Opinion

Felix Salmon

Volatility: The flipside of moral hazard

By Felix Salmon
May 17, 2010

Jim Surowiecki today looks at the flipside of the moral hazard trade: if you can’t count on governments to bail you out in extremis, then you’re likely to have volatile and unpredictable markets.

Political risk is hard to manage because so much comes down to the personal choices of policymakers, whether prime ministers or heads of central banks. And those choices aren’t always going to be economically rational—witness Merkel’s recent tergiversations. Similarly, the U.S. government’s failure to bail out Lehman Brothers in 2008 seems to have been in part the result of Treasury Secretary Henry Paulson’s desire not to be seen as Mr. Bailout. Investors, then, are being forced to read the minds of policymakers—not something they’re good at. Markets work best when there’s lots of information available and a historical track record to go on; they excel at predicting things like horse races, election outcomes, and box-office results. But they’re bad at predicting things like who will be the next Supreme Court nominee, as that depends on the whim of the President.

Surowiecki is saying not only that Merkel should have bailed out Greece with alacrity and that Paulson should have bailed out Lehman: he goes on to praise successful interventions in the markets such as the Clinton/Rubin bailout of Mexico, Hong Kong’s successful 1998 intervention in its own stock market, and the Obama Administration’s decision to preserve as much equity and debt value of the banking system as it could.

In all these cases, government intervention was used to prop up market prices — of Mexico’s bonds, of Hong Kong equities, and of US bank stocks and preferred debt. And yes, when there’s a government put, volatility goes down. But that doesn’t mean that government puts are a good idea: after all, it’s not the job of government to reduce market volatility.

What’s clear is that governments — and I’m including central banks here — have much less ammunition now than they did pre-crisis, even if they still have the willpower to intervene to save markets from themselves. And the willpower is evaporating rapidly, to boot. The result is that the moral-hazard play is becoming increasingly dangerous, and that volatility is sure to stay high.

The only thing keeping markets from plunging on worries surrounding European finances is faith in the political credibility of the European Union and the ECB. And on that front, there’s a lot more downside than there is upside, since we’re leaving a world of very high European cohesiveness and entering a world of much greater uncertainty. It’s already clear that the UK is going to be absent from the European project for the foreseeable future; the big risk is that the Germans will follow suit.

A lot of investors have made a lot of money from the moral-hazard trade over the past 15 years or so. When that trade comes to an end, expect the losses to be just as big, if not bigger.

Comments
12 comments so far | RSS Comments RSS

Well nothing can continue to go up on a straight line.From the LTCM bailout , the magnitude of the bailouts has been going up to the massive almost $1 trillion bailout by Europe.Bailouts will have to end and a it will be a good thing too , since they have not solved anything yet.

Posted by AGreenInvestor | Report as abusive
 

If governments now lack the ammunition and the desire to save the markets from themselves through intervention, then it’s a safe bet that these same governments will seek a much stronger regulatory presence in the capital markets, much greater than anything seen heretofore, to prevent any potential future market meltdowns. Investors may not like that fact; quants dreaming up new structured products certainly won’t like it, as governments will view any new, complex financial instruments as a potential threat to the ‘order’ that will have been established by a massive government oversight of the capital markets. The bright guys on Wall Street may have outsmarted themselves this time, as it is hard to imagine any government, given the current anti-market tenor, not taking advantage of this to re-regulate the markets with a vengeance. Like it or not, it’s a vote-getter.

Posted by Gotthardbahn | Report as abusive
 

I’d put Surowiecki up with there with Megan when it comes to a genius for missing the fundamental point. While it may be correct that if you can’t count on governments to bail you out you’re likely to have volatile markets, if you CAN count on governments to bail you out, you don’t really have a “market” in the economic sense anymore. Instead you have a mechanism for channeling wealth and reward to insiders or to the politically well-connected, and at times totally randomly, instead of one that offers allocative efficiency by pricing capital and risk appropriately, as only true markets can do. Unfortunately, we’ve been living with these administered and politicized markets since the LTCM bailout, if not earlier. Maybe it’s been so long that Surowiecki has forgotten what markets looked like before the Greenspan-Bernanke put was taken as a given by so-called “investors.”

Posted by maynardGkeynes | Report as abusive
 

No LOLR in Europe! Great! Let’s have:
1) A Debt-Deflationary Spiral
2) Every Country for itself and God against all.
3) The rise of German Nationalism.
I’ll just have to look, having read the book.

Posted by DonthelibertDem | Report as abusive
 

I’ve got to go Evans-Pritchard on this one:

http://www.telegraph.co.uk/finance/finan cetopics/financialcrisis/7734280/Banks-d ump-Greek-debt-on-the-ECB-as-eurozone-fl ashes-credit-warnings.html

“The ECB’s strategy of draining liquidity to offset the stimulus from the bond purchases risks making matters worse. “They are using one-week deposits for sterilisation and the effects of this to make short-term funding more expensive. This will force banks to sell assets to shrink their balance sheet and risks causing a credit crunch,” he said.

