The U.S. budget stalemate may fuel a resurgence of turbulence for equities should lawmakers fail to agree amid a slowing economy or deterioration in Europe’s debt crisis, according to Robert Engle, who won the 2003 Nobel Prize in economics for developing ways to analyze volatility.
“If we do go over the fiscal cliff you’ll see volatility go up,” Engle, 70, said in an interview today in Washington.
Deadlocked lawmakers may be “creating excessive volatility by their inability to make decisions on a timely basis and in a sensible, coordinated way.”
Stock-market turbulence that may result from triggering the fiscal contraction “would be much more severe” if the U.S. economy starts slowing, said Engle, a professor at New York University’s Stern School of Business. “We see higher volatility in slowdowns typically.”
The Chicago Board Options Exchange Volatility Index, which tracks prices for 30-day options on the Standard & Poor’s 500 Index, soared last year after S&P stripped the U.S. of its top credit rating. The rating agency cited Washington’s political divide in its downgrade, which came amid an intensification of stresses in European markets and after lawmakers struck a deal to raise the federal debt ceiling and cut the budget.
The VIX, as the volatility gauge is known, headed into today’s close at 16.56, below its average of 20.46 over its two-decade history. It posted the biggest increase in four years when markets opened the downgrade, surging 50 percent to 48 on Aug. 8, 2011. The Dow Jones Industrial Average alternated between gains and losses of more than 400 points for a record four straight days that week.
The world’s largest economy will expand by 2.2 percent this year and 2 percent next year, according to the median of 79 economist estimates in a Bloomberg survey. The Congressional Budget Office estimates that the more than $600 billion of tax increases and spending cuts scheduled to take effect in January would probably cause a recession in the first half of 2013 if Congress doesn’t act.
Volatility would be fueled by other factors in addition to the fiscal contraction, said Engle, who earned a doctorate in economics and a master’s in physics at Cornell University.
“It’s likely to be Europe failing to give the next bailout to Greece and then Greece defaults and then all of a sudden other things start to happen and that would impact the U.S. negatively,” he said. “And if at the same time we don’t have a resolution of these long-term issues then that would be bad.”
(Read more about Engle’s Volatility Lab, see his charts and Nobel Prize remarks in Political Capital.)