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Greed, fear in financial markets

18th June 2010

By: Seeraj Mohamed

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It is hard to predict the performance of the global economy and of individual countries. There is less optimism about recovery from the global economic crisis.

Predictors such as procurement, debt extension, job creation and the cost of insurance and credit default swaps all seem to indicate that there is, once again, a huge level of apprehension in South Africa and in most of the global economy. Even countries such as India and China, where economic growth seemed to recover well, are faced with apprehension because of conditions in the global economy. The state of countries such as Greece, Spain, Portugal and Ireland has increased investor apprehension. There is still speculation in global financial markets but the swings in exchange rates, the price of gold and even commodities futures indicate confusion amid short-term profit taking. US treasuries seem to have staged a recovery – not because of increased confidence by speculators in the US market but because of the problems in Europe.

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The great economist, John Maynard Keynes, explained that investment and employment in an economy depended on the expectations of businesses about the future. They would employ and invest more people if they expected conditions to support profitability. Keynes said that, during times when there was no turbulence in economies, prospective investors and employers would use the past as a gauge of future performance. They would also look at whether other businesses were investing.

During times of economic turbulence, the past is not a good gauge for the future, and uncertainty about the future is more severe. Businesses will be less likely to look to the actions of other businesses to guide their behaviour. This uncertainty, which clouds expectations about future probability, will cause a decline in investment and employment. At the same time, banks will be less willing to lend and businesses less likely to risk borrowing for expansion until they feel more certain about the future.

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The huge growth of the financial sector over the past three decades adds further difficulties for investors. Greed and fear play a much bigger role in shaping our economic destinies today. The increase in the frequency of financial crises due to the increase in the size of the financial sector means that there are more periods of uncertainty that reduce investment and new employment. Further, the significant growth in spe- culation in financial markets has led to a situation where prices of commodities and financial assets, such as equities and bonds, have become less reliable indicators of the actual performance of the economy. For example, the return of speculators to US treasuries would indicate that markets are confident about the US economy. However, the return to treasuries was driven by fear of what could happen to Europe. The performance of US jobs, credit and corporate investment provided the reason for investors to buy US treasuries.

The fact that the US dollar is still playing the role of the global reserve currency and that the US treasuries are still seen as safe bets seem to be more about the weakness of other countries and following past patterns of behavior than confidence in the US economy. The US economy and many other economies that went on debt and consumption binges have yet to fully recover from the financial crisis. They have yet, as many economists would say, to fully adjust to new conditions.

Adjustment in this context would mean a shift from borrowing to saving, which would severely reduce aggregate demand and lead to negative economic growth and job losses. The stimulus packages in the US, China and elsewhere have allowed the adjustments to be postponed. Unfortunately, further severe adjustments will have to occur. Governments can mitigate some of the pain, but they cannot totally miti- gate the impact of profligacy that led to the financial crisis. Unfortunately, their jobs are even harder as greed and fear still operate at full scale in global financial markets.

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