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What should Greece do?

February 16th, 2010

There’s been a lot of discussion of the problems of Greek sovereign debt, its implications for the euro and so on. But I haven’t seen much discussion of what the Greek government should do in dealing with the simultaneous problems of an economic downturn and unsustainable debt (feel free to point me to good discussions).

The course of action being demanded by the bondholders and their advocates, as well as by the EU governments that are likely to bear the costs of a bailout is that of drastic retrenchment on the lines the IMF would normally advocate in cases of this kind. But that is obviously not a desirable policy response when considered in macroeconomic terms. I’m not well informed on the details of Greece’s budget problems, so I’m mostly going to make generic suggestions that are applicable to a case like this.

What Greece needs, if it can be delivered is a policy that will maintain its access to credit markets, while avoiding a drastic contraction in the short run. That requires a credible commitment that holders of Greek government bonds will be paid in full, or fairly close to it, a commitment that is inconsistent with sustained budget deficits.

The strategy that seems to be indicated is one that has the following main characteristics

* A sustained increase in the ratio of tax revenue to national income over time. That suggests a commitment to raise the VAT rate gradually over several years, with the extra revenue being hypothecated to debt service. On the income tax side, the most credible commitment to raise revenue in the long run is probably one of vigorous action against tax avoidance and evasion, benefitting from the efforts of the bigger European economies in this respect

* On the expenditure side, it’s likely that Greece, like most countries has unsustainable commitments on retirement incomes. A staged increase in retirement and pension ages, as has been done in Australia, is a reasonably credible way of constraining future growth in expenditure without too much adverse impact in the short run.

* Finally, there are the various non-conventional ways previous governments found to take on debt obligations, for example by mortgaging future income flows. Unlike the case of standard government bonds, there is no need to preserve access to this kind of borrowing in the future. On the contrary, action to ensure that no future government can borrow in this surreptitious fashion is highly desirable. So, these deals should be renegotiated to reduce the burden they impose, with the threat of repudiation/default in the absence of a satisfactory agreement. The prominent role of major Wall Street banks in organising these deals is a potential political asset here. An outcome in which Goldman Sachs gets stiffed, while bondholders in general are paid, would be an ideal way of softening the political pain associated with expenditure cuts and tax increases.

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  1. February 23rd, 2010 at 12:57 | #1

    EG,
    1. I had no reason to doubt you – I had just not heard this and I read on this a fair bit.
    2. I always prefer that risk is sheeted home to those taking it. Having monitored traders actually working on a trading desk I know what motivates them and encourages them to take more or less risk. The big motivator is that fear / greed balance. Once you get rid of the fear, greed takes over.
    If it is Mums & Dads then they can take action against their advisors. It happens on a regular basis and is often successful before it even hits the courts.Class actions, while often possible, generally aren’t needed. Advisors normally want to protect their reputation and a case about this sort of thing does not help that.
    3. “As history shows” is a very weak argument, EG. Links & studies, please. I have seen that history in action and I would take some convincing that it does not. See 2 above.
    4. I am not sure what point you are trying to make here. There is a lot of talk about what options the EU has – one is (obviously) a straight bailout. I would consider this a poor choice of action for the reasons I have outlined.
    5. The reactions of the ratings agencies merely provide further information to the people trading in the markets that exist for debt. It is the collective decisions of those people that truly punish (or reward) the actions of the issuers of that debt.
    6. I concur. This is fascinating for those of us not directly affected. The Greek debt situation has been a slow motion train wreck for a long time.

  2. Ernestine Gross
    February 23rd, 2010 at 15:56 | #2

    TerjeP(say tay-a), no need to apologise for baffling me because I wasn’t baffled. I beg you to have a little more patience with my alleged pedantry nature.

    Suppose, as before, we interpret the term ‘nation’ as a geo-politically defined country. Suppose further that citizens of country A buy securities issued by citizens or institutions in country B and the issuers default.

    You adviced that the term ‘nation’ means government.

    I say, a government is but an institution.

    Why, I ask you, would the citizen in country A distinguish between losing, say $x of past savings due to the default of a citizen from country B and the default of the government (an institution) from country B?

  3. February 23rd, 2010 at 16:10 | #3

    Ernestine,
    How is the government of Nation “A” taking on the debts of Nation “B” if it was the individuals (or companies) in Nation “A” that bought the bonds of Nation “B”? Sure – to the extent that the individuals in Nation “A” cannot absorb the losses and go bankrupt there may be some flow on, but this is hardly aking to “…taking on the debts of ‘nation’ B”.
    As you said – government is just an institution, it does not mean that the debts of the individuals or companies in Nation “A” are part of the government.

  4. Ernestine Gross
    February 23rd, 2010 at 16:39 | #4

    @Andrew Reynolds

    @ 1, page 2

    1. –
    2. Traders are not financiers.
    As for advisers, the clever lot write disclaimers (eg rating agencies)
    3. I wrote: “As history shows, the belief that the threat of bankruptcy will automatically prevent it, is a naive belief and so is the weaker form of this belief that actual bankruptcy would improve future behaviour.”

    Do you really ask for evidence that bankruptcies are occurring? Surely you read the press every so often.

    4. I wrote on a few quite obvious differences between the GFC and the Greek situation.

    5. It escapes me to understand why people are prepared to pay for rating agencies’ reaction! It is like paying someone for finally having also seen the elephant in the room.

  5. TerjeP (say tay-a)
    February 23rd, 2010 at 16:45 | #5

    EG – they would distinguish so as to avoid lending to the same party again. Just because the government of Nation B defaults there is no reason to stop lending to Fred Smith from nation B, and vise sersa.

  6. Ernestine Gross
    February 23rd, 2010 at 19:45 | #6

    TerjeP (say tay-a)

    1.You are telling me that a government should be treated like an individual when it comes to default.

    2. I recall you say that there is a crucial difference between governments and individuals due to only the former having the power to tax.

    3. You are for ‘small government’ and low taxes.

    Now consider the case where government C at time t=1, …, k has followed your advice regarding taxes (setting aside record keeping problems with the C government in Greece) and the proverbial Fred Smith has improved on the low tax policy of the C government by private creative accounting means. As a result, Fred Smith has accumulated substantial private wealth and Fred Smith has an impeccable credit rating. Government C is followed by government S at time t=k+1 and discovers that the financial position left by government C is not sustainable.

    According to your post, there is no reason to stop lending to Fred Smith but there is every reason to force the successor government, S, of the country in question, to default (they must not raise more taxes) with the implication that government S will not be able to raise more funds by issuing securities.

    I say, this is a clever strategy to achieve a political objective of ‘no government’ . I also say this is neither fair nor desirable.

  7. February 24th, 2010 at 01:08 | #7

    EG,
    2. Don’t say that around any bank’s trading desk. The buy side and the sell side, as well as the origination side largely work as one. In reality banks largely operate in an integrated fashion.
    3. Perhaps we could restate that as imprisoning murderers does not stop anyone at all from killing? Interesting idea of criminology. Again, this does not tee up with reality. If the government stepped in to help everyone that made reckless bets then I would head out to the casino tomorrow.
    4. And?
    5. The ratings agencies, by the nature of their contracts with the rated companies, have access to a lot of internal information that we, and the people in the trading rooms, do not have. The ratings as a result can prove valuable. For normal instruments by the ratings agencies actually have a fairly good record of picking defaults, so their ratings have a value. That’s why, historically, people have paid for them. Where they fell down, as they have admitted, is they got the ratings wrong for various new classes of instruments. If that escapes you, then don’t pay for it. You have no need to pay. The ratings themselves they give away.
    .
    I will let Terje have a look at your response to him, but my question is how can a private company force a government to default? The government will decide whether or not to pay. Fred will also make that decision. Both will have regard to their capacity to pay in coming to that decision and what other steps they can take to avoid it.
    AFAICS Terje has never said they must not raise taxes. Personally I would say merely that to do so would normally be the wrong move for the welfare of the people of the country. It does not logically follow that there will be no circumstances at all that taxes cannot be raised.

