Behind Panicky Markets, Faltering Governments

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Why now?

There's no obvious trigger to the mayhem in the stock markets over the last several weeks. Greece may default on its debts, but that's been a worry for nearly two years, and it's probably not imminent. Other European countries are overindebted, but there's nothing new about that, either. Here in the United States, high unemployment has become a given, with money tight for many families, and credit scarce. But that, too, has been going on for three years or more.

[See how to escape the middle-class squeeze.]

Some parts of the economy have even been getting better. Corporate profits remain strong and most big companies are healthy. American consumers are slowly paying down debt and improving their finances. Interest rates are at record lows. A recent uptick in home sales suggests that some buyers think the housing market may have bottomed out.

Yet stocks have been plunging, and economists worry that a double-dip recession is on the way—or maybe even here.

So what gives? Here's what: Governments are checking out. For the first time since the financial crisis of 2008, policymakers in Europe and the United States are either fumbling on economic policy, or simply backing away from helping the economy. One prominent example was the Federal Reserve's "Operation Twist"--its plan to replace short-term bonds in its portfolio with longer-term ones. The maneuver may drive long-term interest rates slightly lower, which will help home buyers and other borrowers. But it's less of a boost than investors had been hoping for. And since it simply replaces one kind of bond with another in the Fed's portfolio, it pumps no new money into the economy. To many investors, it seems like the Fed is running out of tricks and losing its stomach for risky interventions in the economy. So markets plunged following the announcement.

In fact, many of the extraordinary government measures of the last three years are winding down, including spending from the big 2009 stimulus plan. Many economists feel that a few key measures set to run out at the end of this year ought to be extended, especially payroll tax cuts for most workers and extended unemployment insurance for the jobless. But the ongoing spat between President Obama and congressional Republicans could jeopardize that and remove yet another pillar of support from the shaky economy.

[See why big companies are axing jobs.]

It's obvious that unusual government stimulus efforts need to end sooner or later. The fear weighing on markets now, however, is that politicians in Washington and Europe will yank the crutches—or simply prescribe the wrong treatment—before the economy is healthy enough to stand on its own. Forecasting firm IHS Global Insight points out that bad economic news is now coupled with "political paralysis and the risk of a serious policy mistake"—the perfect recipe for roiling the stock markets.

There are straightforward ways to provide some relief. But most of them involve policy decisions that politicians now seem to be tilting against. Economist Mark Zandi of Moody's Analytics identifies several steps policymakers could take to reassure markets and guarantee that a double-dip recession doesn't happen. In the United States, he says, the Fed needs to be much more aggressive, perhaps buying $75 billion worth of bonds per month indefinitely, until the economy starts to look better. That would add to inflation fears, but it might also compel investors to get off the sidelines and banks to lend more. Congress and the White House, Zandi says, need to maintain spending in the short term while coming up with a credible debt-cutting plan that will kick in a few years from now, when the economy is healthier.

[See 8 things missing from Obama's debt plan.]

In Europe, Zandi and others would like to see the European Central Bank cut interest rates and buy more bonds, like the Fed has done, instead of the tighter policy the ECB has pursued up till now. Europe, he believes, should also enlarge the bailout fund set aside for nations wallowing in debt, and do more to assess the health of Europe's banks and shore them up if necessary. Many investors think it would be beneficial to hasten the endgame in Greece—whether that turns out to be default or a much bigger bailout—instead of taking incremental steps that merely delay decisive action.

Some of these steps may happen eventually, but policymakers have shifted away from the kind of big-bang actions that the United States took, for example, when it bailed out the banking industry in 2008 and passed the stimulus bill in 2009. Instead, there's now more of a just-in-time approach to heading off disaster. That's how Republicans and Democrats handled the summer negotiations over extending the nation's credit limit, waiting until the government virtually ran out of money before inking a deal to allow more borrowing--a process now widely regarded as a debacle.

The same thing seems to be happening now in the battle over whether to pass a temporary budget needed to keep the U.S. government operating past the end of the month. There are many more deadlines like this looming over the next 12 months, with business owners wondering how many times Washington will hold the economy hostage to political demands. Congressional Republicans have even urged the Fed to refrain from any more monetary stimulus , because it could "erode the already weakened U.S. dollar or promote more borrowing by overleveraged consumers." (Economists aren't sure how those two developments would harm the economy, however.) Meanwhile, in the Eurozone, where action requires consensus among 17 disparate nations, there's no obvious alternative to dithering incrementalism.

