Finance and politics: Two peas in a pod

Two interesting stories have emerged over the past week. And no, it is not the substantive losses incurred by the investment banking behemoth J.P.Morgan & Chase in their corporate-wide hedging business. One is an increasing murmur about the possibility of a 1987 style equity market crash in the United States. The other is the possibility of a Greek exit from the euro. The two are seemingly disconnected - and yet, what they both have in common is the idea that more governmental action is needed, or else catastrophic outcomes are on their way. Irrespective of whether this is true or not, what this implies is that governmental policy towards the functioning markets remains a key, if not the critical, variable in the foreseeable future. In the US, this translates to the question of whether the Federal Reserve will undertake another round of quantitative easing, the strategy that involves the Federal Reserve buying more privately issued debt instruments from the banks in exchange for cash. The much heralded and reviled QE3 would then work its way to prop up the equity markets' sagging strength.

In Europe, as of writing Greece is yet to either repudiate or honour the borrowings from the bond market to the tune of €430 million (Dh2.01 billion) on May 15. As per Bloomberg news services, Greece has €1.5 billion (Dh7.01 billion) in funds as of now. (Note the irony that JPMorgan lost $2-$3 billion over the past month and in the words of its CEO Jamie Dimon, they'll "still make a lot of money" in the next quarter).

Hard choices

Greece's ability to extract tax revenue by making hard choices — pensions, public services cut backs coupled with tax increases — is where the question lies. The post-election scenario in Greece is still in a flux and while the Eurozone political class watches it keenly, they too seem wary of which way the winds would blow.

In a survey quoted by the business television channel CNBC, between 60-70 per cent of foreign exchange traders seem to think Greece will exit the euro.

The consequences for Greece by exiting can be a choice between catastrophe to simply terrible. Bank runs, contractual breakdowns, collapse of the banking system, in absence of labour reforms, negate any advantage proffered by the depreciation of the new currency vis-à-vis the euro would vanish soon, the new borrowings to finance expenditure and obligations would be steep. And most importantly, the politics of the country seem less than conducive to any reform or legitimate leadership. Predictably, bond yields in not just Greece, but other inflamed European countries like Spain, have begun to spike again.

In an effort to calm the flames, the Prime Minister of Luxembourg (and keenly heard voice in the world of European finance) says: "If there are dramatic changes in circumstances, we wouldn't close ourselves off to a debate over extending the deadlines."

Only solution

In plain words, the Europeans will help out Greece if a semblance of domestic political rapprochement can be displayed. The darker issue is also the question that if Greece drops out, what should prevent Spain or Portugal from dropping out. European governmental help - be it through the fiscal or monetary authority -- seems to be yet again the only way out. To stop the bleeding. For now.

On October 19, 1987, in the US, the Dow Jones Index dropped around 22 per cent. The US economy had been flapping about in a progressively weaker climate after the highs of 1986; along with the pervasive use of derivatives called portfolio insurance which came right around the time program trading platforms were emerging resulted in a unique combination of events that led to a massive selloff. Some eminent market observers these days, such as Marc Faber of the "Gloom, Doom and Boom" report, argue that similar perfect storm is on the horizon.

They infer this from a weak US economy, the equity markets led by a few superstars, the empire of algorithmic trading that sifts through signs of technical misalignments and makes large bets.

The columnist works for a major European investment bank in New York City. All opinions are personal and don't reflect any institutional perspectives.