When risk becomes uncertainty

By Felix Salmon
May 14, 2010
today's torrid market action: the positive effects of last weekend's emergency meetings clearly didn't last even until Friday, and the ever-weakening euro is now dragging down the continent's bourses. This isn't (just) a sovereign-credit issue any more: the financial markets have worked out that there's a pretty simple trade-off between fiscal austerity and economic growth.

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It’s going to be another panicky weekend in Europe after today’s torrid market action: the positive effects of last weekend’s emergency meetings clearly didn’t last even until Friday, and the ever-weakening euro is now dragging down the continent’s bourses. This isn’t (just) a sovereign-credit issue any more: the financial markets have worked out that there’s a pretty simple trade-off between fiscal austerity and economic growth.

At the same time, markets clearly don’t believe that fiscal austerity is going to be a reality either: Greece’s CDS spreads are now back out over 600bp, and the rest of sovereign Europe seems to be gapping out too.

Most worryingly of all, the biggest losers today on European stock exchanges have been the banks — which means that we could be heading for a reprise of the 2007 credit crunch.

The big picture here is that risk, in Europe, is being replaced by uncertainty. The difference is that risk can be priced, while uncertainty can’t, and a market dominated by uncertainty is always going to be jittery and dangerous. No one knows whether the trillion-dollar bailout package announced last weekend will ever actually exist in practice; no one knows whether there’s a Trichet Put or not; no one knows whether the historic alliance between France and Germany, in which both of them do whatever it takes for the sake of European unity, still really exists; and everybody knows that the UK now has the most eurosceptic government since Margaret Thatcher resigned 20 years ago.

Meanwhile, on this side of the pond, we’re seeing large stock swings yet again, with the Dow down over 200 points and the VIX at 33: the uncertainty in Europe is clearly spilling over to the U.S., and this time a phone call from Barack Obama to Angela Merkel is unlikely to do much visible good.

This isn’t a second financial crisis yet. But the fact is that the world’s governments and central banks have much less ammunition than they did last time around if such a thing were to emerge. So the possible downside is enormous, especially given how much markets have rallied in the past year. If you can’t stand a lot of heat, then this particular kitchen is one to avoid for the time being.


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This is looking like the period from Lehman to Citi, when “No More Lehmans” was finally put forth. For some reason, Govts like these stomach churning roller coaster rides where they appear to guarantee everything, and then take it back, time and again. If you’re going to guarantee everything in the end, the time to say that is right at the start. Then, the panic and uncertainty are quelled, thereby saving money in the long run.

If you end up cutting everybody loose, these mood swings will lead to utter despair. Hey, I spend everyday there, and can explicitly guarantee that it’s not a fun place to be.

Posted by DonthelibertDem | Report as abusive

It will soon become clear to everyone that true, unsanitized quantitative easing is the only way out.

The aging developed world is on a demographic downslope and is engaged in natural delevering. Young people lever up as they finance educations and take out mortgages. Older people pay off their mortgages and don’t get new ones. Hence aggregate money measures are shrinking and have much farther to shrink as natural life-cycle delevering continues across the developed world.

The pattern of shifting debt to the public sector is hardly a solution because we have reached a point where private sector growth is crowded out. The entire premise of governments taking on debt (that they will gradually grow their way out) collapses.

When bigger bond auctions start failing, with no new balance sheet to take over, it will be Q.E. or a debt spiral.

Posted by DanHess | Report as abusive

“This isn’t a second financial crisis yet.”

With all due decorum, respect, and assorted other rubbish, what the hell are you talking about?

The entire world has been slipping into financial chaos from at least 2007 on. Reserved rhetoric looks uncharmingly disingenuous. You sound like a drunken parent on the Lusitania cautioning their little girl that she might get her hair wet.

Posted by Uncle_Billy | Report as abusive

Quantitative easing will not work – push that string all you want, but monetary authorities cannot inflate. When there is a collapse in demand only broad fiscal measures will have the effect you want – cuts in taxes, increase in spending or some combination of both. Toying with rates or reserves or central bank balance sheets is not getting it done.

Posted by Sensei | Report as abusive

Something like 60% of equity trading volume now comes from high frequency trades. You know, 12,000 discrete trades per micro second. It’s all jump the que trading.

Discussions about fundamentals have absolutely nothing to do with today’s version of exchanges. Their only real value is to provide a “narrative” the suckers will believe enough to continue being plundered.

Posted by Beezer | Report as abusive

Then again, I (or rather, Keynes) would probably claim that it really isn’t the case that Risk is being replaced by Uncertainty. Its more along the lines of people realizing that what they *thought* of as measurable Risk, was actually more along the lines of Irreducible Uncertainty.
The point is that it was *always* Irreducible Uncertainty. Its just that people thought they had a handle on it, and could measure it, a-la Risk. I guess, in many ways, this is really just the other shoe dropping. We had the first one back in 2008 (what? VaR doesnt *actually* measure everything? etc.)…

Posted by dieswaytoofast | Report as abusive

@Sensei — Quantitative easing already has worked. We saw this is March 2009, when Bernanke resorted to QE to cut off a deflationary spiral.

