Op-ed about financial market volatility in August 2011

1. On the Recent Financial Market Volatility
A Crisis of Confidence
On Friday, August 5, 2011, the US-based rating agency Standard & Poor’s downgraded US sovereign
debt from AAA status for the first time in its history.
Subsequently, the financial markets saw massive drops beginning on August 8, 2011, with 11.2% drops
in value in the Dow in the US, while all European markets were also hit with major declines. The German
Dax declined by 22%, the British FTSE declined by almost 15%. Likewise, in Asia, Korean and Japanese
markets both tumbled by 3.7%.
http://www.bbc.co.uk/news/business-14418539
http://www.bbc.co.uk/news/business-14414669
Source: BBC News
Rebound
http://www.bbc.co.uk/news/business-14502255
Nevertheless, by Friday August 12, 2011, the markets were in stark rebound. What is happening here?
Has something changed in the market fundamentals?
Change in the Market Fundamentals? Yes and No
The main fundamental which has changed in the financial markets is the credit rating for US sovereign
debt.

2. Change in Confidence
What really happened was a change in the way investors feel about future prospects for stability in the
financial markets. Basically, we can take both the sharp downward swing and the dramatic increase in
volatility as a market signal that financial stabilization measures in both the US and the EU have not
really addressed the major issues. In other words, according to the market outlook, bailouts in the US
have failed and the debt negotiations have also failed. The market outlook vis-à-vis the EU is that
Europe’s reaction to the Greek crisis and the sovereign debt problems of the Mediterranean rim, as well
as general European financial stabilization have been altogether insufficient.
The US
Underlying the downgrade US sovereign debt – and the subsequent widespread selloffs in the US stock
markets – is a general loss of confidence in the soundness of US economic management. While the
banks have been recapitalized and the money quantity has been dramatically increased, microprudential
regulation has been all but neglected. In other words, the American attempt to soundly regulate the
financial crisis has failed. Why did the 400 provisions of the Dodd-Frank act get reduced to 38? Why has
no further regulation been enacted? What plans are there to join and adhere to international financial
regulatory standards?
As for the bailouts, we see that the banks have been re-capitalized, and that the financial institutions
have been rebuilt, and that QE has left massive amounts of liquidity in the financial market, but that
none of that money has been sent into the real economy. The result: unemployment and production
figures never really improved. This is because insufficient regulation has been put into the US financial
and banking sectors. Thus, all the new cash in the system does not actually reach the problem areas for
which it was actually intended. This leads monetary-expansionary needs to be much larger than what
they could be, while the crisis-response effect is largely mitigated and risk of crisis is increased
dramatically.
And as for the debt-ceiling negotiations, the cuts will simply mean a drop in growth. The cuts will also
mean an upwards re-distribution of income and wealth in the US economy. The real answer was to
perhaps increase revenues. In short, both the Democrats and the Republicans have come to an
agreement to launch an upwards redistribution of wealth, despite the fact that Obama’s democratic
mandate was exactly the opposite of that.
Furthermore, getting rid of the Gephardt Rule (automatic debt-ceiling rule) means that this sort of
showdown might occur again and again. The Republicans took a calm budgetary process, and turned it
into an annual risk of default showdown. They created an economic crisis where there was none before,
only to redistribute wealth upwards. What is worse is that the Democrats went along with it all.
This is why the US was downgraded by the rating agencies.
 A drop in growth for the coming few years.
 Future prospects of legislative showdowns on the budgetary issues

3.  A dramatic increase in the money supply. Besides QE1 and QE2, the US has pledged to keep
interest rates low until 2013.
 The lack of microprudential banking and financial banking regulation
 A bailout which did not reach the real economy, due to insufficient regulatory standards
I would say that Washington’s mismanagement played a huge role in this situation.
Europe
While the drop in the financial markets was particularly bad on Wall Street, it was also severe in Europe.
Overall, there are good reasons for which the financial markets have also lost their confidence in the
European markets.
In some ways, Europe’s situation resembles that of the US. Specifically, the money supply has increased
dramatically (both in the Eurozone and in the UK), while microprudential regulation has generally not
improved much.
With respect to the sovereign debt situation, European austerity measures are bound to have the same
effects on growth as those in the US. Furthermore, as the headlines have shown us in the UK, Greece,
and Spain, angry European youths have already decided to take to the streets on this issue.
Spain: http://www.bbc.co.uk/news/world-europe-13466977
Greece: http://en.wikipedia.org/wiki/2010%E2%80%932011_Greek_protests
On top of that, the Eurozone has been revealed to be much more unstable because the crisis has made
it painfully clear that the Eurozone has no pre-set plans to deal with the financial trouble of the
member-nations. This is despite the fact that monetary policy in the Eurozone is set along a strict price-
stability mandate, with no pronounced growth mandate (this was already likely to result in economic
troubles in both the Mediterranean rim and in Eastern Europe. My question is why did the ECB not
decide on an “Anglo-French” monetary policy, whereby both growth AND price stability are mandated?
To add even more fuel to the fire, EU common market rules allowed and even encouraged cross-border
banking, without having proper microprudential rules in place to mandate responsible and sustainable
European banking practices. In fact, prior to 2008, financial-regulatory regimes were different from
country to country across the EU, with little-to-no coordination between banking authorities in the
various EU countries.
While this is more or less a perfect recipe for financial troubles over a 10-year time-span, the EU did not
have a financial crisis mechanism. The result is:
 A drop in growth for the coming few years
 A dramatic increase in the money supply
 The lack of microprudential banking and financial banking regulation

4. In the face of all this, the response from Europe has been a bilateral response whereby Germany and
France have decided to respond to the economic troubles in the Mediterranean rim on their own. It is as
if California tried to resolve its debt crisis by asking Vermont for a loan. Does that not just seem like a
stupid way to do things?
Some Bright Spots in Europe
Since the emergence of the financial crisis in Europe in 2008, there has been an effort to coordinate
both financial crisis response policy by founding the EFSF, as well as the EFSM and financial, banking,
insurance and fiduciary regulation by means of the ESRB, EBA, and ESFS.