[See what Bernanke might say to his GOP critics.]

To some extent, the western economy is suffering from withdrawal symptoms as it struggles to function without aid it has become addicted to. It may be the ultimate irony when traders--the last defenders of unfettered capitalism—decry a lack of government support for the economy. But there's as much uncertainty now coming from political pronouncements as from the economy itself. Politicians are doing a mighty disservice to everybody dependent on a healthy economy by issuing ultimatums, refusing to compromise, making businesspeople guess what important policies will be and generally daring the markets to collapse. It's not a coincidence that markets plunged after the summer debt drama in Washington produced disappointing half-measures and a downgrade in America's credit rating.

The economy can recover without help from government, but it will take a long time and cause a lot of pain along the way. The question is, how much. Will there be a full-blown financial crisis in Europe? Or will policymakers manage to stop the bleeding? Could a big U.S. bank such as Bank of America collapse? Or will regulators make sure such a momentous event never happens? Will Congress do anything at all to help create jobs and boost the economy? If not, is there anything more the Fed can do? Or are workers and businesses completely on their own at this point?

[See what will happen if Greece defaults.]

These are the questions investors are trying to sort out, and with so little guidance from western capitals, they really have no choice but to plan for the worst. So the markets yo-yo their way to lower and lower closes. Governments may yet save the day, with last-minute moves that cheer investors. But the gravity dominating the stock markets indicates that nobody's counting on it.

Twitter: @rickjnewman

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5 Things Roiling the Markets

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Volatility is the new normal. OK, got that. But are we truly unable to mitigate the nauseating ups and downs in the stock market?

Policymakers in the United States and Europe have spent much of the last three years intervening in the economy, to halt a financial crisis and prevent a bad recession from becoming worse. By now, you'd think all that firepower would have solved the problem. But it hasn't. So far this year, the S&P 500 stock index is down about 8 percent, with investors worried that a traditional autumn hex could bring more losses. In Europe, which is arguably in worse shape than the United States, stocks are down nearly 20 percent for the year. What's perhaps most unnerving is that policymakers seem flummoxed about what to do--and their floundering might make things worse, instead of better.

[See 7 ways Obama can gain credibility on jobs.]

Manic swings in the market over the last month or two reflect deep uncertainty about whether another financial crisis is brewing, or an anemic recovery will eventually pick up steam. While nobody knows, the causes of all that uncertainty aren't mysterious. Here's a cheat sheet laying out the five biggest worries, along with steps that might make things better:

European debt. It's been 16 months since the first Greek bailout, yet there still aren't enough funds in place to guarantee that Greece, Ireland, and Portugal will remain solvent and return to normal borrowing any time soon. Greece's problems continue to worsen, requiring more and more money and making an eventual default seem likely. If Greece defaults, Ireland and Portugal could follow. And debt fears are now driving up borrowing costs for Italy and Spain, which could create self-fulfilling debt crises there if those countries don't enact sharp spending cuts, tax hikes, and other politically unpalatable austerity measures. If defaults ensue, the biggest unknown is whether the European banks that hold much of the debt are strong enough to absorb the losses, or whether there would be a Lehman-style financial panic requiring all-hands intervention in global capitals. Markets tend to plan for the worst.

What might make it better: A bold and convincing plan. The European Central Bank has been far less aggressive in dealing with European debt problems than its counterpart in the United States, the Federal Reserve, was in dealing with the subprime crisis of 2008, which was similar in magnitude. "The ECB needs to be more aggressive with asset purchases, as other central banks have been," writes Tomas Holinka of Moody's Analytics. That would require more financial backing from eurozone countries for Fed-style "quantitative easing," or bond-buying. Holinka also argues that the ECB should spell out its plans for buying troubled debt—similar to the way the Fed has telegraphed its monetary policy—instead of keeping markets constantly guessing.

[See what to expect from the stagnant economy.]

