Exogenous shocks are events from outside the economic system that affect its course. These could be short-lived political events, changes in government policy, or natural disasters, for example. How do shocks contrast with economic trends? Over time, trends in an economy are likely to stay relatively constant. As such, they should already be discounted in market expectations and prices. Exogenous shocks may have short-lived effects or drive changes in trends. They are typically not built into prices or at most are only partially anticipated.

Exogenous Shocks. Oil Shocks

Most shifts in trends are likely to come from shifts in government policies, which is why investors closely watch both specific measures and the overall direction of government policy (e.g., consumer friendly, business friendly, export friendly).

The biggest impact occurs when there is new government or a major institutional shift. For example, a major fiscal law that prevents the government from borrowing beyond certain limits can be a very effective constraint on excessive spending. A decision to make the central bank more independent or to enter a currency union could have a major impact on the economy. Such government-induced impacts typically are swiftly felt.

Some shocks do not affect trends but are felt in a more immediate or short-term manner. While they are often negative, they are not always so. In 1986, the unexpected breakup ofan Organization of Petroleum Exporting Countries (OPEC) meeting without an agreement to cut production led to a sharp decline in oil prices. This event played an important role in keeping inflation low for several years after that. The fall of the Berlin wall triggered German reunification and a ''peace dividend'' for governments as they cut defense spending (Equity Total Return Swaps).

The creation and assimilation of new products, markets, and technologies provide a positive, longer-term impact on economic trends. Too often, analysts focus on shorter- term benefits, under-appreciating the evolving nature of the technologies and the scope of their effects. For example, the evolution of communication technologies from the telegraph, telephone, phonograph, wireless (cellular and satellite), and Internet has been a source of great positive economic impact. These gains show up in TFP growth.

Shocks cannot be forecast in general. But there are two types of economic shock that periodically affect the world economy and often involve a degree of contagion, as problems in one country spread to another. Oil shocks are important because a sharp rise in the price of oil reduces consumer purchasing power and also threatens higher inflation. Financial shocks, which can arise for a variety of reasons, threaten bank lending and therefore economic growth.

Oil Shocks

Crises in the Middle East regularly produce spikes in oil prices. Military conflicts that led to declines in world production of oil occurred in 1973 to 1974, 1979, 1980, 1990, and 2003 to 2004. Even though oil is a smaller input to the world economy now than it was in the 1970s, a sudden rise in prices affects consumers' income and reduces spending. Inflation rates also rise, though here the effect is ambiguous. Although inflation moves up initially, the contractionary effect of higher oil prices restricts employment and opens up an output gap so that, after a period, inflation slows to below the level where it otherwise might have been.

 

There have also been episodes of declining oil prices, most notably in 1986 and again in 1999. These tend to have the effect of extending the economic upswing because they contribute to lower inflation. Low oil prices and low inflation boost economic growth that can contribute to overheating, as was seen in the United States in 1987 and again in 1999 to 2000. Dependence on Middle East oil remains high, and the sources of political instability in the region remain numerous.

Financial Crises

Periodic financial crises affect growth rates either directly through bank lending or indirectly through their effect on investor confidence. In the last few decades, events in emerging markets have been the cause of several crises. The Latin American debt crisis of 1982, the Mexican currency crisis of 1994, the Asian financial crisis of 1997, and the Russian crisis of 1998 are examples. The last was particularly important because it threatened both financial markets and investment banks with widespread collapse. The reason was a possible domino effect due to the subsequent collapse of Long-Term Capital Management (LTCM), a large U.S. hedge fund. Most of LTCM's positions had been based on expectations of declining risk spreads. When the Russian crisis sent those spreads upward, it triggered a crisis. Among central banks, the U.S. Federal Reserve's response to these emerging market crises was particularly proactive. The Fed injected liquidity into the system, thereby reducing U.S. interest rates and moderating the impact on financial institutions.

There have been other financial crises. Banks are always potentially vulnerable after a major decline in asset prices, particularly property prices, as in the United States in the early 1990s. In that case, the Fed's response was to keep interest rates low for a prolonged period to provide sufficient liquidity to ensure that the payment system could continue. That action would have been more difficult in a world of low inflation or deflation. Financial crises are therefore potentially more dangerous in a low interest rate environment.

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