Wishful non-thinking won’t stop the economy vaporising

I think I have finally caught the Oxford English Dictionary out. Look up volatility in the online OED (it's addictive, I warn you) and you'll find the following definitions:

  1. "Readiness to vaporise or evaporate, tendency to be readily diffused or dissipated in the atmosphere, especially at ordinary temperatures."
  2. "Tendency to lightness, levity, or flightiness; lack of steadiness or seriousness."
  3. "Adaptability for flight."
  4. "Capacity for ready or rapid movement."
  5. "Computers: The property of a memory of not retaining data after the power supply is cut off."

Time for an update, guys. You are missing a definition of volatility that has been in daily use in the world's stock markets for years. And this kind of volatility - the financial sort - is giving the global economy a fright.

First, let us define volatility in the way the OED omits. Put simply, it is a statistical measure of the frequency and amount of movement in the price of a security like a share or a bond. If, for example, you buy a share at the beginning of the year and, in the course of the next 12 months, its price scarcely changes at all, then it has low volatility. But if it jumps 5 per cent on day one, falls 10 per cent on day two, jumps 11 per cent on day three, and so on, then it has high volatility.

Note that the direction of the change doesn't matter. Big upward jumps are as much a symptom of volatility as big downward slumps. The mathematically minded among you will appreciate that there is a link from volatility to standard deviation, which tells you the average dispersion of a set of data values from their statistical mean. (The finance geeks who have been taught how to price share options have an even fancier concept - implied volatility - but let's leave that for another day.)

Last week, after years of drifting downward, financial volatility came back with a vengeance. Stock markets plunged just at the very moment they were approaching their pre-dotcom-bust highs. US equities are down almost 4 per cent on a month ago. In London the plunge has been just under 6 per cent. Some emerging markets have been hit even harder, with cumulative four-week declines of 9 or 10 per cent (Russia and Turkey).

And it is not just stock markets that are suffering from a bout of volatility. Commodity prices have been on a rollercoaster - especially copper and gold - soaring to record highs and then falling sharply back last week. Measures of implied volatility also jumped upwards, though they are still a long way from their last big spike in 2002. Volatility sounds technical - until it's your nest-egg that's suddenly a tenth smaller.

As usual, financial analysts have a story to explain the return of volatility. The latest inflation data in the United States "surprised on the upside", as they say on Wall Street. Core inflation, excluding food and energy costs, is now running at an annual rate of 3.2 per cent.

Surveys suggest that people expect inflation to rise higher in the future. This puts the relatively un-tested chairman of the Federal Reserve, Ben Bernanke, in a quandary. Should he put interest rates higher, to dampen inflationary expectations? Or could that spark a crisis in the already weakened US housing market and a spasm of pessimism on the part of highly indebted consumers?

Such short-run explanations are characteristic of both Wall Street and the City, where vast significance is often attached to a single indicator or a mere word uttered by the Fed chairman. Question: why, only a year ago, were so many of these same analysts happily heralding "the death of volatility"?

The answer is that they were indulging in what a financier of an earlier generation, Siegmund Warburg, would have called "wishful non-thinking". Measures of volatility had declined since around 2002. The happy non-thought was that these trends could continue indefinitely.

Here's what was happening. Fears that the dotcom bust (or 9/11) might cause a 1929-style Wall Street crash were dispelled as Alan Greenspan pumped low-interest liquidity from the Fed to the markets. American consumption kept growing as asset-price inflation moved from the stock market to the property market. Meanwhile, the possibility of another 1997-style Asian crisis receded as Greenspan's counterparts in Tokyo and Beijing accumulated huge reserves of dollars. The world's financial markets trended smoothly upwards in unison, and down went volatility.

But all this was based on a manifestly unsustainable process. The booming US was importing vast quantities of Asian manufactures, and paying not with exports but with dollar-denominated IOUs. Driving the boom was the readiness of Americans to re-mortgage their houses and save not a cent of their income.

Most economists could see roughly how - but not when - this spiral of international and domestic debt accumulation would end. The dollar would start to weaken. Inflation would start to creep up. The Fed would raise rates. Consumers would tighten their belts. And if any of this happened with a jolt, then volatility would be back. Textbook stuff.

Nevertheless, as often happens in financial upswings, a variety of fancy theories were formulated to give the appearance of rationality to the wishful non-thinking. A new international monetary system had come into being, we were told, modelled on the post-war Bretton Woods system, in which Asians pegged their currencies to the dollar and enjoyed rapid and risk-free export growth. It was a "stable disequilibrium", others suggested, oxymoronically. The United States wasn't really running a huge deficit; it was exporting some magical "dark matter" not captured by the official statistics.

I, too, had a go at rationalising last year's prevailing exuberance, suggesting that foreign investors might not mind lending vast sums to the US at trivially low rates of return if this was a kind of tribute to the American empire, paid in return for the benefits of the pax americana.

My point, however, was precisely that this could not go on for very long. After all, an empire can continue to collect its tribute only if the pax it provides is real and has legitimacy. Unfortunately, the American project of transforming and stabilising the Greater Middle East has run into increasingly obvious trouble since the invasions of Afghanistan and Iraq. Indeed, mounting political risk in the region has been one of the drivers of higher oil prices this year, another source of renewed volatility.

One way to understand the problem is to adopt a much longer-run perspective than investors and traders generally take. Go back to the first age of globalisation, in the years from around 1880 to 1914. Then, too, there were pronounced declines in financial volatility in stock and bond markets. Interest rates were low and stayed low despite rising commodity prices. Those were good times in the City.

Those good times ended with a bang when Europe went to war in 1914. Overnight, liquidity dried up, forcing the major stock markets quite literally to close their doors. Volatility rocketed. It turned out that investors had mistaken liquidity for security. They had failed to price in the real possibility of a military challenge to Britain's imperial hegemony.

Of course, the world is not exactly the same now as then. The anglophone empire today is not a creditor but a debtor. Its currency is not backed by gold, but is just paper. And the threat it faces is not a neighbouring great power, as Britain did in 1914, but something at once more nebulous - Islamist terror? A new Iranian empire? - and potentially harder to defeat.

Whether those differences make the world more or less prone to a liquidity crisis than it was in 1914 I am not sure. But it seems reasonable to conclude that we should all hold on tight if, as seems likely, volatility is coming back with a bang. Come to think of it, perhaps "readiness to vaporise or evaporate" is not such a bad definition of volatility after all.

finance economics
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