European political dysfunction. Related to Europe's debt problem is the inherent difficulty of having a coordinated policy in a loose confederation of 17 nations, some rich, some middling, and some poor. There are constant squabbles over the terms of the Greek bailouts, for instance, with some nations now demanding collateral in order to participate. In Germany and France, where banks would suffer sizable losses from defaults, political leaders must convince skeptical voters that sending taxpayer money to bankrupt nations is in their interest. "No doubt, the politics are highly complicated," says Jacob Funk Kirkegaard of the Peterson Institute for International Economics. "There's no treasury secretary in Europe, and no central fiscal authority." That leaves politicians continually deferring to the European Central Bank, which itself has been reluctant to intervene.

What might make it better: Decisive political action. Greece could reform its bloated patronage economy faster than expected. Italy could surprise the markets with a convincing austerity program. Spain could provide fresh evidence that its regional banks are healthy. But none of that seems likely.

[See what Bernanke wants Congress to do.]

Besieged American banks. Three years after the controversial TARP bailouts went into effect, there are fresh concerns about the U.S. financial system. Investors aren't worried about widespread insolvency this time, but about some banks' ability to withstand losses and remain profitable. Bank of America's stock, for instance, is down nearly 50 percent for the year, due mainly to worries about billions in bad mortgages and legal liabilities stemming from the bank's disastrous purchase of Countrywide Financial in 2008. Some analysts believe B of A has still failed to account for billions in potential losses tied to subprime mortgages. Another problem is that B of A and many other banks still face a potentially huge settlement with state attorneys general over fishy foreclosure proceedings.

And now, the federal government is suing many of same banks it bailed out in 2008, seeking nearly $200 billion in damages for flawed mortgage-backed securities backed by Fannie Mae and Freddie Mac, the government-chartered housing agencies now propped up by $150 billion in taxpayer funds. "It is ironic," says David Zervos of investing firm Jefferies, "that we have spent so much time and effort to shore up the core financial system over the last three years, only to rip it apart with additional regulatory burdens and non-stop litigation." It's also deeply unnerving to investors, since litigation and politically charged policymaking are far more unpredictable than ordinary economic developments.

What might make it better: A lot of settlements. Almost any resolution of the statewide probes into improper foreclosure proceedings will relieve bank investors. It's also possible that the federal government will settle its big lawsuits against the banks, as long as it can recoup enough money to offset some of the taxpayer losses on Fannie and Freddie, and declare victory.

[See who will benefit from the slowing economy.]

American political dysfunction. The political showdown over the debt ceiling this summer turned into an economic disaster, since politicians essentially proved that they're willing to harm the economy while pursuing their own parochial goals. While it produced a modest agreement on paring the national debt, the summer deal also fell far short of targets set by both sides. That led to the first-ever downgrade of America's credit rating, along with a plunge in consumer and business confidence and a 9-percent stock-market nosedive in the month following the deal. Forecasters now warn that further political brinksmanship is possible and that additional "policy mistakes" may be the biggest threat to the U.S. economy.

What might make it better: Genuine leadership in Washington. Starbucks CEO Howard Schultz is orchestrating a campaign among business leaders meant to pressure politicians into prioritizing the nation's economic needs above their own careers or ideological concerns. There's a chance it could work. Since expectations for Congress are so low, it would boost confidence if the "supercommittee" recently appointed to come up with another $1.5 trillion in debt reduction actually did it, without another drawn-out showdown that puts the economy on tenterhooks. In fact, investors would welcome just about any bipartisan effort to stimulate hiring, fix the housing meltdown or improve the government's finances.

[See how the debt fiasco damaged the economy.]

The risk of another recession. The combined effect of those four preceding problems is that another recession seems a lot more likely than it did a few months ago. Moody's Analytics, for instance, puts the odds of a recession at about 40 percent, about double the risk from earlier this year. The pernicious effects of festering European debt problems and political gamesmanship in Washington leave the entire economy far more vulnerable to shocks.

What might make it better: Fewer political roadblocks. In many ways, the economy is far healthier than during the dark days of 2008. Except for banks, most big companies are in good shape, with lean payrolls and strong balance sheets. Though they still have a long way to go, consumers have been consistenly paying down debt. The worst is probably behind in the housing bust, and Washington has at least begun to address the mushrooming national debt. If political leaders could do no harm and some good, global investors would breathe a sigh of relief.

Twitter: @rickjnewman

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