Volatility: The flipside of moral hazard

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.

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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.


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