Can the Markets Learn to Live With Fear?

For the first time in nearly a year, financial markets have reawakened to fear.

Until a few weeks ago, global markets had been marked by an almost eerie calm, with equities rising modestly but consistently, bonds trading in a narrow, reasonable range, and activity from mergers and acquisition to new public offerings showing steady signs of progress. Companies have been generating astonishing profits even in an unsteady global economy, and earnings have consistently blown through expectations. But then Greece coughed and the whole world caught a nasty cold.

How did this spiral so quickly? Greece itself seems a paltry excuse — the $140 billion bailout package for Greece is less than the $180 billion it cost the U.S. government to bail out AIG alone in October of 2008, and Greek debt hasn't been packaged into trillions of dollars of derivatives the way housing loans were in 2007 and 2008. The overall guarantees to stabilize the value of the euro are larger, of course, but Greece touched an Achilles heel — a cliché we can use appropriately in this case — of the markets, namely confidence and credit. What plunged the world into the maelstrom nearly two years ago was the freezing of credit markets; equities plunged only in response to what was happening in global bond and money markets. Greece and the troubled state of European banks raised those fears yet again, not for the general public just yet but in the small world of finance that serves as conduit for all global economic transactions. The men — and some women — who manage these flows are suddenly and uncomfortably back to the question: What if it happened again?

What's fascinating, and troubling, about recent weeks is that for all the money injected into the global systems by aggressive government spending and for all the manifest growth in Asia, nothing stands in the way of a repeat of the fall of 2008 and early 2009 except the confidence of a relatively small number of institutions. All it takes is a few bad ratings by a trio of ratings agencies — Moody's, S&P and Fitch — a sudden increase in inter-bank lending rates (known as LIBOR), a sharp sell-off in equities as people try to hoard cash, and a media echo chamber that heightens the sense of crisis, and bam! We're back on the brink.

It's not a question of a few institutions being too big to fail; it's the fact that the global supply of credit flows through specific and very limited channels — Wall Street and European banks, electronic trading exchanges, Asian and Latin American central banks, and a few money managers like Pimco. If they get spooked, it ripples through every market in the world within days and sometimes within hours.

These ripples — including a sharply contracting supply of credit and capital along with breathtaking sell-offs in equities — can happen even as real-world conditions are stable. We used to speak of the divide between Wall Street and Main Street. Now we can add to that the divide between financial markets and real world economies. The Shanghai stock market, for instance is down double-digits this year even as the Chinese economy is expanding at a rate north of 10%. While the U.S. remains deeply troubled and its banks wary of lending, overall economic activity is immense and expanding. The European Union, for all its flaws, is home to more wealth than anywhere in the world — more than sufficient to manage the challenges of Greece, Spain and Portugal. And in Asia, Latin America, Australia and India, the past two years haven't been a Great Recession — they've been a time of unparalleled prosperity, low inflation and burgeoning confidence. Yet none of that precludes the global financial system from having panic attacks.

In short, more than ever, financial markets are characterized by a thin line between stasis and collapse, between steady expansion and the economic abyss. Global financial markets are having to adjust to the ever-presence of catastrophic, technology-enhanced meltdowns much as states had to adjust to the nuclear age after World War II. For a while, fear would erupt and spread virally, with people cowering under school desks and heading to bomb shelters. Then we started to calm down and adjust to the fact that mass destruction was ever-possible — but not very likely.

Still, today's market psychology (which Wednesday drove the Dow below 10,000 for the first time in more than three months) and its possible consequences would be more disturbing save for one fact: the amount of money sloshing around the world — trillions in cash, trillions in sovereign wealth funds and central banks, and trillions on corporate balance sheets. Financial mavens will tell you that panics and crises have a way of draining liquidity from the system, but today there is so much liquidity that it can't so easily be drained as much as it can be insufficiently deployed. Distrust of the financial system has meant that some of that liquidity has been kept out of the financial system, out of stocks and out of bonds. So while panic can devastate markets, the money on the sidelines acts as a buffer, though that's small comfort if you're deeply invested in equities when the plunge occurs.

The past weeks are certainly a reminder that the global financial system remains highly concentrated and overly susceptible to fear. But they are also a useful reminder that what happens in financial markets is not synonymous with what happens in real world economies. Too much damage in the financial system will crush real world activity — and that's precisely what happened in the aftermath of the fall of 2008. But for now, what's happened is a brief trip back to the brink. And if, as seems likely, we pull back from the edge, that will lessen the risks considerably for some time to come. In a world where great connectivity brings with it great moments of risk, the best we can expect is to learn to manage the fear and not feed the panic.

Karabell is the president of River Twice Research and a co-author of the forthcoming book Sustainable Excellence