It all seems to be coming down to the wire: Slowdwn in the US and Europe, downgrade of economic propects in Canada; Greece on the brink of default and financial contagion feared as a consequence. Since the onset of the Global Financial Crisis (GFC) the markets have repeatedly received asurances from the authorities that the situation was containable and under control and that the policy path set by them was appropriate. Now it seems that these assurances were misplaced. Where did it all go so horribly wrong?
The â€œBrazil Tradeâ€ was a joke scenario that was bandied about on many of the trading desks that I have worked on in years past. Basically the story goes as follows: you pick your trades ahead of a set of economic releases, do them in huge size and with leverage, and then buy a one-way ticket to Rio de Janeiro and go to the airport. Leave one of the traders on the trading desk to watch the screens and the blotter. After the numbers release, you phone your desk from the airport to find out what happened (yes, this storyline involves communications technology that pre-dates the Blackberry, I-Pads, and proliferation of digital news screens). If your positions go onside big time, then you leave the airport go back to the desk in anticipation of a big bonus payout, and life continues as usual. If, alternatively, you blow up, you get on the plane and live off of your previously accumulated pelf in moderate confort on the beach in Rio. (The Nick Leeson / Barings debacle in 1994 was a criminal variant of the Brazil Trade that involved a luxury yacht.)
The bottom line of the Brazil Trade is thus simple: if you win the low probability bet; you win really big and life goes on as before and is even better; if you lose, life as you know it is over because you are now a fugitive living in purgatory.
Any prudent banker or trader knows that you need to blow the bad deals and bad trades out of your portfolio before the next cycle of profit making starts. However, the entire approach to crisis management in North America and Europe over the last three years has been to attempt a short circuit of this process and to foist the impression on the markets and the public that no reckoning or adjustment was or is needed in order for life to go on as before.
And, in implementing this vision of the way out of the crisis, vast amounts of taxpayer dollars have been put at risk.
Now the strategy is starting to fray in earnest. In Europe political support for the bailout strategy is faltering, Germany appears to be positioning for Greek default, while the other peripheral countries slip closer to the edge and major banksâ€™ share prices plummet â€“ short selling ban or no. The resignation in the last few months of two senior ECB officials â€“ Juergen Stark and Axel Weber (note: Weber was the heir-apparent to Trichet over Draghi) â€“ signals deep policy divisions at the Central Bank. For the policy hawks unfortunately, these two resignations represent a victory of the bailout-supportive policy doves and, most likely, a continuation of present ECB policies.
In the US the latest wheeze in the form of the Obama Jobs Plan signals just how far removed from the reality of the markets the policymakers and politicians there are. What of the recent bust up over the debt ceiling and the stated need of the Debt Reduction Super Committee to find $4 Trillion in cuts before the end of 2011? Apparently this does not matter any more – $450 billion will be spent on extending unemployment benefits and other transfers before consideration of the funding mechanism is settled. More fundamentally, in our opinion the whole package boils down to a â€œpotluckâ€ policy grab bag that can only incentivize the unemployed in the US to stay unemployed. If passed by Congress, it will not achieve anything meaningful outside of an increase in the US Federal debt.
Canada is not immune. Not only are our debt levels very high by international standards, the can has been kicked down the road by the authorities here while our economy remains vulnerable to accelerating slowdowns in the US, Europe and China. There should be no question, but that the de-risking of the economy here from exposure to another major credit event must be a policy priority. For the avoidance of doubt we are not advocating more stimulus (in fact the very opposite) but more active risk management of the Zombie situation and more predictable control over government finances at all levels of public administration.
We are in this unfortunate situation because the authorities in North America and Europe never encouraged the markets to make the needed adjustments three years ago. Had they let the markets find a solution and refrained from meddling:
ïƒ¼ The eventual price tag would have been lower and much more predictable,
ïƒ¼ Inflation risks would be less,
ïƒ¼ Unemployment would be lower,
ïƒ¼ The number of sovereign, corporate and banking zombies would be MUCH LOWER,
ïƒ¼ Sovereign debt burdens would be MUCH LOWER,
ïƒ¼ The risks of an uncontrolled debt deflation and credit market collapse would be MUCH LOWER,
ïƒ¼ The economies of America and Europe would be recovering.
The rapidly escalating crisis has swept the outcome of last weekendâ€™s G-7 in Marseilles into the dustbin along with the sports pages and classified ads. This week we have more policy and political meetings in Europe; and next week we have the Federal Reserve Open Market Committee in a two day meeting down on L Street. The markets are now saying a Greek default is inevitable, other countries and buisnesses are edging closer to the precipice and yet the policymakers continue to bang the same drums.
Is anyone packed for a long trip?