Reprinted from: The Globe And Mail
By: David Parkinson
In times of financial crisis – like, say, Europe in June, 2012 – it would be handy to know someone who has time-traveled into the future and can tell us how it’s all going to turn out, wouldn’t it?
I t appears there’s a guy like that right here in Canada. His name is Peter Berezin.
Okay, so Mr. Berezin, an economist and financial market analyst at Montreal-based independent research firm BCA Research Inc., hasn’t actually built a time machine. But in the latest edition of his company’s flagship report, The Bank Credit Analyst, on which he serves as managing editor, Mr. Berezin has peered into the future to pen a report dated 2021. In it, he imagines he’s looking back on how the European debt crisis came to a frightening head in the early fall of 2012 – and envisions how the euro zone and its common currency were able to emerge from it, largely intact.
Under his entirely plausible scenario, Greece abandons its austerity pledges, defaults on its debt payments, creates a new (devalued) currency to meet its domestic payment obligations, and is booted from the euro. A banking crisis ensues, quickly spreading from Greece to other countries, especially Spain. Investor confidence implodes and sovereign bond holders stampede for the exits, not just in Spain but in Italy and France and other euro countries, too, pushing interest rates on government borrowing dangerously high and threatening to drive the region into economic depression. The European Central Bank responds by cranking up the monetary-stimulus machine, but to little effect. Stock markets plunge as investors flee risk assets, not just in Europe but globally.
It all sounds disastrous, until the ECB intervenes in this runaway freight train of a crisis with one big, bold move: “The Cap.”
He imagines that on Oct. 9, 2012, the ECB fixes a ceiling on yields on 10-year government bonds at 6 per cent, for all European sovereigns except now-outsider Greece. It does this by pledging to intervene in the market and buy up “unlimited” amounts of government debt to keep yields below the cap, cranking out as many euros as necessary to stabilize the bond market.
(Mr. Berezin is having a little fun with the fictitious date he chose, Oct. 9. That’s the same date the Dow Jones industrial average hit both its record high – in 2007 – and its bottom in the early-2000s bear market, in 2002.)
There’s no question his solution is heavy-handed; the outcry in some constituencies of the market would certainly be loud, self-righteous and accusatory. The idea of a government institution all but hijacking a supposedly open public financial market isn’t particularly palatable to me, either, all things being equal.
But all things are not equal. Not even close.
Unfortunately, open-market forces don’t care much what damage they inflict while pursuing self-interest. As we saw in 2008, those interests – involving grabbing your money, cutting and running, and/or turning the screws on those who desperately want to grab their money and cut and run – have a way of magnifying and accelerating crises, turning fears and risks into self-fulfilling harsh realities. And that’s where we’re headed in the European bond market in 2012, without a counterbalancing force – the ECB, the lender of last resort – to stop it.
“The euro zone in 2012 was squarely caught in a negative feedback loop,” Mr. Berezin’s futuristic report argues. “If bond yields breach a certain level, investors may price in a higher probability of default. This, in turn, would cause yields to rise even more, leading investors to price in an even higher probability of default, and so on.”
“By capping yields, the ECB effectively short-circuited this negative feedback loop.”
The alternative, leaving the financial markets to their own devices, gets more unpalatable by the day. ECB head Mario Draghi has already acknowledged that the interbank lending market has essentially ceased functioning in Europe, a situation that threatens to eventually seize up other financial markets and entire economies. When things get ugly enough, the markets are more than capable of chewing off their own limbs in fits of self-loathing greed or panic, and pretty much everyone will feel searing pain if or when that happens.
Even ardent free-marketers won’t stand too high on principle if the alternative is bleeding to death.