On 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%.

http://www.bbc.co.uk/news/business-14418539

http://www.bbc.co.uk/news/business-14414669

Source: BBC News

Rebound http://www.bbc.co.uk/news/business-14502255

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 the Market Fundamentals? Yes and No 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.

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.

The lack of microprudential banking and financial banking regulation

A bailout which did not reach the real economy, due to insufficient regulatory standards

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.

Spain: http://www.bbc.co.uk/news/world-europe-13466977

Greece: http://en.wikipedia.org/wiki/2010%E2%80%932011_Greek_protests

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.