The gales of volatil­ity not go­ing any­where

The Pak Banker - - OPINION - Mo­hamed A. El-Erian

EAR­LIER this year, fi­nan­cial mar­kets around the world were forced to nav­i­gate a per­fect storm - a vi­o­lent dis­rup­tion fu­elled by an un­usual amal­ga­ma­tion of smaller dis­tur­bances. Fi­nan­cial volatil­ity rose, un­set­tling in­vestors; stocks went on a roller­coaster ride, end­ing sub­stan­tially lower; govern­ment bond yields plum­meted, and lenders found them­selves in the un­usual po­si­tion of hav­ing to pay for the priv­i­lege of hold­ing an even big­ger amount of govern­ment debt (al­most one-third of the to­tal).

The longer th­ese dis­tur­bances per­sisted, the greater the threat to a global econ­omy al­ready chal­lenged by struc­tural weak­nesses, in­come and wealth in­equal­i­ties, pock­ets of ex­ces­sive in­debt­ed­ness, de­fi­cient ag­gre­gate de­mand, and in­suf­fi­cient pol­icy co­or­di­na­tion. And while rel­a­tive calm has re­turned to fi­nan­cial mar­kets, the three causes of volatil­ity are yet to dis­si­pate in any mean­ing­ful sense.

First, mount­ing signs of eco­nomic weak­ness in China and a se­ries of un­char­ac­ter­is­tic pol­icy stum­bles there still raise con­cerns about the over­all health of the global econ­omy. Given that China is the se­cond largest econ­omy in the world, it didn't take long for Euro­pean of­fi­cials to re­duce their own growth pro­jec­tions, and for the In­ter­na­tional Mon­e­tary Fund to re­vise down­ward its ex­pec- tations for global growth.

Se­cond, there are still le­git­i­mate doubts about the ef­fec­tive­ness of cen­tral banks, the one group of pol­i­cy­mak­ing in­sti­tu­tions that has been ac­tively en­gaged in sup­port­ing sus­tain­able eco­nomic growth. In the US, doubts fo­cus on the will­ing­ness of the Fed­eral Re­serve to re­main "un­con­ven­tional"; else- where, how­ever, doubts about ef­fec­tive­ness con­cern cen­tral banks' abil­ity to for­mu­late, com­mu­ni­cate, and im­ple­ment pol­icy de­ci­sions. For ex­am­ple, rather than view­ing mon­e­tary au­thor­i­ties' ac­tivism as an en­cour­ag­ing sign of pol­icy ef­fec­tive­ness, mar­kets have been alarmed by the Bank of Ja­pan's de­ci­sion to fol­low the Euro­pean Cen­tral Bank in tak­ing pol­icy rates even deeper into neg­a­tive ter­ri­tory. Third, the sys­tem has lost some im­por­tant safety belts, which have yet to be re­stored. There are fewer pock­ets of "pa­tient cap­i­tal" step­ping in to buy when flight­ier in­vestors are rush­ing to the exit. In the oil mar­ket, the on­ce­pow­er­ful Opec has stepped back from the role of swing pro­ducer on the down­side - that is, cut­ting out­put in or­der to stop a dis­or­derly price col­lapse. Each of th­ese three fac­tors alone would have at­tracted the at­ten­tion of traders and in­vestors around the world. Oc­cur­ring si­mul­ta­ne­ously, they un­set­tled mar­kets. Intra-day volatil­ity rose in vir­tu­ally ev­ery seg­ment of global fi­nan­cial mar­kets; ad­verse price con­ta­gion be­came more com­mon as more vul­ner­a­ble en­ti­ties con­tam­i­nated the stronger ones; and as­set-mar­ket cor­re­la­tions were ren­dered less sta­ble.

All this came in the con­text of a US econ­omy that con­tin­ues to be a pow­er­ful en­gine of job cre­ation. But mar­kets were not vot­ing on the most re­cent eco­nomic de­vel­op­ments in the US. In­stead, they were be­ing forced to judge the sus­tain­abil­ity of fi­nan­cial as­set prices that, boosted by liq­uid­ity, had no­tably de­cou­pled from un­der­ly­ing eco­nomic fun­da­men­tals.

In the wake of this volatil­ity, mar­kets have re­cently re­gained a more sta­ble foot­ing. Yet the fun­da­men­tal longer-term chal­lenge of al­low­ing mar­kets to re-price as­sets to fun­da­men­tals in a rel­a­tively or­derly fash­ion - and, crit­i­cally, with­out caus­ing eco­nomic dam­age that would then blow back into even more un­set­tled fi­nance - re­mains.

In­deed, the more fre­quent the bouts of fi­nan­cial volatil­ity in the months to come, the greater the risk that it will lead con­sumers to be­come more cau­tious about spend­ing, and prompt com­pa­nies to post­pone even more of their in­vest­ment in new plant and equip­ment. And, if this were to per­sist and spread, even the US - a rel­a­tively healthy econ­omy - could be forced to re­vise down­ward its ex­pec­ta­tions for eco­nomic growth and cor­po­rate earn­ings.

Durably stabilising to­day's mar­kets is im­por­tant, es­pe­cially for a sys­tem that has al­ready as­sumed too much fi­nan­cial risk. It re­quires a pol­icy hand­off in­sti­gated by more re­spon­si­ble be­hav­iour on the part of politi­cians on both sides of the At­lantic - one that un­der­takes the much-needed tran­si­tion from over­re­liance on cen­tral banks to a more com­pre­hen­sive pol­icy ap­proach that deals with the econ­omy's tri­fecta of struc­tural, de­mand, and debt im­ped­i­ments (and does so in the con­text of greater global pol­icy co­or­di­na­tion).

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