By definition, fear and  greed mark periods of irrationality. These evil twins of speculation signal a move away from investment and into a world in which rumors, gossip, and irrational behavior rule the landscape. In the current market, a whisper of a potentially undesirable German Parliament vote could send markets down 3%.

History and psychology indicate that this is simply a bear market strung along by fear, an irrational decline that, although troublesome, will eventually return to “normal” levels. But even though the current stretch of fear is prolonged, intense, and volatile, the sobering backdrop of global financial crises and an extended recession continue to loom over the market.

Then perhaps the fear isn’t fear at all, but a justified symptom of a changing financial system.

Domestic macroeconomic issues include lagging unemployment numbers, slow GDP growth and a tremendous decrease in investment. On top of that, the housing market has begun to decline once again, corporate profits have taken another beating, and banks again are rumored to be undercapitalized. “There are issues about the weakness of banks and uncertainty about how the government will respond to another banking crisis,” says Professor Zitzewitz, an economics professor at Dartmouth College.

Even bigger issues lie overseas – the prolonged Greek debt crisis, and concerns over the solvency of Italy, Spain, and Portugal, threaten to send the Eurozone into a financial crisis of epic proportions.

With all of these potentially disastrous domestic and international issues, Thomas Flexner, Global Head of Real Estate at Citibank, believes that the market is behaving somewhat rationally. “This is reasonable fear based on the uncertainty of the markets,” he says. “Irrational implies that the fear is misplaced or unfounded.”

If, indeed, the fear is rational, then the consequences are severe. It suggests that the incredible world economic growth over the past several decades has been inflated.

“In the past twenty years, global markets were magnified by credit creation – easy central bank policies and easy leveraging created credit that turned into purchasing power, propelling global GDP,” says Flexner.

The debt owed to the creditors has to be paid back, slowly and painfully. This paying down of debt could drastically limit the advance of the global economy for many years. If our fears come true, then we could be entering a new economic reality of shrinking credit and a diminished financial  system.

At the same time, some investors continue to make big bets on our financial system, confident that the American economy can come out of the recession unscathed and unchanged. Some might argue that the bear market has been exaggerated, that although some of the concerns are real, the sharp decline in the equities market has been intensified by fear and rumor-mongering.

On August 18th, 2011, the Dow declined a whopping 415 points based on a “trio of disappointing economic readings” and a Morgan Stanley report that the US and Europe may be heading for another recession.

Those losses were erased a few days later as the Dow posted consecutive gains of 322 and 145 points based on an “FDIC report that the number of US banks in trouble is declining.” The Dow slipped 388 points on September 22nd, 2011, for a 3.48% loss based on “several reports…warning of the dangers of another global recession.”

Again, the losses were erased by a 272 point rise two days later on rumors that the German Parliament would vote to expand the bailout fund for Greece.

From this, it seems that the extreme upswings and downswings in stock prices can be attributed to only a few economic reports. To a rational observer, a few poor (but far from disastrous) economic readings should not lead to a 3.48% decline in the blue-chip stock index of the most financially powerful nation in the world.

The tremendous attention that investors are paying to small,  insignificant data points may be evidence that the levels of fear currently exceed market rationality. “The market is moving around more than justified by the news,” Professor Zitzewitz says.

The fear could be stemming from group psychology. The closeness of the financial community, in which relationships rule all, could potentially lead to prolonged bouts of groupthink in which traders and investors move together in herd behavior, acquiring information only from those already within the circle and of the same mindset.

As a result, the effects of a single, unfounded rumor is intensified as it moves through the collective conscious of the financial markets, unchallenged by outside analysis.

Prospect theory also suggests that people who have already achieved gains would be risk-averse, while those who have suffered losses become risk-loving.

It’s possible that as investors received overwhelmingly favorable returns in 2009 and 2010 have now become risk-averse, and even the slightest tremor in the financial bedrock would lead them to quickly shift their investments to less risky instruments.

Ironically, it is the very fear that leads investors to take their money out of stocks that makes the stock market decline. The actions of the investors are a self-fulfilling prophecy.

The fear, volatility, and global decline in financial markets may not be justified, but by their very existence, create an environment that reaffirms their fear.

As Flexner states, “Fear, unfortunately, becomes self-fulfilling. It’s investor’s fear that creates redemptions, forces hedge funds to sell their liquid assets, and eventually decreases the values of those very assets. That’s the biggest problem with fear. Fear in the financial markets transmutes itself into  reality.”

The People’s Republic of China cannot continue to enjoy the same economic prosperity it has enjoyed in the past through its manufacturing-export-driven economy in the next decade. Instead, it must focus its attention on improving domestic consumption of goods and services.

Export-driven economic growth has had an important place in Chinese history. During the imperial era, the Silk Road brought silk and other “exotic” goods from China to the western world. The Silk Trade brought such prosperity to the Chinese empire such that the palace mandated execution for any individual that revealed the process for silk-making.

Since then, China has gone through economic and political turmoil, culminating in the rule of Mao Zedong in the second half of the twentieth century. Deng Xiaoping’s subsequent ascension to the role of “paramount leader” saw economic liberalisation, bringing great wealth and prosperity to the regions that participated in a new manufacturing-export-driven economy.

China experienced a steadily high GDP growth rate over the past 30 years due to foreign investment, lifting many peasants out of poverty and bringing luxuries unimaginable to the previously poor populations in the country.

Through careful economic planning, China has become one of the dominant exporters of consumer goods in the world. Its GDP per capita has risen from a mere $439 in 1950 to over $3000 today.

However, in the recent decade, China’s socioeconomic condition, as well as the global economic downturn in 2008, has necessitated action on part of China’s leaders to change the direction of the nation’s economic planning away from its current method of growth.

