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. Last Updated: 07/27/2016

Paying the Price for the End of Complacency

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Global financial markets are nervous and with good reason. The long period of low and stable interest rates is coming to an end. Since the events of August, when U.S., German, French, Chinese and other banks were caught holding suddenly illiquid assets backed by U.S. subprime mortgage securities, the interbank markets in main financial centers have tightened. Liquidity is at a premium, trust is low, and market volatility has risen.

Even if the U.S. Federal Reserve's Open Market Committee were to lower its key lending rate -- a move that was expected Tuesday -- and signal that there would be further easing to support economic activity, this would be too little, too late.

In the months ahead, millions of U.S. households will suffer the unanticipated consequences of their legitimate desire to become homeowners without having adequate savings or income. All would have been well if housing prices had continued their ascent and interest rates remained low. But they were unlucky and in some cases the victims of fraudulent lending procedures. With a U.S. presidential election campaign under way, the chorus calling for both more Federal Reserve action and greater regulation is going to become louder.

Russia is not, and will not be, immune from these developments. Nor will anyone else for that matter. That said, Russia is in a favorable position, relatively speaking, because of its strong reserves, a stabilization fund at 11 percent of gross domestic product, a fiscal surplus, high oil prices and a relatively transparent capital market that is less prone to the global economic contagion factor.

One of the most striking features of the global economy over the past 20 years has been a large reduction in the volatility of economic growth. In the United States, for instance, the variability of output growth has more than halved over the past two decades. Of course, this phenomenon, also known as the "great moderation," did not occur everywhere simultaneously. Volatility in East Asia began to fall only after the financial crisis of the late 1990s. In Japan, Latin America and Russia, volatility dropped in a meaningful way only in the current decade. But by now, the decline has become nearly universal, with huge implications for global asset markets.

Even assuming the broader positive trends in globalization and technological progress continue, a rise in macroeconomic volatility could still produce a sharp fall in asset prices. As former U.S. Treasury Secretary Lawrence Summers warned at the end of last year in the Financial Times, "The new year will begin with the greatest divergence for a generation between the general view of global risks as reflected by conventional wisdom and the risks as priced in financial markets." He also noted that asset prices in financial markets reflect the risk premiums to cover the possibility of default that corporations or developing countries have to pay to borrow money at or near historic lows. In addition, estimates of the volatility of the stock, bond and foreign exchange markets inferred from the prices of options were near record lows.

Without reviewing the extensive debate on the causes of this "great moderation," it is sufficient to stress that the massive equity and housing price increases of the past dozen or so years probably owe as much to greater macroeconomic stability as to any other factor. As output became more stable, investors did not require a large risk premium, so the prices of risky assets rose.

As Harvard economist Ken Rogoff asked, "This brings us to the $200 trillion question: What could cause macroeconomic volatility to start rising?" The figure of $200 trillion is roughly the value of global money and asset markets, including housing. Earlier this year, Rogoff thought that the greatest risk might be geopolitical instability. He could still be right. But, as the spillover from the subprime mess has shown, even the heart of the modern financial system was vulnerable.

Former U.S. Federal Reserve Chairman Alan Greenspan's memoirs, "The Age of Turbulence," were published on Monday, which underscored his usual, uncanny sense of timing. This was the same day that Greenspan's extensive interview with the Financial Times appeared in which he said that U.S. housing prices are likely to fall significantly from their present levels, admitting that there was a bubble.

He also emphasized that Ben Bernanke, his successor at the Federal Reserve, would have to tread carefully because the risk of an "inflationary resurgence" was greater now than when he was the at the helm. "We are in a period now when it is far more difficult than it was when I was chairman," Greenspan said. "You have got to be a lot more careful in lowering rates in response to crises."

Greenspan observed "that the trade-off between unemployment and inflation has shifted." Notably the disinflationary effect of globalization underlying the "great moderation" will fade. The integration of a billion workers from the once centrally planned economies of China and the former Soviet bloc into the global market system had a profoundly disinflationary effect on prices worldwide. But once all these workers are connected to the world economy, "the rate of change goes to zero," he said.

At the same time, cost pressures are beginning to rise. Greenspan also sees oil going to $100 per barrel and worries about rising fiscal deficits driven by entitlement spending as the United States and the rest of the rich world ages. "In that environment, inflation expectations will rise," he noted, and the Federal Reserve should not exacerbate the situation. With his warning that the fundamental forces that delivered the era of disinflation are starting to recede, Greenspan said that inflation in the years to 2030 may be closer to the 4.5 percent average from 1939 to 1989 than the lower rate of recent years.

If markets are repricing risk, the provision of liquidity by central banks, including Russia's Central Bank -- and even the Federal Reserve's first step in reducing its short-term interest rate -- may do little to prevent a significant economic slowdown. Of course, it is too early to tell how markets will react.

It would be prudent, however, to prepare to live with greater market volatility. Take exchange rates for example. The dollar dropped to an all-time low against the euro of $1.39 last week in anticipation of the Federal Reserve action. Hence, the narrowing of interest rate differentials. Further cuts could induce an even weaker dollar. Meanwhile, the ruble strengthened this week against the dollar to its highest level since October 1999.

Credit markets are unlikely to regain their confidence any time soon. Trust will have to be rebuilt -- institution by institution.

In the meantime, even leaving aside the effects of a downturn in real economic activity and corporate profits, equity markets could be negatively affected to the extent that more conservative cash management in financial institutions, including banks, will curtail the use of short-term money to fund long-term positions.

This will be the price to be paid for the end of our complacency.

Martin Gilman, a former senior representative of the IMF in Russia, is a professor at the Higher School of Economics in Moscow.