V is for Volatility

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Economics would be a pale imitation of itself without volatility, or at the very least about as stimulating as watching paint dry. Luckily the world is a complicated place, where prices fluctuate for various reasons, and this, for the most part, is a good thing.

On a microeconomic level, producers wouldn’t be able to discover demand if there was no volatility. Volatility is indeed an essential ingredient for commerce to exist, with entrepreneurs engaging in a process of arbitrage between the price at which they buy inputs and the price at which they sell output. Furthermore, there would be no way of allocating scare resources to their most efficient use if we didn’t have price movements to guide the market.

Price changes are also needed to encourage investment in a particular sector. Long-term trends in commodity prices, such as Asia’s growing demand for protein, tell farmers that the investment needed to convert their land to dairy pasture is likely to payoff in the end (though not guaranteed).

Although price fluctuations usefully steer production and investment, this doesn’t mean all types of volatility (or lack thereof) are equally desirable. The effect of politics on markets can stifle or increase volatility completely separate from fundamental price drivers.

International debt markets are a good example. The yield on 5-year Greek government bonds has been trading at a fairly consistent level of just over 4 percent for some time. Meanwhile Argentinian 4-year bonds (the closest comparable security) are trading at 7.6 percent. The difference has almost nothing to do with economic fundamentals, since both countries are in major financial strife. 

An investor, who knew nothing about the political support being lent by the European Union, might conclude from the yields that Greece is responsible with its public finances compared to Argentina. In actual fact Greece’s public debt to GDP stands at 161 percent, whereas Argentina’s public debt is equivalent to 42 percent of GDP.

The opposite can also be true. Investors in New Zealand’s listed electricity sector know only too well how volatile share prices have been due to the Labour and Green’s proposal to restructure the market, when in actual fact the fundamentals of the industry haven’t really changed.

To conclude, change, or volatility is a good thing in economics, provided it is based on market fundamentals and not political hot air.

Next week is Welfare!