True quantitative easing is a real big gun. Ask a Zimbabwean if it is possible to manufacture inflation. I am certainly not suggesting that level of money creation, but it is clear that unsterilized Q.E. kills deflation, if it is big enough.

And guess what: in March 2009, Bernanke didn’t even whip out the really big guns. He bought bonds and mortgages, which put money in banks where it can trickle slowly into the economy.

What is are the really big guns? New money-financed tax cuts (discussed by Milton Friedman) would put money directly in the hands of the people. Ben didn’t do anything like a helicopter drop but a money-financed tax cut would be it.

The deflationary destruction of credit is substantial and a trillion or two may not be enough to cause inflation, but as sure as the sun comes up, there is a number at which Q.E. gets inflation going.

Posted by DanHess | Report as abusive

Don the Totalitarian Democrat is right. Governments should guarantee everything, with reckless disregard for their own solvency. So long as the government remains solvent everything will be excellent and everyone will be happy. After they are no longer solvent… hm, we can just worry about that later.

Posted by johnhhaskell | Report as abusive

@DanHess What do you suggest the Fed purchase now, besides more bonds and mortgages? The only thing the central bank can do is add to their balance sheet. But all this does is add reserves to the banking system – they aren’t buying those assets from you or me, they buy them from banks to provide added liquidity and ease credit (even Bernanke prefers the term “credit easing”). To really affect aggregate demand these reserves would have to be lent out, borrowed and spent by firms or consumers. But who in their right mind is seeking new debt? The demand for new credit just isn’t there for QE to be effective – assuming it ever is. This is the only way the Fed can “create” money, but it isn’t inflationary in the sense you suggest because it isn’t adding any net assets to the private sector. It reshuffles the composition of private sector holdings without creating anything new.

The really big gun you describe is FISCAL policy not monetary policy. The Fed cannot impose taxes or spend money or print dollars and drop them from helicopters. The Fed cannot inflate. The US Congress can – and probably should.

Posted by Sensei | Report as abusive

@Sensei: The Fed can print money to buy treasury bonds, the money then goes into your pocket directly through a government handout of $1000 for every adult, children, and dog in the country, effective immediately.

That’ll solve any and all deflation fear. It’s the environmentally friendly helicopter.

Posted by MarshalN | Report as abusive

@MarshaIN “The Fed can print money to buy treasury bonds…”

They can only purchase bonds that already exist – bonds which are held by private parties and represent non-government financial assets. Exchanging bonds for cash just changes the composition of these assets and doesn’t create anything new.

The Fed can’t give people money through monetary operations. Only the fiscal authorities can do that – by taxing less or spending more.

Posted by Sensei | Report as abusive

@Sensei: What I meant was for the government to issue new T-bills that goes straight from the Treasury to the Fed, and in return, the Fed “buys” them from the Treasury. The government then in turn gives the money out via tax cut, free money, whatever you want to call it. You can do it through an intermediary to make it look legit, but the end result is the same.

I’m not saying that’s what they should or would do. I’m just saying that there is nothing stopping them from printing money.

Posted by MarshalN | Report as abusive

@MarshaIN What’s the point of that? The federal government doesn’t need to issue bills and sell them to the Fed (or anyone else for that matter) to get money – if this is ever actually done as you describe it’s only done to maintain the “funding fiction” that we’ve codified into law for no good reason. The US Congress can cut taxes or spend money unilaterally without any real constraint or any real coordination with the Federal Reserve. The gov doesn’t need to have money in the bank to fund a tax cut or cut a check. In fact, the government doesn’t really have (or need) money the way private entities do.

The Federal Reserve cannot “print money” in the way you are describing – creating new financial assets. The federal government, in contrast, “prints money” every day of the week. They also destroy a fair amount of money each day through taxation. The question is this: will they create more and destroy less? The deficit must increase – that is the only way to “print money.” The central bank has nothing to do with this.

Posted by Sensei | Report as abusive

MarshalN is right. If Congress spends more than they take in, Treasury needs to sell bonds to cover this shortfall. The willingness of the market to finance government shortfalls is finite.

The Fed can simply buy treasuries (and they did this to the tune of $1 trillion in the past year or so). This has been, in essence, new high-powered money that goes into the system. All those that sold treasuries to the fed during the past year got electronic cash in return. This is new cash that did not exist before.

Indeed, through the mechanism MarshalN talks about, there have been substantial new cash infusions into the economy. Aid to the states in 2009 and tax rebates, part of Obama’s stimulus plan, were funded when the treasury issued debt while the Federal Reserve bought up the debt.

Theoretically the Fed can sell these treasuries back into the market and drain that liquidity back out but there is no sign of that on the horizon.