  8. TerjeP (say tay-a)
    February 24th, 2010 at 05:23 | #8

    I’ve said that if the debt burden is extreme it may well be better to default than to continue slugging the citizens with higher taxes. It depends on the circumstances.

    1. From the perspective of the lender yes. If they default you should be very coy about lending to them again.

    2. Yes.

    3. If Fred Smith has proven he can manage finances and repay his debts and the government has defaulted then of course lending to Fred instead of the government seems more sane. However Fred need not be wealthy nor a tax minimiser. He could just be an average Fred who lives within his means. In fact this is the much more common type of Fred.

  9. Graeme Bird
    February 24th, 2010 at 07:31 | #9

    It must be remembered that its no bailout of the Greek people. Thats just a cover-story. Its really a bailout of bankers. The bankers spend all their time horridly mis-allocating resources, and they then prove incredibly adept at getting people to bail them out, and yet more adept at pretending its someone else who is being bailed out.

    There is no sense of responsibility as to where the bankers are directing societies scarce capital resources. In this case the bankers are directing these resources to budgetary irresponsibility. In other words the bankers are directing capital resources down the toilet as it were. The loss to the world in terms of potential wealth creation has to be simply staggering.

  10. February 24th, 2010 at 10:40 | #10

    Graeme,
    You might make more sense if you dropped the “bankers are teh evil” stuff. Yes, if it happens this would be a bailout (to an extent) of those who have lent to the Greek government. Yes, as a result (and as I have argued up the thread) the lenders should bear the cost of lending to a bad risk. I do not think they should be bailed out.
    Bankers, though, are like the rest of us – imperfect, prone to greed, fear and other errors. They make mistakes in resource allocation. Those faults, though, we all have. I have been greedy, I have not invested through fear and I have made what turned out later to have been mistakes, as, I would think, have you.
    In this case, though, the Greek government is also partially responsible as they actually borrowed the money. The Greek people are also partially responsible as they keep electing governments that just kept running deficits and borrowing more.
    To say that the bankers are “…spend[ing] all their time horridly mis-allocating resources…” is just as silly as saying the same about the Greek government or people.

  11. Ernestine Gross
    February 24th, 2010 at 14:54 | #11

    @TerjeP (say tay-a)

    “If Fred Smith has proven he can manage finances and repay his debts and the government has defaulted then of course lending to Fred instead of the government seems more sane. However Fred need not be wealthy nor a tax minimiser. He could just be an average Fred who lives within his means. In fact this is the much more common type of Fred.”

    A case of changing the problem to fit the desired solution.

  12. TerjeP (say tay-a)
    February 24th, 2010 at 15:00 | #12

    EG – I don’t understand your comment.

  13. Ernestine Gross
    February 24th, 2010 at 15:04 | #13

    Terje, You are excluding the ‘type of Fred’ in my example to support your argument.

  14. Ernestine Gross
    February 24th, 2010 at 15:12 | #14

    @Andrew Reynolds

    I submitted a detailed reply to your post @7 and at 10, p.2 with links to articles in a foreign language newspaper. The post didn’t get through and I suspect it is because of the links. Essentially, I provided a bit more detail on the relationship between Goldman Sachs and the Greek government, dating back to 2002, the amount of fees collected by Goldman Sachs, and their latest approach to Athens in November last year. The newly elected government did not bite.

    I refer to my initial post and let you work out how you ended up with the content of 7. There has been a considerable amount of slippage.

    I consider your mental model of how the banking system works since deregulation to be outdated and your defence of bankers (other then tellers and branch managers) on the grounds of the odd error and bankers being humans not credible. There are systematic wealth transfers.

