Behind panicky markets, faltering governments

Thursday’s woes and the struggles of the last few weeks are rooted in fear of two things: economic weakness and a lack of will among leaders to do much about it.

By MSN Money Partner Sep 22, 2011 6:32PM

By Rick Newman for U.S. News & World Report


Why now?


There's no obvious trigger to the mayhem in the stock markets over the last several weeks. Greece may default on its debts, but that's been a worry for nearly two years, and it's probably not imminent. Other European countries are overindebted, but there's nothing new about that, either. Here in the United States, high unemployment has become a given, with money tight for many families, and credit scarce. But that, too, has been going on for three years or more.


U.S. News & World ReportSome parts of the economy have even been getting better. Corporate profits remain strong and most big companies are healthy. American consumers are slowly paying down debt and improving their finances. Interest rates are at record lows. A recent uptick in home sales suggests that some buyers think the housing market may have bottomed out.


Yet stocks have been plunging, and economists worry that a double-dip recession is on the way -- or maybe even here.


So what gives? Here's what: Governments are checking out.


Policy fumbles and retreats

For the first time since the financial crisis of 2008, policymakers in Europe and the United States are either fumbling on economic policy, or simply backing away from helping the economy. One prominent example was the Federal Reserve's "Operation Twist"-- its plan to replace short-term bonds in its portfolio with longer-term ones. The maneuver may drive long-term interest rates slightly lower, which will help home buyers and other borrowers. But it's less of a boost than investors had been hoping for. And since it simply replaces one kind of bond with another in the Fed's portfolio, it pumps no new money into the economy.


To many investors, it seems like the Fed is running out of tricks and losing its stomach for risky interventions in the economy. So markets plunged Thursday following the announcement.


In fact, many of the extraordinary government measures of the last three years are winding down, including spending from the big 2009 stimulus plan. Many economists feel that a few key measures set to run out at the end of this year ought to be extended, especially payroll tax cuts for most workers and extended unemployment insurance for the jobless. But the ongoing spat between President Obama and congressional Republicans could jeopardize that and remove yet another pillar of support from the shaky economy.


It's obvious that unusual government stimulus efforts need to end sooner or later. The fear weighing on markets now, however, is that politicians in Washington and Europe will yank the crutches -- or simply prescribe the wrong treatment -- before the economy is healthy enough to stand on its own. Forecasting firm IHS Global Insight points out that bad economic news is now coupled with "political paralysis and the risk of a serious policy mistake" -- the perfect recipe for roiling the stock markets.


Aggressive action is needed

There are straightforward ways to provide some relief. But most of them involve policy decisions that politicians now seem to be tilting against. Economist Mark Zandi of Moody's Analytics identifies several steps policymakers could take to reassure markets and guarantee that a double-dip recession doesn't happen.


In the United States, he says, the Fed needs to be much more aggressive, perhaps buying $75 billion worth of bonds per month indefinitely, until the economy starts to look better. That would add to inflation fears, but it might also compel investors to get off the sidelines and banks to lend more. Congress and the White House, Zandi says, need to maintain spending in the short term while coming up with a credible debt-cutting plan that will kick in a few years from now, when the economy is healthier.


In Europe, Zandi and others would like to see the European Central Bank cut interest rates and buy more bonds, like the Fed has done, instead of the tighter policy the ECB has pursued up till now. Europe, he believes, should also enlarge the bailout fund set aside for nations wallowing in debt, and do more to assess the health of Europe's banks and shore them up if necessary. Many investors think it would be beneficial to hasten the endgame in Greece -- whether that turns out to be default or a much bigger bailout -- instead of taking incremental steps that merely delay decisive action.


Some of these steps may happen eventually, but policymakers have shifted away from the kind of big-bang actions that the United States took, for example, when it bailed out the banking industry in 2008 and passed the stimulus bill in 2009. Instead, there's now more of a just-in-time approach to heading off disaster. That's how Republicans and Democrats handled the summer negotiations over extending the nation's credit limit, waiting until the government virtually ran out of money before inking a deal to allow more borrowing--a process now widely regarded as a debacle.


U.S. shutdown looms

The same thing seems to be happening now in the battle over whether to pass a temporary budget needed to keep the U.S. government operating past the end of the month. There are many more deadlines like this looming over the next 12 months, with business owners wondering how many times Washington will hold the economy hostage to political demands.


Congressional Republicans have even urged the Fed to refrain from any more monetary stimulus , because it could "erode the already weakened U.S. dollar or promote more borrowing by overleveraged consumers." (Economists aren't sure how those two developments would harm the economy, however.) Meanwhile, in the Eurozone, where action requires consensus among 17 disparate nations, there's no obvious alternative to dithering incrementalism.


To some extent, the western economy is suffering from withdrawal symptoms as it struggles to function without aid it has become addicted to. It may be the ultimate irony when traders -- the last defenders of unfettered capitalism -- decry a lack of government support for the economy. But there's as much uncertainty now coming from political pronouncements as from the economy itself. Politicians are doing a mighty disservice to everybody dependent on a healthy economy by issuing ultimatums, refusing to compromise, making businesspeople guess what important policies will be and generally daring the markets to collapse. It's not a coincidence that markets plunged after the summer debt drama in Washington produced disappointing half-measures and a downgrade in America's credit rating.


How much pain lies ahead

The economy can recover without help from government, but it will take a long time and cause a lot of pain along the way. The question is, how much.


Will there be a full-blown financial crisis in Europe? Or will policymakers manage to stop the bleeding? Could a big U.S. bank such as Bank of America collapse? Or will regulators make sure such a momentous event never happens? Will Congress do anything at all to help create jobs and boost the economy? If not, is there anything more the Fed can do? Or are workers and businesses completely on their own at this point?


These are the questions investors are trying to sort out, and with so little guidance from western capitals, they really have no choice but to plan for the worst. So the markets yo-yo their way to lower and lower closes. Governments may yet save the day, with last-minute moves that cheer investors. But the gravity dominating the stock markets indicates that nobody's counting on it.


More from Rick Newman at U.S. News & World Report: