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Why markets ignore 'geopolitical and geo-economic peril': Martin Wolf explains

Aaron Task
Editor in Chief

As if the anniversary of the Sept. 11, 2001 terror attacks weren't enough, President Obama's address Wednesday evening was a stark reminder that the world is a dangerous place. The President's plan to "degrade and ultimately destroy" the extremist group Islamic State -- also known as ISIS and ISIL -- was notable because it called for expanding American airstrikes into Syria and will involve a coalition of regional and European allies, but not U.S. ground troops.

"I have made it clear that we will hunt down terrorists who threaten our country, wherever they are," the President said. "That means I will not hesitate to take action against ISIL in Syria, as well as Iraq. This is a core principle of my presidency: if you threaten America, you will find no safe haven."

Much of the political discussion Thursday was about whether the President's policy was the "right" one, and a reversal of his anti-war rhetoric or -- as many Republicans claim -- too limited by his proclamation the effort "will not involve American combat troops fighting on foreign soil."

U.S. stocks fell early Thursday but recouped most of the losses and Brent crude hit a two-year low but the financial markets carried on as if totally unaware of the events in Iraq -- much as they have (largely) ignored Russia's incursions into Ukraine this year despite the potential threat to Europe's economy and overall stability. After trading as low as 16,984, the the Dow closed down a fraction at 17.049 while the S&P and Nasdasq closed with modest gains. 

"It's very difficult for the financial markets to judge how to price geopolitical risk," Martin Wolf, chief economics commentator at The Financial Times explains in the accompanying video, and offers perhaps the most salient and simple explanation for why the financial markets seem less concerned about geopolitics than the headlines suggest is merited.

"If things remains as they are now, which is likely, the economic effect of such events is relatively small so it's right to ignore," he says. "There's a quite low probability of an absolute disaster [where] we suddenly move to a completely differently world; World War Three as it were. A very low probability of disaster is very difficult to price - which is partially why we get into financial crises. The markets therefore lose their ability to price it so they ignore it."

But there is a connection between geopolitics and the markets; and one where the latter is moving the former vs. the other way around.

The financial crisis "clearly undermined the credibility and effectiveness of the West and the Western model of capitalism, which was seen as triumphant after the Cold War," Wolf observes. "Western prestige, Western effectiveness have declined. Partly because of that, people are testing the West" -- be it ISIS or Vladimir Putin.

Some of this "testing of the West" was inevitable due to China's rising power -- what Wolf calls "a fruit of globalization" -- and the failure of globalization and integration in the Middle East, he says.

Still, looking at the headlines this morning -- and thinking about the events of 9/11 -- I'm drawn to something Wolf writes in his latest book, The Shifts and the Shocks: "Transitions in global power are always fraught with geopolitical and geo-economic peril because the incumbent ceases to be able to provide the necessary political and economic order and the rising power does not see the need to do so."

Aaron Task is Editor-in-Chief of Yahoo Finance. You can follow him on Twitter at @aarontask or email him at altask@yahoo.com.

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