  15. February 24th, 2010 at 16:24 | #15

    Ernestine,
    I have worked in the risk, treasury and middle office functions of major banks both here and overseas for several years. Before that I was working on the prosecution of a bank failure. Recently I was working for years for a major audit firm, partly working on the audits of minor and major banks.
    If my knowledge of the deregulated banking system is out of date then an awful lot must have changed in the last year since I largely moved out of the area.
    As for the other bit – of course there are major wealth transfers. There are huge amounts of money being shifted around, and not all of them are totally honest and some are downright dishonest. Like the rest of us, bankers are capable of outright fraud. Like the rest of us, put a huge pot of money in front of them and expect them to be always completely honest and upright is an unrealistic expectation. They are human.
    The question is how do you deal with it.
    You seem to believe (and please correct me if I am wrong) that we should assume they are dishonest and put them in a regulatory strait-jacket. Personally, I have seen how those strait-jackets work and I do not believe they actually fix anything. They may well make it worse. There is a reason that the Greek banking system is seen as corrupt, not subject to the will of customers and unable to provide much finance to the government, forcing them to go offshore to raise finance. I will give you a hint – the reason is not because Greece has a deregulated banking market.

  16. TerjeP (say tay-a)
    February 24th, 2010 at 17:54 | #16

    Ernestine Gross :
    Terje, You are excluding the ‘type of Fred’ in my example to support your argument.

    My argument works with either type of Fred. I only offered a particular type to demonstrate that the type of Fred you offered isn’t a requirement.

  17. Ernestine Gross
    February 24th, 2010 at 21:22 | #17

    @Andrew Reynolds

    Andrew R.,

    No, I don’t suggest that one ought to start with the presumption that bankers are dishonest only because, as you say, there are cases of dishonesty and outright fraud. I am also not suggesting more regulation per se. I would describe the problem as a system design problem. That is, even if there would be no case of dishonest behaviour or outright fraud, a complete collapse of the financial system we have cannot be excluded. This risk is called systemic risk. The bankruptcy of one single bank, Lehman, provided a preview of total system failure. Accounting methods are known to be very effective to detect dishonesty and outright fraud but they are not helpful to detect systemic risk (financial accounting assumes that the system works and the only problem is due to individual agents in the system misbehaving.) You may recall that derivative securities were marketed as risk management tools to corporate treasurers all over the place (videos were sent to management schools). Now there is a growing awareness that these securities have added risk. Why? I don’t claim to have all the answers but I can offer the following. The pricing models of derivative securities, using ‘no-arbitrage’ arguments, make it very clear that if these securities are priced correctly then these securities are redundent (superfluous). But they exist in the real world. They exist in the real world because they provide additional leverage! The more of the stuff that is on the market the more leverage. Wall Street investment banks created more and more types of derivatives and derivatives of derivatives. There is little doubt now that the GFC (and the problem of Greece) is a problem of excessive leverage. In your post @7, you write: “The buy side and the sell side, as well as the origination side largely work as one. In reality banks largely operate in an integrated fashion.” Correct. But this is part of the problem. It is self-dealing, blurred by interbank transactions. IMHO, a quantitative restriction on various types of securities that can be issued and restrictions on who can issue which type of security and an appropriate record keeping system would be the right direction to look for a better financial system.

    I understand from the German press that Goldman-Sachs has a severe repution problem in the EU as a consequence of its assistance to past governments in Greece. Further, the discussions between the EU and the Greek government involves the former supervising and auditing official accounts. If it comes about, it would be a first ever. As you know, straight bailouts are not allowed in the EU. There is opposition to the curtailment of public expenditure and increases in taxes in Greece – understandably because the clever financing deals of the past allowed people to live in an unreal world.

  18. Ernestine Gross
    February 24th, 2010 at 21:55 | #18

    TerjeP (say tay-a) :

    Ernestine Gross :Terje, You are excluding the ‘type of Fred’ in my example to support your argument.

    My argument works with either type of Fred. I only offered a particular type to demonstrate that the type of Fred you offered isn’t a requirement.

    Lets spell it out then what your argument means. You say that irrespective of how an arbitrarily chosen ‘Fred’ has obtained wealth, as long as his wealth is big enough to always meet his debt obligations, savers have no reason not to lend more to Fred.

    Now lets apply your premise to the institution of a government. As long as a governmental ‘Fred’ confiscates enough wealth to meet its debt obligations there is no reason for savers not to lend to the governmental ‘Fred’.