Mr Redeker said the ECB is pursuing a contractionary policy to assuage concerns in Germany that Club Med bond purchases will stoke inflation. “They have read the German press and it made their hair stand up on their necks. The reality is that a deflationary cycle is developing in Euroland and the ECB will eventually have to start quantitative easing,” he said.

Dominic Wison, market chief at Goldman Sachs, said talk of an EMU break-up were overblown but echoed concerned about strains in the short-term money markets. “The LIBOR-OIS spreads widened consistently through the week. Ongoing pressures on funding have not yet been quieted. As we saw in 2008 and 2009, those stresses – if they do not subside – are generally toxic for markets,” he wrote in a client note.”

Munchau is right, but, in the short term, so is Redeker.

Posted by DonthelibertDem | Report as abusive
 

Don,

If you are referring to the 1930s, it’s important to remember that it wasn’t the failure of Creditanstalt that caused the trouble. It was the bailout of Creditanstalt— a bailout too far.

Greece is not paying everyone back at 100 cents/dollar. It can’t, so it won’t. Who will eat the losses? What about Portugal and Japan? They can’t pay back what they borrow, either. Should we bail them, too?

The taxpayers of the less insolvent countries not only shouldn’t be obligated to eat all the losses, they can’t be— the losses are too big and national balance sheets too stretched already.

Posted by WVJoe | Report as abusive
 

Surprisingly, the life expectancy in the club med states of Greece, Italy and Spain are all longer than in wealthier Germany. This is a reversal of what is normally seen. The difference is not huge, but lets not imagine that Greece, Italy and Spain are suffering grinding poverty. They have had a pretty good thing going on.

Posted by DanHess | Report as abusive
 

Here’s my view of 1931:

The situation as relates to Germany & the UK is as follows:

The US was:
1) A Huge Creditor to them
2) A Huge Exporter to them
3) Had Tariffs on their goods

This was a kind of closing vise, in that it made it very hard for them to pay us without austerity for their own people. For a time they could borrow, import gold, shift the pain to their people around, but that eventually wound down. When it did, Britain basically rewrote the terms of the deal, while Germany was granted better terms.

Sadly, the better terms for Germany came too late.

Posted by DonthelibertDem | Report as abusive
 

The days of Long, Buy and Hold are over

http://storyburn.com

Posted by STORYBURNcom2 | Report as abusive
 

One statement you make, that it isn’t the governments job to lower volatility makes it seem like you think economic history started in1980. There were a lot of changes in the 80′s, many for the worst as we have seen recently, Reaganomics has died a long painful death but we do have a new day here.

Government as defined by the constitution as me and you and the the 330 million of us absolutely have that responsibility, are you seriously suggesting that we leave up to the business sector? Now that makes no sense as businesses job is to develop products and services that allow it to “gain and retain profitable customers” according to Dr. Peter Drucker.

Where in that role do you see business concerning itself with macro economics.

If you don’t understand that then we are in trouble, oh yea, we are.

Regulate fairly, enforce aggressively and sentence severely.

Posted by jstaf | Report as abusive
 

My e-mail to Surowiecki:

Dear James,

When there is no danger of a sovereign crisis, Keynesian methods work. When there is danger of a sovereign crisis, Keynesian methods do not work. At such a point, the government can’t borrow more, can’t tax more, and is left with the options of inflation and/or default. With most developed country governments having unfunded liabilities and debts of ~$4x GDP, it is no surprise that weak countries like the PIIGS or structurally weak concepts like the Eurozone are in trouble.

http://alephblog.com/2010/03/03/the-pain -has-to-go-somewhere-but-where/ (on the US)

http://alephblog.com/2010/03/14/promises -promises-2/ (on the World)

There is no easy way out here, and our politicians are only fooling themselves. This is not a liquidity crisis; this is not predominantly a solvency/sovereign crisis. This is a cultural crisis, where nations will have to say what they stand for, or fail.

Sincerely, and with respect,

David

Posted by DavidMerkel | Report as abusive
 

Neither logic nor terminology of free market capitalism apply to what we’re seeing now, namely non-stop upward redistribution of wealth via convoys of hijacked vehicles that can’t even manage their own hot-air supply but suck the last drop of blood out of everything else on earth.

Door Number 1: Volatility? Bring it on. Let it burn itself out. Bleach the ashes and everything this tainted market has touched, that no spore of its cannibal virus remain alive.

Door Number 2: Would you rather Merkel had slept with it on the first date?

Door Number 3: Little something in between – ménage à GS, perhaps?

Don’t worry, Felix. Surowiecki can’t make up his mind, either.

Posted by HBC | Report as abusive
 

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