underlying the downgrade US sovereign debt – and the subsequent widespread selloffs in the US stock markets – is a general loss of confidence in the soundness of US economic management. While the banks have been recapitalized and the money quantity has been dramatically increased, microprudential regulation has been all but neglected.  In other words, the American attempt to soundly regulate the financial crisis has failed. Why did the 400 provisions of the Dodd-Frank act get reduced to 38? Why has no further regulation been enacted? What plans are there to join and adhere to international financial regulatory standards?
As for the bailouts, we see that the banks have been re-capitalized, and that the financial institutions have been rebuilt, and that QE has left massive amounts of liquidity in the financial market, but that none of that money has been sent into the real economy. The result: unemployment and production figures never really improved. This is because insufficient regulation has been put into the US financial and banking sectors. Thus, all the new cash in the system does not actually reach the problem areas for which it was actually intended. This leads monetary-expansionary needs to be much larger than what they could be, while the crisis-response effect is largely mitigated and risk of crisis is increased dramatically.

And as for the debt-ceiling negotiations, the cuts will simply mean a drop in growth. The cuts will also mean an upwards re-distribution of income and wealth in the US economy. The real answer was to perhaps increase revenues. In short, both the Democrats and the Republicans have come to an agreement to launch an upwards redistribution of wealth, despite the fact that Obama’s democratic mandate was exactly the opposite of that.

Furthermore, getting rid of the Gephardt Rule (automatic debt-ceiling rule) means that this sort of showdown might occur again and again. The Republicans took a calm budgetary process, and turned it into an annual risk of default showdown. They created an economic crisis where there was none before, only to redistribute wealth upwards. What is worse is that the Democrats went along with it all.  

This is why the US was downgraded by the rating agencies. 

  •  A drop in growth for the coming few years.
  • This is why the US was downgraded by the rating agencies.
  • Future prospects of legislative showdowns on the budgetary issues
  •          A dramatic increase in the money supply. Besides QE1 and QE2, the US has pledged to keep interest rates low until 2013.
  •  A bailout which did not reach the real economy, due to insufficient regulatory standards    
  • The lack of microprudential banking and financial banking regulation

I would say that Washington’s mismanagement played a huge role in this situation. 

·         Europe

While the drop in the financial markets was particularly bad on Wall Street, it was also severe in Europe. Overall, there are good reasons for which the financial markets have also lost their confidence in the European markets.

In some ways, Europe’s situation resembles that of the US. Specifically, the money supply has increased dramatically (both in the Eurozone and in the UK), while microprudential regulation has generally not improved much.

With respect to the sovereign debt situation, European austerity measures are bound to have the same effects on growth as those in the US. Furthermore, as the headlines have shown us in the UK, Greece, and Spain, angry European youths have already decided to take to the streets on this issue.

On top of that, the Eurozone has been revealed to be much more unstable because the crisis has made it painfully clear that the Eurozone has no pre-set plans to deal with the financial trouble of the member-nations. This is despite the fact that monetary policy in the Eurozone is set along a strict price-stability mandate, with no pronounced growth mandate (this was already likely to result in economic troubles in both the Mediterranean rim and in Eastern Europe. My question is why did the ECB not decide on an “Anglo-French” monetary policy, whereby both growth AND price stability are mandated?

To add even more fuel to the fire, EU common market rules allowed and even encouraged cross-border banking, without having proper microprudential rules in place to mandate responsible and sustainable European banking practices. In fact, prior to 2008, financial-regulatory regimes were different from country to country across the EU, with little-to-no coordination between banking authorities in the various EU countries.
While this is more or less a perfect recipe for financial troubles over a 10-year time-span, the EU did not have a financial crisis mechanism. The result is:
  • A drop in growth for the coming few years
  • A dramatic increase in the money supply
  • The lack of microprudential banking and financial banking regulation

    In the face of all this, the response from Europe has been a bilateral response whereby Germany and France have decided to respond to the economic troubles in the Mediterranean rim on their own. It is as if California tried to resolve its debt crisis by asking Vermont for a loan. Does that not just seem like a stupid way to do things?

    Some Bright Spots in Europe

    Since the emergence of the financial crisis in Europe in 2008, there has been an effort to coordinate both financial crisis response policy by founding the EFSF, as well as the EFSM and financial, banking, insurance and fiduciary regulation by means of the ESRB, EBA, and ESFS.

    About the Author:
    Max Berre is an economist who has worked as a sovereign debt expert at the Inter-American Development Bank in Washington and has taught financial economics at Maastricht University in the Netherlands. 

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