    I don’t agree with your moral philosophy. I actually don’t believe you agree with it either. I suspect that there is a hole somewhere in your implicit theoretical model of political economy..

  19. TerjeP (say tay-a)
    February 24th, 2010 at 22:57 | #19

    EG – lenders will make their own judgements based on many factors. You seem to be trying to labour some divergent moral point. My point is merely that the credit worthiness of a government is distinct from the credit worthiness of it’s citizens. That if a government defaults that does not mean than any given citizen of that nation is now automatically less credit worthy. Governments and individuals are separate entities and lenders understand the distinction.

  20. Ernestine Gross
    February 25th, 2010 at 08:23 | #20

    Terje, it was the newly elected Greek government that rejected any further business with Goldman-Sachs in November last year (source: Sueddeutsche Zeitung). Lets see who is going to default when the newly elected Greek government is taking a stance against tax evasion. Some ‘lenders’ understand only the size of their bonuses.

  21. February 25th, 2010 at 10:35 | #21

    Ernestine,
    It looks like you need to speak with one or more of the people in a business school – preferably someone with real experience.
    Derivatives cannot add to the total losses in a financial system. All they can do is transfer them. I know many here would splutter at that, but think about it. A derivative derives its value from some underlying instrument (that is why it is called a derivative), so losses on the underlying are what (normally) matters, with those losses being transferred depending on the nature of the derivative.
    You will have noted the qualifier in there. There are some derivatives that have a structured payout that make a disproportionate return, but these are not that common, so for the purposes of macro stability they can be ignored.
    For the most part derivatives are very useful – importers and exporters find currency forwards invaluable, borrowers find swaps extremely useful, those producing or buying gold, or wanting to hedge share transactions generally find options cover the risks they not only want covered, but may need to cover to meet their duties as trading entities.
    Banks use securitisations to remove debt from their books (as often required by regulators). The CDOs that have such a reputation are merely a form of securitisation.
    Derivatives, therefore, are extremely useful.
    What the core, underlying problem was in the US was simple – poor lending. The losses were determined the moment that the practice became lending to poor risks – all the derivatives and other things did was to put the losses incurred somewhere other than in the lending institution.
    Derivatives do not exist in the real world to provide additional leverage, they exist to meet real business needs to transfer risk. Try telling an exporter that the forward contract they just bought was not needed in the real world and they will laugh in your face. The gold producers need some pricing certainty – options and gold forwards provide that. Banks, when they lend, may need to get the loans off their books for perfectly legitimate (or regulatory) reasons. Again, these are not there to “provide additional leverage”, they are there to meet business needs.

  22. TerjeP (say tay-a)
    February 25th, 2010 at 12:10 | #22

    EG – based on what you have said I have no objection to the actions of the new Greek government. Typically crack downs on tax evasion don’t yield much new revenue but if you want to retain tax powers then it is a necessary periodic ritual.

    I’m not sure if you have acknowledged my point about Fred.

  23. Ernestine Gross
    February 25th, 2010 at 12:46 | #23

    Andrew Reynolds,

    Thank you very much for your advice but I am not going to buy it. Why on earth do you believe that what business came to believe they need is what adds to the stability of the financial system?

    It is easy to show how derivatives add leaverage: Consider the simplest financial derivative, a european call option written on an equity share. The (non-linear) payoff of the call can be duplicated by a portfolio of the underlying equity share and a bond (with zero default risk). The price of the option is less than the cost (cash outlay) of the equivalent portfolio. If this is not leverage then what is??

    Incidentally, I would not call a forward contract a derivative.

    And who is ‘business’ anyway? Corporate managers, corporate accountants and corporate lawyers who use other people’s money or people who put their own money where their mouth is? Warren Buffet belongs to the second type of ‘business’. He is quoted as having considered derivatives as financial weapons of mass destruction.

    You write: “Banks, when they lend, may need to get the loans off their books for perfectly legitimate (or regulatory) reasons. Again, these are not there to “provide additional leverage”.

