Volatility's Great Moderation
To understand why financial market volatility is so low, it helps to remember that other volatility miracle of recent years, the Great Moderation. Despite Europe, despite the fiscal cliff, despite the upcoming US elections, the VIX, the so-called fear index, hit its lowest levels on Friday since before the financial crisis began in 2007.
The VIX, which gauges investor perceptions of how jumpy trading in the S&P 500 will be in the coming month, hit 14.25 and has nearly halved since June.
Given how uncertain so many things are currently, and given how financial markets usually react to uncertainty and surprise with volatility, that’s an astounding fall, something which could, on face value, look reassuring, a new Great Moderation but this time in financial markets.
The Great Moderation was the name economists gave to a period starting roughly in the mid-1980s and ending, quite roughly, in 2007, in which the laws of the business cycle seemed to have been relaxed, if not abolished outright. Rather than alternating between periods of rapid expansion and contraction, GDP growth in the industrialised economies moderated in pattern, to everyone’s great relief and self-satisfaction.
The idea of the Great Moderation is now an anachronism, a bit like the War to End All Wars, but at any rate we believed it for a while, and more importantly behaved as if it were true. This helped the idea to become a self-sustaining, if time-limited, phenomena; households and businesses took on more risk, and more debt, because they were less fearful of being caught short in a violent recession or financial crisis.
During the period the credit for the new era was generally given to central banks, many of whom were given new independence from political control. The idea was that technocrats had finally cracked it, and if left to manage the economy, could lead us into a new world in which recessions would be few and short and depressions unknown.
Perhaps the high point of this millennial thinking was a 2003 lecture to the America Economic Association by Nobelist Robert Lucas in which he declared: “Macroeconomics in this original sense has succeeded: Its central problem of depression-prevention has been solved for all practical purposes, and has in fact been solved for many decades.”
Assymetric policy and the VIX
That was all poppycock, of course. While policy-makers were instrumental in the Great Moderation, it was as enablers of dubious risk-taking. The Federal Reserve was the leading practitioner, easing policy when financial markets became jittery or the economy stalled, but failing to remove the punch bowl during what were self-evident bubbles.
The underlying reality of the Great Moderation was that it was driven by a massive build-up of debt, which did indeed help to smooth growth and consumption but which built up in its wake huge risks. As we saw in 2007 and 2008 economic volatility, a bit like energy, cannot be destroyed, only switched from one form to another.
So what does all this have to do with the VIX, and with that lovely sipping cool drinks on the beach while our stocks rise in value feeling so many of us have? The fall in the VIX comes from the very same locus as the rise of the Great Moderation, and therefore must have a real risk of meeting the very same type of outcome.
Financial markets are not calm, or returned to normal; they have been pacified with the very same central bank medicine, though with slightly different delivery systems, as was the global economy up until 2006.
The VIX is low because belief in extraordinary monetary policy, in the near future, is high. Debt in the global economy has only gone up, though more of it is on government balance sheets than before. Governments and central banks are absorbing and issuing debt in an attempt, partly successful, to blunt the impact of the Great Moderation-induced quasi-depression.
It is, of course, possible that what we are witnessing is simply the result of the socialisation of private risk taking. Leverage has come out of the financial system as a direct result of the crisis, and so perhaps the reaction to future instability will be less.
That logic only holds, however, for as long as governments can successfully continue to absorb, and issue, debt. If that comes into question, for whatever reason, the volatility will be back and much bigger than what we’ve seen before, both in market and economic terms.
We may be a long way away from that, and the time of worry-free speculation may continue, but it’s important to remember that even governments can’t absorb unlimited risk.
At some point the suppressed energy of volatility will come out.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)