Monday, March 4, 2013

Central Banks Can Only Do So Much

Not so long ago Moody's Investors Service lowered ratings on Italy, Portugal, Slovakia, Slovenia and Malta by one notch and slashed Spain's sovereign rating by two notches. The ratings agency also cut the outlook on France, the United Kingdom and Austria. The moves reflect the susceptibility of the countries to the growing financial and macroeconomic risks emanating from the euro-area crisis and how these risks exacerbate the affected countries' own specific challenges. We must wonder how soon America will trigger a down-grade considering the recently proposes budget. The 1.5 trillion dollar deficit America has ran each of the last several years means spending on every man woman and child in America, over 4,500 dollars more then the government takes in.

It is around a general view or group of expectations that financial markets and economic actors build their bets. Financial markets may react to a this "stimulus" by behaving ever more dangerously, until some shock triggers an epic collapse. This is different from a world in which financial markets assume that macroeconomic stabilization policy is sophisticated enough to prevent big nominal swings in the economy, and when the central bank allows or enables a big drop in nominal output everyone is caught off guard. There is a subtle difference between crises associated with the financial-market and those associated with central-bank incompetence. The two may go together, but that doesn't mean they're equivalent events or that attempting macroeconomic stabilization is a bad idea.

Governments and their central banks can't suppress all volatility, just the nominal swings. Real shocks may still upset financial apple carts, providing the needed market messiness. We can look again at 2008 for an example. It seems probable that the oil price spike of the first half of 2008 was destined to induce a recession. An aggressive central bank might have succeeded in keeping nominal output growth relatively stable, but inflation was likely to rise and real output decline in that scenario, based solely on the supply shock. I suspect that kind of recession was more than enough to topple vulnerable financial institutions and clear out a lot of financial brush. It needn't have implied a near-Depression, however.

Macroeconomic stabilization is consistent with healthy volatility; real shocks can be perfectly good at trimming back over-aggressive financial actors. It's a mistake to think that a deep, demand-side recession is the only thing that will do where financial-market discipline is concerned. It must be noted that: suppression of macroeconomic volatility isn't as big a problem for financial markets as is the "moral hazard" of  interfering and manipulating markets. I'm not sure that the relatively smooth macroeconomic performance of the last 30 years was as big a contributor to financial-market vulnerability as was the practice of stepping in to bail-out key creditors.

I'm currently working my way through the New York Times bestseller The Black Swan. In the book Nassim Taleb makes it clear that we never have a clue from where the next unexpected shock will hit our world. A guest on a television financial show put forth an interesting and seldom talked about theory, he thought emerging market were the Achilles heel that would bring about our next crash. These markets have done very badly so far this year, yet people have left their money in them as a long term investment. Emerging markets hold a large amount of  investors wealth, if they continue to drop because of risk, and if people would stampede to get out it would be devastating.

Our investment world is built on a foundation of faith and trust, if that begins to crack or crumble, real problems quickly form. People quickly forget how an economy grinds to a halt when suppliers or factories refuse to ship without securing "payment up-front". Unfortunately much of what we see and are told is a lie, and that is a fact, remember MF Global and Enron. If a market move occurs fast, most investors can not react and are left holding the bag at the bottom, these same investors then act as a roadblock to a market rebounding. If they loose faith and become disillusioned they often dump their stock over a period of years and at the sign of any rally. The financial crisis that began in 2007 also seems to indicate a fundamental flaw at the heart of the consumer society, the flaw being its emphasis on debt-propelled retail therapy.

Footnote:  Bernanke totally missed all the signs of a forming housing bubble in 2006. Recently he has been bathing in the spotlight, but as a hero and savior of the world economy his ego may have bested him. If he was a little more honest, and a little less arrogant he would say the following


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