Posted by DanHess | Report as abusive

@DanHess As a matter of law (or policy) we require the Treasury sell bonds to match a federal budget deficit $ for $. But the issue and purchase of these bonds comes AFTER the money has been created and spent. That mechanism isn’t funding or financing anything. It’s a fiction we maintain for political purposes, a piece of fiscal theater. If no one stepped up to buy these bonds – if an auction failed – it would make no difference. Having the Fed buy them is utterly pointless.

“The willingness of the market to finance government shortfalls” is irrelevant. The Treasury could stop issuing treasuries tomorrow and it wouldn’t affect our government’s capacity to spend in the least. The United States government can spend whatever amount of US dollars it wants without taxing or borrowing to fund those expenditures. That’s what it means to be a monetary sovereign.

“All those that sold treasuries to the fed during the past year got electronic cash in return. This is new cash that did not exist before.” – Not true. The cash they received is not new money, high-powered or otherwise. How did they acquire those treasuries in the first place? At some point they exchanged dollars for treasuries (interest-bearing dollars, in essence). These treasuries are so liquid and so secure that owning them instead of “cash” represents no compromise of private spending power. Treasuries are as good as cash. When the Fed or anyone else buys them from you it doesn’t give you new money (excepting interest) – it just gives you your money back in another form – all that changes is the composition and term structure of your dollar assets. You aren’t any richer. And it doesn’t boost private spending power the way a tax cut would. A tax cut, by the way, that doesn’t need to be funded or financed.

This all started because you suggested Quantitative Easing was needed on a massive scale. But most of the examples you’ve provided (aid to states, tax cuts) have nothing to do with monetary policy – they are purely fiscal. And these funding mechanisms you and MarshalN describe are not how we can achieve inflation or reflation or boost demand in the aggregate. I’m just trying to show how little the Fed (or any central bank) can do to accomplish your desires. All they really control is the rate paid on reserves. The way to combat deflationary forces is to run larger (unfunded) deficits. Something like a payroll tax holiday would be far more effective – that’s the kind of Quantitative Easing we all could handle.


Posted by Sensei | Report as abusive

@Sensei: You have it backwards. The Fed is the one that deals with creating and destroying money. It just makes money out of thin air. If you don’t believe me or Dan, you should do some research on your own on the subject of who creates money in the US economy — I’m pretty sure an intro level economics textbook should do the job. I can tell you right now it’s not the US Treasury.

In fact, a quick google search led me to this, a summary of the chapter on the Fed from Greg Mankiw’s popular book

http://www.csun.edu/bus302/Lab/ReviewMat erial/macro6.pdf


Posted by MarshalN | Report as abusive

@MarshalN Goodness! No offense, but telling me to do some research and then pointing me to Mankiw is outrageously funny. His textbook view of money creation – fractional reserve banking and the magical money multiplier – has little relation to how our financial system really operates. Banks don’t lend reserves. The loan desk and the reserve desk don’t talk to each other – or need to. Banks first makes loans to credit-worthy borrowers, irrespective of reserves, and after making the loans, if they are short reserves bank-wide, they simply borrow them overnight from the interbank market or directly from the Fed. The money multiplier is a myth – it only works in Greg Mankiw’s textbook world.

I know you don’t believe me – and you’ll never get any closer to understanding what I’m saying by reading the likes of Mankiw – but I repeat it again: the Fed cannot inflate. Fiscal policy is the only monetary policy that matters.

Posted by Sensei | Report as abusive

“Fed Plans to Inject Another $1 Trillion to Aid the Economy”
http://www.nytimes.com/2009/03/19/busine ss/economy/19fed.html?_r=1&hp

“WASHINGTON — The Federal Reserve sharply stepped up its efforts to bolster the economy on Wednesday, announcing that it would pump an extra $1 trillion into the financial system by purchasing Treasury bonds and mortgage securities.”

Posted by DanHess | Report as abusive

Mass purchase of T-Bonds or – worse – fistfuls of MBS-BS from the sleazy shysters who fabricated them is no way to pump money into the economy. It’s tantamount to devaluing the currency itself by carcinogenic misappropriation of taxpayer wealth.

But that’s what the Federal Reserve does all the time. They need to give the name “Federal” back to the people and see how they fare doing business under a truer title, such as Stand-in Wall Street Fluffers-R-Us.

Posted by HBC | Report as abusive

Again, even if those amounts are correct and not just the Fed spinning a back-door bank bailout, it doesn’t inject money directly into the economy. If your mechanism requires credit creation to work – those added bank reserves turning into new loans – it is doomed to fail in this economy: the demand for credit just isn’t there. It’s credit demand that drives loan expansion – not reserves. Adding reserves by expanding the Fed’s balance sheet will strengthen banks (its real purpose) but it will not “bolster the economy.”

If $1 Trillion net was really injected into the economy we would see dramatic improvements in employment and capacity utilization. The Fed doesn’t have the ability to do that. Only the government can accomplish that through higher spending or lower taxes.

Posted by Sensei | Report as abusive