BackViews | The dangerous spiral of fear
Views | The dangerous spiral of fear
PremiumFile photo of traders working on the floor of the New York Stock Exchange, in New York.AP Photo.
Next, the US Federal Reserve buttressed this darkened outlook by flagging ‘significant downside risks’ at its September 20-21 meeting. To counter these risks, it took measures to rebalance its $400 billion reserve portfolio towards a longer maturity to encourage business spending; and it supported the household mortgage market through reinvesting the principal payments from its holdings of agency debt and agency mortgage-backed securities.
Third, the political divisions amongst Europe’s policymakers over the resolution of sovereign debt risks remained unresolved.
Financial markets the world over were simply unable to digest all this: major global indices fell 4% on average in America (S&P 500, Dow Jones); close to 5% in Europe (FTSE 100, DAX); and from 3-9% in Asia on September 22, 2011.
All this combined explosively to bring the world global economy on the verge of a collapse. What is one to make of it?
First, it appears to be the case that neither policymakers nor markets can postpone confronting reality anymore. Second, policymakers are fast losing their ability to alleviate investor fears, which are escalating with alarming rapidity: Why else would markets react the way they did – sharp reversal from stocks - to the Fed’s decision? Why did the statement by the G20 leaders fail to quell investors’ mounting concerns over Europe? Third, the blurring of lines between monetary and fiscal policy rules and the bending of institutional roles triggered by the crisis has now reached a point of reckoning in Europe: Policymakers and investors are thus quite likely to differ sharply over what constitutes the best-course solution to the Euro zone’s lack of fiscal integration. Fourth, as in earlier crises, market signals are getting distorted by becoming less objective about fundamentals and more pronounced about perceived risks.
All this is feeding into each other in a dangerous spiral of fears about recession, financial market losses associated with European banks’ exposure to junk sovereign bonds, financial instability risks from the unraveling of debt imbalances in Europe, negative investor sentiment leading to rising risk aversion and so on. No one knows whether this circularity will explode full-blast as in 2008 or manifest in a continuous crisis-like situation. But there appears to be little choice except to adjust and lower expectations for policymakers worldwide have little firepower for any shock therapy now.
Renu Kohli is a macroeconomist and a former staff member of the International Monetary Fund and the Reserve Bank of India.
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