Jewish World Review May 23, 2006 / 25 Iyar, 5766

World markets' wild ride: Economic volatility is back with a vengeance

By Niall Ferguson

http://www.JewishWorldReview.com | I think I have finally caught the Oxford English Dictionary. Look up "volatility" in the online dictionary (it's addictive, I warn you). Among the definitions you'll find are, "readiness to vaporize or evaporate," "tendency to lightness" and "capacity for … rapid movement."

Time for an update, guys. You're 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's define volatility in a way the dictionary omits. It's a statistical measure of the frequency and amount of movement in the price of a security. If, for example, you buy a share and, during the next 12 months, its price scarcely changes, then it has low volatility. But if it jumps 5% on day one, falls 10% on day two and so on, then it has high volatility.

Last week, after years of drifting downward, financial volatility came back with a vengeance. Stock markets dived at the very moment they were approaching their pre-dot-com-bust highs. U.S. equities are down close to 4% from a month ago. In London, the drop has been just under 6%. Some emerging markets have been hit with cumulative four-week declines of 9% or 10%.

And it's not just stock markets that are suffering. Commodity prices have been on a roller coaster — especially copper and gold — soaring to records and then falling sharply back.

As usual, financial analysts have an explanation. The latest inflation data in the U.S. "surprised on the upside," as they say on Wall Street. Core inflation, excluding food and energy costs, is running at an annual rate of 3.2%. Surveys suggest that people expect inflation to rise higher. This puts the relatively untested chairman of the Federal Reserve, Ben S. Bernanke, in a quandary. Should he set interest rates higher, to dampen inflationary expectations? Or could that spark a crisis in the already slowing U.S. 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 London, where vast significance is often attached to a single indicator or 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 about 2002. The happy non-thought was that these trends could continue indefinitely.

Here's what was happening. Fears that the dot-com bust (or 9/11) might cause a 1929-style Wall Street crash were dispelled as former Federal Reserve Chairman Alan Greenspan pumped low-interest liquidity from the Fed to the markets. American consumption soared as asset-price inflation moved from the stock market to the property market. Meanwhile, the possibility of a 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 upward in unison, and down went volatility.

But all this was based on a manifestly unsustainable process. The booming U.S. was importing vast quantities of Asian goods, paying for them with IOUs in dollars. Driving the boom was the readiness of Americans to remortgage their houses and save not a cent of their incomes. 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, academic 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, modeled on the postwar Bretton Woods system, in which Asians pegged their currencies to the U.S. dollar and enjoyed rapid and risk-free export growth. It was a "stable disequilibrium," others suggested, oxymoronically. The U.S. 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 rationalizing the prevailing exuberance, suggesting that foreign investors might not mind lending vast sums to the U.S. 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, the empire can continue to collect its tribute only if the pax it provides is real and has legitimacy.

Unfortunately, the American project of transforming 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 — yet another source of renewed volatility.

Come to think of it, perhaps "readiness to vaporize or evaporate" isn't such a bad definition of volatility after all.