China’s success in building consistently high-performing manufacturing-export-driven economy is because of its comparative advantage in the provision of labor.

Due to its large population, China can provide cheaper manufacturing for products ranging from iPods to t-shirts.

However, with the implementation of its One-Child Policy for population control, China’s capability to produce at a cheaper rate has slowly declined. The population growth rate decreased from 1.5% in 1980 to 0.6% at present.

Although annual net population growth is considerable, China faces a rapidly aging population because of the One-Child Policy, and thus there will be a decline in the labour force available for manufacturing-intensive jobs over the coming years.

Furthermore, the standard of living in China has risen dramatically over the past decade, in-line with the growth in per-capita GDP. Labour is no longer as cheap as it was before, and workers in China now make three times as much as workers in Pakistan and Vietnam. There is a shortage of workers in some regions, and some producers have found themselves hiring recruiters to go into the countryside, offering improved benefits and higher salaries to entice workers to join their factory.

In addition, there is a wealth gap between the coastal regions of China, which have seen rapid urban growth and development of infrastructure such as high-speed railways, and the inland, rural areas of China, many of which are still without electricity. The GDP per capita difference between the richest province and the poorest is ten-fold. There is a lack of affordable health care and social security in China, and combined with poor infrastructure in rural areas, social instability is clawing at the central government.

Faced with these issues, it is imperative that China’s government focus its efforts on developing itself internally and encouraging domestic consumption. With a three trillion US dollar currency reserve[v], the government is well-positioned to spend vast sums of money on civil infrastructure, such as electricity and communications delivery. If modern technologies available in cities were brought to the rural areas of China, there would be a change towards a more domestically-driven economy.

China should also increase individual household consumption.  Currently, China’s household savings rate is over 30%, dramatically higher than those of many other nations[vi]. This is due to the lack of social security and the need for Chinese men to own a house in order to marry.

Although Chinese people do consume tremendous amounts of luxury goods, they fear economic uncertainty, and especially with the lack of a government safety net, Chinese households tend to save more money for emergencies, and to provide for elderly family members.

At the same time, there is a low savings interest rate paid by banks, since they are state-run, which cannot keep pace with inflation. These factors combined make the life of the average Chinese citizen less pleasurable than beforee.

The changes facing China’s economy are of potentially great benefit to the standard of living for the Chinese people – better-developed domestic infrastructure would improve the quality of life for millions of peasants living without modern amenities in the countryside, while government incentives for consumption of non-essential goods could provide an opportunity for many Chinese families to acquire new products and live a wealthier lifestyle.

Zimbabwe 100 Trillion

The International Monetary Fund estimated that by January, Zimbabwe’s inflation rate had escalated to 150,000%. The Zimbabwean government has refused to release inflation figures in an effort to keep prices down since last June. That plan has failed as businesses have used inflation estimates to set prices.

The Zimbabwe Reserve Bank decided to increase the money supply to ease the cash crisis. Yet this will only worsen the problem. The Reserve Bank is considering issuing a new currency of a lower denomination. However, if Zimbabwe is unable to implement monetary reform along with the new currency, inflation will continue to spiral out of control.

Zimbabwe’s raging hyperinflation is a result
of a lack of revenue to cover expenditures.
The Zimbabwean government has been
unable to reduce spending, subsequently
racking up a very large fiscal deficit. A
government can finance its spending in three ways: by taxing the public, selling government bonds, or printing money.

Due to existing economic woes in Zimbabwe, it is not feasible for the government to raise more revenue by increasing taxes. Zimbabwe already has one of the highest tax rates in the world, as the average citizen is subjected to a 35% income tax. However, despite these high taxes, the Zimbabwean government provides very few social benefits for its people. Many people in Zimbabwe barely have enough money to afford basic necessities like transportation, food and rent, let alone fund their government’s fiscal expansionary policies.

Zimbabwe is unable to raise revenue through the sale of government bonds because there is no public demand for them, stemming from a lack of faith in the Zimbabwean government.

Contrarily, every year the U.S. government raises billions of dollars of revenue by selling bonds and securities to the public. The U.S. has established a reputation as a creditworthy institution, and has never defaulted on its debt obligations. Zimbabwe on the other hand, has been plagued with political unrest and financial insecurity. Investors are unwilling to risk their money in a precarious political environment in order to finance a government with questionable credit history. The Zimbabwean government is handicapped by their inability to raise revenue by issuing debt.

Unable to levy taxes or sell bonds, the Reserve Bank has resorted to printing money as a solution to their fiscal woes. The inflation rate has drastically increased from 3,700% in April of 2007 to 66,000% in December of 2007 to 150,000% in January of 2008. Zimbabwe used to be one of Africa’s most prosperous nations, however, poor monetary policy has destroyed the economy and unleashed hyperinflation.

The central bank’s loosening of monetary policy not only finances the fiscal and trade deficits, but also targets Zimbabwe’s past decade of negative GDP growth. In 2000, Zimbabwe’s president, Robert Mugabe, enacted land reform that severely hurt the country’s maize productions. The production of this staple crop, dropped by as much as 75% as a result of the reforms. This had a strong negative impact on rural incomes, exports, and food securities. Unemployment reached 80%, manufacturing fell 51% from 1997 to 2005, and exports declined by a half from 2001 to 2005. As a result, aggregate demand and the economy’s total output decreased significantly. The Reserve Bank’s policy theoretically could shift aggregate demand back to long run output. However, increasing money supply has only resulted in hyperinflation and an exacerbation of the Zimbabwe’s economic recession.

Historically, countries that have suffered from hyperinflation have resolved the problem by restoring faith in their currency and by enacting strict monetary reform. Zimbabwe must end its economic misrule by beginning to deal with its hyperinflation.