The volatility spiral - Corporate Finance

Chief Executive, The, Jan-Feb, 1995 by Joel Kurtzman

I recently attended a breakfast meeting in Manhattan where former German Chancellor Helmut Schmidt was the speaker. I had met the chain-smoking statesman years before in Europe when I was a young economist at the United Nations. Back then, we talked about the post-Bretton Woods economic arrangement. Schmidt, who was the architect of Germany's economic rise, was pessimistic about the chances for long-term stability. I was curious to see if his views had changed.

"Chancellor," I said, taking him aside. "What do you think now of the global economic system?"

The ex-chancellor trained his large, gray eyes on me. Smoke swirled. "System?" He said, puffing on his cigarette. "Bretton-Woods was a system, and that was long ago. We now have a floating non-system."

Schmidt's up-and-down, floating non-system is as fickle as it is adept at moving capital from market to market. It is a dangerous place, not just because it responds quickly to economic and financial information, but because it is so large, trading more than $1 trillion a day in currencies alone. Such vast amounts of money, sloshing through the world's computers, can wreak havoc on the markets or stocks.

Two factors make this possible: rapidly falling transaction costs and easy access to information. Computer programs - descendants of Harry Markowitz's Nobel Prize-winning Capital Asset Pricing Theory equations - help investors ferret out international arbitrage possibilities with the click of the mouse. Some of these global money-management programs sell for as little as $99. Without transaction costs to inhibit them, investors, linked to the markets through modems, satellites, and fiber-optic lines, wait for the slightest management slip.

Just look at recent history. Though the American economy was growing only moderately, 1993 was a record year for the issuance of stocks and bonds. About $850 billion in new bonds and $150 billion in stocks were released. What was remarkable was not just the size of new issues but the fact that 30 percent of the buyers were from overseas. The electronic rush of what I call megabyte money into the country drove up the Dow, kept interest rates down, and set a floor for the dollar.

Last year, something changed, and it had nothing to do with economic fundamentals. International investors grew wary of the U.S., largely as a result of inflation fears, though inflation never materialized, and the dollar was strong. In the second quarter alone, according to the Securities Industry Association, foreign investors sold a net $2.2 billion more in stocks than they bought.

World investors raced to the emerging markets of Latin America and Asia in a reverse capital-flight maneuver, and they did it with ease. knowing that if it didn't work out, they could always invest somewhere else - in seconds. Long-term interest rates climbed, the dollar fell, and the Dow was jostled.

Living in the non-system has inured us to the Dow's wild swings and to the dollar's ups and downs. But it is important to remember that such swings are new. Since World War II, eight of the 10 most volatile trading days on Wall Street all occurred since 1987. This has conspired to shorten investors' time horizons. While once the average bond was held to maturity, now it is held for less than two weeks. We are living in the financial equivalent of the ex-Yugoslavia.

Should we try to stabilize the volatile system? How about using the central banks?

"Central bankers," said former Chancellor Schmidt with characteristic bluntness, "understand nothing of what's going on."

Schmidt is right. Last November, "the Federal Reserve, after watching the dollar fall to an all-time low against the yen, decided it had dropped too much. It bought $2 billion worth of dollars in the markets. These actions increased the value of the dollar by exactly six-tenths of 1 percent. The next day, the markets corrected the Fed's actions and drove the dollar back to its previous low. So much for the Fed.

How about dampening the swings with a transaction tax?

Japan has a such a tax and has not been spared from financial grief. And if only one nation raises the cost of investing, capital simply will go elsewhere.

Philosopher Marshall McLuhan once said the electronic media was an extension of the human nervous system, prone to bouts of the jitters. He was right. Electronically linked markets are part of the media, too. A flutter of worry over interest rates in November, and mighty Fidelity Investments, with a $150 billion mutual-fund portfolio, loses $100 million in net withdrawals. An "exhausted" Boris Yeltsin, on his way back home from America, misses an airport rendezvous with the Irish Prime Minister, and the ruble tumbles.

The electronic mind is a reactive mind. Either companies learn how to influence it, or they pay the markets' price. In coming months, we'll look at their financial strategies, successes, and failures. But one thing is certain: No regulatory cavalry is on the way.

Joel Kurtzman, former editor of the Harvard Business Review, is an international business consultant and author. He is the director of the International Trade Program at The Manhattan Institute.