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Tuesday, 03-October-2006
Project Syndicate - Television and newspapers continue to trumpet every twist and turn of global financial markets. In truth, however, the big story is the soothing calm that has engulfed virtually every major asset class, from stocks to bonds. Is the whole investment world on Prozac?
Conspiracy theories abound, particularly among the ranks of financial traders, for whom volatility is like wind to a sailor. These traders confidently figure that as long as markets gyrate, no matter what the direction, they can always make money. And, thanks to the rest of us who don’t have the time, information, and skill to match wits with them, they are mostly right. But, with today’s dormant markets, the pickings are slim.
The favored bogeymen of the day are giant government investors, particularly Asian central banks, with their trillions of dollars in assets. These super funds, whose managers do not necessarily share the same passion for profit as private investors, are said to be squeezing the life out of interest rates and exchange rates. “The big Asian central banks are oppressing us,” one young trader recently complained to me.
What a difference a decade makes. During the 1990’s, private investors looked at big, lumbering central banks as cash cows, long on money and short on financial acumen. George Soros once made a billion dollars off the Bank of England in just an hour. His basic strategy was a standard one: bet against any central bank that tries to defend an inconsistent macroeconomic policy.
Traders did not win every battle, of course. It was the speculators whose blood flowed in the streets when they attacked Hong Kong’s dollar peg in 1998. But overall, betting against big government financial institutions proved to be a richly rewarding business.
That was the 1990’s. Today, many traders see formerly inept state giants as financial geniuses, capable of taming complex financial formulas and exploiting their superior size and trading information to squeeze the life out of currency and interest rate markets. These behemoths’ innate conservatism, having calmed bond and currency markets, is now having a similar effect on stocks. Although few accuse Asian central banks of explicitly conspiring to calm global markets, some say that their common cautious approach to trading is a form of implicit collusion.
As much as we may sympathize with young would-be millionaire traders, does their story of oppression make any sense? Could it be true that huge government investors from Asia (not to mention Russia, Latin America, and the Middle East) have quietly taken control of world markets? Perhaps, but the bogeyman theory seems a bit overblown.
Yes, the big Asian central banks do sit on almost $3 trillion in assets; China’s central bank alone has around a trillion dollars. This gives them a capital base similar to the combined assets of all the world’s major hedge funds.
But this metric is very deceptive. Hedge funds constitute only a small percentage of overall world financial markets, which, according to a recent study by the McKinnsey Global Institute, now exceed $120 trillion. And hedge funds, unlike banks, can leverage their bets, borrowing to take on assets many times the size of their capital base. Otherwise, George Soros and his wealthy fellow investors could not have dreamed of taking on the Bank of England.
In fact, the explanation for market calm probably lies elsewhere. So, if a conspiracy of Asian central banks is not to blame for the volatility drought that is parching traders’ earnings, what is?
Surely, today’s low volatility is partly cyclical. Stock market volatility was also very low during the early 1990’s, before reaching new peaks later in the decade. Moreover, financial innovation and globalization allow markets to spread risk more effectively than ever before, placing it in the hands of those who can best manage it. Improved central bank policy is another huge factor. In the early 1990’s, the average level of world inflation exceeded 30%; now it is less than 4%.
All of these changes have in turn contributed to lower economy-wide output and consumption volatility in both rich and developing countries. They have also contributed mightily to the high general level of asset prices, helping create the vast riches of which today’s hungry young traders are so jealous.
So will today’s relative market calm continue? Unfortunately, no. Today’s brave new world of financial globalization will almost surely face severe new stress tests, reminding us that recessions still happen.
Frankly, although I do not see the five-year-old global expansion coming to an end yet, there is no question that risks are on the rise, with output in the United States having slowed sharply in the third quarter, and central banks’ hands tied by inflation risks. Further ahead, it is not hard to imagine geopolitical instability – possibly emanating from Iran, Iraq, or North Korea – unsettling markets.
Whatever the scenario that ends the calm, today’s age of low volatility will seem like a distant dream to most of us – and a forgotten nightmare for ambitious financial traders.

Kenneth Rogoff is Professor of Economics and Public Policy at Harvard University, and was formerly chief economist at the IMF.

Copyright: Project Syndicate, 2006.
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