A couple of years ago – or before banks started to go bust – economists sometimes liked to talk about a phenomenon they christened the “Great Moderation”.

This was the idea that the 21st-century financial system and global economy had become so stable and sophisticated that dramatic swings in activity had seemingly disappeared. Volatility, in other words, was supposed to be an issue of the past.

These days a new phrase is needed to describe these Not-So-Moderate-After-All times (the Great Panic, perhaps?). On Friday, the Chicago Board Options Exchange Volatility index (the Vix), rocketed 32.1 per cent to 89.53, as equity markets suffered another dramatic sell-off. The gyrations of the yen, euro, sterling and dollar have also been wild, pushing levels of currency volatility to heights barely seen in decades.

This has at least two crucial implications for the financial world. First, as volatility returns with a vengeance to the investing world, many market players are experiencing a profound psychological shock. After all, in recent years many investors had bought into the Great Moderation argument, either deliberately or by intellectual osmosis. Many of them had never before seen a world where almost all asset classes could swing wildly in value.

What has happened recently has left many investors and bankers utterly dazed and confused. No wonder some senior policy makers argue in private that one of the biggest problems dogging the financial system is a dire shortage of investors with enough courage to buy assets now trading at distressed levels. On one level the absence of scavengers might seem “irrational”, given that plenty of cash-rich institutions still exist. On another level it makes perfect sense, given how shell-shocked many institutions now seem – and the sheer difficulty of predicting what other disorientated investors might do next.

The second, more tangible implication of the return of volatility relates to the models that banks and hedge funds use to measure their assets. When banks extend credit to hedge funds, they often use so-called “value at risk” models (VAR) to measure the risks attached to such loans. These models typically assess the riskiness of an asset by measuring how its market price has moved in the past.

During the Great Moderation, this approach cast a fabulously flattering light on the investment world, creating the impression that it was safe for banks to extend massive volumes of credit to hedge funds. Moreover, since banks typically use VAR to measure the risk attached to their own assets too, these models also seduced banks into feeling complacent about their own risks.

Now, this process has gone violently into reverse: as volatility surges, VAR models are showing that the risk attached to almost any transaction has exploded upwards. Thus banks are selling assets and slashing loans to the funds – in turn sparking more fire sales and increasing volatility in all asset classes. It is a vicious trap that does much to explain why the market upheavals have infected so many asset classes, ranging from subprime to sterling to Shanghai shares. It is hard to see how policymakers can halt this spiral quickly.

In recent days, some senior policymakers have been quietly talking to the banks, and encouraging them to “think about the wider system” before they cut credit lines to hedge funds. But policymakers are reluctant to order banks to stop selling assets or squeezing hedge funds, let alone directly bail out any hedge funds. Instead, they appear to hope – if not pray – that injections of capital will lessen the need for banks to readjust themselves to their VAR models in such a violent manner.

It is to be hoped such prayers will be met. If so, this deleveraging storm should gradually blow itself out in the coming months. But it remains a delicate war of investor psychology and computer models. What is crystal clear is that it was sheer madness for financiers ever to have relied so heavily on these VAR models during the first seven years of this decade – particularly when they were so badly distorted by a false belief that the Great Moderation would always last.

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