5 Things Roiling the Markets

The biggest economic problem is now political ineptitude.

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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.

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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.

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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.

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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.

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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.

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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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