The Financial Domino Effect: Positive And Negative

by: Ben Emons

Global central bank easing has been through several distinct stages since 2009. It went from liquidity (TALF) to QE to creativity (Twist) to aggression (QE3, EURCHF peg). Fiscal policy followed along, from stimulus to austerity to 'kick the can'. Both types of policy sequences are domino type effects, and so far they have been offsetting each other. The domino theory was something from the 1950s, when there was fear communism would quickly spread in South East Asia. Today the theory has resurfaced in the Middle East spreading violence, South Africa mine strikes and Euro skeptic movements. Economies have been undergoing contraction that has fueled social protests and financial markets are reacting to both. They could be categorized as domino effects that encompass three elements: social-political, economic and financial.

These effects continue to dominate globally. The financial effect is now centered on improving monetary transmission, aimed at directly injecting stimulus into the real economy. The social-political is about dysfunction of the political spectrum unable to deal with difficult choices. The economic effect is about realization that fiscal multipliers have been greater than thought causing a larger drag on economic growth. Mixing the three effects together it presents a basic framework of how social-political, economic and financial effects interact. In between stand financial markets that influence all three effects. A politician worried about the debt ceiling points to how financial markets may react adversely. Business and consumer confidence has been closely linked with stock market performance. Banks and other institutions rely on financial markets for income, and so forth. It appears that domino effects have a circular motion. Politicians react to markets, markets react to politicians, economy reacts to markets and politicians, monetary policy reacts to all three. These are what's called feedback loops that could be defined as positive and negative domino effects.

The positive and negative effects have created wedges between, for example, stock prices and bond yields, but also between elevated asset prices and the sluggish real economy. The wedge - being large - is continuously evaluated by politicians, monetary policy makers as well as people on the streets. Ongoing highly accommodative monetary policy can underpin asset prices, political uncertainty can undermine those prices, while the spillover to the real economy is unclear. The loop between markets, economy, politics and people creates an inherent momentum behind positive and negative domino effects. Domino effects can eventually subside when a 'corner solution' is reached. Such solutions could range from debt restructuring or debt monetization or unexpectedly higher growth. Domino effects tend have paths that can lead to extremer outcomes such as inflation or default, as the effects drive the push for corner solutions and grand bargains.

For investors this is a complex world where constant reassessment of appropriate insurance is a necessity to guard against the extreme. The kind of investor psychology is the combination of both positive and negative domino effects. Eventually some sort of destination may be reached but investors have to accept greater volatility in the process.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.