In this summer’s buzz book here in Germany, philosopher Joseph Vogl argues financial market deregulation has led to the difficulties the Western economic system has suffered over the past five years.
Vogl claims the creation of different types of derivatives like securities, bonds and credit default swaps after the end of the Bretton Woods accord on financial regulation aimed to render investment in the deregulated financial system risk-free. And fatally, a complicated mathematical equation — the Black-Scholes formula — led many investors to assume that this was the case.
Because the equation assumed that the financial future would follow the patterns of the past, that markets gravitated around equilibrium and that all risks could be calculated as falling within a band of possibilities, any unforeseen event within the financial system came to damage that system inexorably.
That’s because investors had already bet that the future would turn out in a certain way, says Vogl. When it didn’t turn out the way they expected, they were left exposed. A panic sell-off began, as everyone, roughly at the same time, realised their futures or bonds might not yield what they had expected them to.
This sort of sell-off has occurred repeatedly on the markets since the late 1980s as prognostications led investors repeatedly astray. And that’s not the worst of it. Shortages of credit provoked by fluctuations on the financial markets have repeatedly flowed through to other sections of the economy, causing downturns — and the northern hemisphere recession of the past five years.
Today, it seems we’re on the verge of the second big market sell-off in five years, with many expecting world markets to dump stocks this morning.
The cause: the decision by credit ratings agency Standard & Poor’s to reduce the United States’ credit rating one notch down to AA+ on Friday, after weeks of back and forth between Democrats and Republicans over an agreement to raise the ceiling on the US federal debt. That decision means US Treasury bonds will be dumped around the world.
Indeed, reports German weekly Die Zeit, such moves are inevitable: not because anyone thinks the US will go bankrupt, but because governments have obliged investment funds to "contractually guarantee their clients that they’ll only buy products that have the top credit rating." Among the countries in this category: France, Germany, Canada and the UK.
The decision of the ratings agency to decrease the US credit rating has been controversial and the Obama Administration has criticised the agency after accounting errors were found in its decision report on the US rating. Standard & Poor’s has continued to defend its "political" decision to take the US down a notch on Sunday’s US talk shows, reports Mexico’s El Universal — and the agency’s head says there’s a one in three chance it will cut the US rating again within the next two years.
In Europe, too, the ratings agencies are facing trouble, with Italian magistrates opening an inquiry into claims that Moody’s and Standard & Poor’s "manipulated the financial market and abused confidential information", says Turin’s La Stampa. Prosecutors accuse the agencies of distributing "unfounded and imprudent" opinions about the Italian sovereign debt, reports the paper.
Among the most serious claims in the suit lodged by two consumer rights groups: in a report released in June, the agency condemned measures not yet presented in their final form to the Italian cabinet, causing a financial market dive. The agencies deny the claims.
Meanwhile, falls on Middle Eastern stock markets on Sunday in reaction to the Standard & Poor’s decision were some of the largest since the turn of the century, says Brazil’s O Globo. The stock market in Tel Aviv, for example, lost 7 per cent over the day, with trading suspended for an hour due to a panic selloff immediately after the start of trading. "The market has now lost 18 per cent since the start of the year" says the newspaper.
The losses in the Middle East came after a weekend of frantic phone conferences in Europe as political leaders tried to minimise the difference between what Italy and Germany have to pay to finance their public debts. Late on Sunday night, responding to French and German calls, the European central bank gave a "green light" to unnamed countries that will purchase Italian treasury bonds, writes Roman daily La Repubblica. The announcement came hours after Berlin and Paris told the Italian government it had to accelerate its austerity plans and balance its books a year earlier than expected.
The expected falls in the markets today will further contribute to several days of losses on the markets last week, with stocks dumped and the gap between what Spain and Italy on the one hand and Germany on the other have to pay to finance their debts rising to hitherto unseen levels.
The average market falls of around 10 percent last week were "absurd" according to Germany’s business daily, the Handelsblatt. "Those who say the capital markets are information efficient are either blind or naïve," writes economist Michael Hüter. For even as "states tackle their debt problems, the market and the ratings agencies react" as if they’re not aware of those decisions.
In a sign that German industry has had enough of the financial market turmoil, Hüter, the Director of the Institute for Economic Research, turns on the latter:
"The debt crisis has also a lot to do with the fact that the financial markets didn’t pay close attention and — regardless of the actual development of the given country’s debts and the debt to GDP ratio — they had a positive disposition to their sovereign debt, as the low differentials between the German and Greek debts right through to autumn 2009 show."
Joseph Vogl’s book on the financial markets provides a worrying answer on why that might be the case. He refers to the footbridge between St. Paul’s Cathedral and the Tate museum in London a decade ago. The bridge, built without large supports, was meant to keep its balance through the footsteps of those walking across it.
Yet the bridge’s own tiny oscillations meant that those strolling across the bridge adjusted how they were walking. This led to further adjustments by others on the bridge and so on, until the bridge started to sway dangerously.
It was found that if around 150 people crossed the bridge at the same time, it would collapse. And so the elegant bridge was closed and clumsy support structures were added. Yet the financial markets, writes Vogl ominously, function analogously:
"Price fluctuations lead to rational reactions, which spark adjustments and these through further feedback to a "perfect storm"… the passers by on the bridge react like banks, the oscillations of the bridge like price fluctuations."
For the sake of the world’s economic stability, let’s hope he’s got it wrong.
ABOUT BEST OF THE REST: It’s a big world out there and plenty of commentators and journalists are writing about it — but not always in English. And not surprisingly, ideas about big events of the day shift when you move away from the Anglosphere. Best of the Rest is a fortnightly NM feature by Berlin-based journalist Charles McPhedran. Charles reads the news in French, German, Spanish and Portuguese and reports on what the rest of the world is saying about the big stories.
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