    With due respect for your professonal experience in your applied area, but the above is nonsense in the context of financial system risk. The ‘legitimate’ (regulatory) reason are known as capital adequacy ratios (accounting type ratios). By getting loans ‘off their balance sheets’ the said banks are using the same amount of equity more than once to generate accounting profits (and bonuses) by means of lending more. If you can’t see that this is increasing leverage system-wide, then I am getting close to thinking of you as the Monckton of Finance. But I believe this is not a fruitful line of thought. I put it to you that the problem of systemic risk is something else than what you may think it is and it is outside the conceptual framework of accounting and management of corporations but within the grasp of some original minds of successful business people such as Buffet or Soros.

    (Business schools aren’t all the same either in terms of teaching and research nor are their students. They range from highschool to top university level).

    Back to the topic, what should Greece do? There is obviously no easy answer. The EU Commission is threatening the Greek government to take it to the European Court for failing to enforce repayment of about Euro80million in tax subsidies that had been given to hundreds of companies (including foreign companies) in contravention with EU rules. Source: Sueddeutsche Zeitung, 24/02/10.

  24. February 25th, 2010 at 13:00 | #24

    Ernestine,
    I should add that, in transferring risk, derivatives can act to concentrate it, increasing systemic risk (as happened with AIG). In the case of Lehman’s that you brought up, though, it was not the concentration of market risk, it was simply liquidity risk. People lost confidence that Lehman’s would be able to pay as and when and so withdrew their funds. Lehman’s was still valuable, as shown by the price paid for it (and subsequently increased).
    Dealing with this possible concentration I see as important, but I believe it can be dealt with through disclosure, rather than through the heavy handed blunt instrument that more regulation would be.
    The point to make here, though, is that derivatives can also act to disperse risk, thus actually reducing systemic risk overall. Short of massive fraud and the resulting cover-up, I believe that the sorts of disclosure that shareholders (and the ratings agencies) are increasingly demanding is the best way to meet this need.

  25. February 25th, 2010 at 13:23 | #25

    EG,
    Looks like we crossed comments, there.
    A forward contract, whatever you want to call it is a derivative, as are swaps (another form of forward contract) and so are many other things – such as the “getting the loans off your books” style contracts you are talking about. They are all forward contracts.
    If you are going to continue this discussion, then please let me know what you are talking about, as you seem unclear.
    If you do not regard forwards as derivatives, then CDOs are not derivatives. Que?

  26. Ernestine Gross
    February 25th, 2010 at 14:49 | #26

    Andrew R.

    I’d prefer to drop the topic of systemic risk because your last post indicates to me that you see everything from the perspective of ‘an accounting entity’.

    It was Goldman-Sachs that sold the Greek government the derivatives which constitute a problem at the time of entry to the EU in 2002. Their involvement resulted in economically misleading national accounts about which the EU Commission isn’t happy at all. And it is Goldman-Sachs which approached the Greek government late last year. They have learned nothing. (I wonder how much more has to happen before the operating license of GS for the EU will be withdrawn.)

    I appreciate that rating agencies offer a convenience for people at trading desks by providing parameter values to be put into a computing program to ‘price’ securities. But I can’t see why payment for such non-recourse services should be a tax deductable expense, given the consequences for taxpayers in many country for their ratings of hot potato securities (risky debt portfolios at the time of issue) as investment grade. There is no excuse I can think of because the relevant theoretical literature had been available for a long time in the public arena – ie ‘full disclosure’ was in place. But my opinion doesn’t count for the problem at hand. What matters is what the EU Commission and the Greek goverment and the EU people in general think of rating agencies.

    The EU Commission doesn’t seem to be in the mood to take rating agencies seriously. As mentioned, Greece may have to put up with financial supervision from the EU Commission.

  27. Graeme Bird
    February 25th, 2010 at 14:56 | #27

    “Governments and individuals are separate entities and lenders understand the distinction.”

    I’m not saying you are not making a fair point Terje. But why impute any human understanding to these morons/welfare queens? If they are not simpletons, then surely they must be cynical jackals, entirely confident of their ability to steal, when their incompetent lending practices come unstuck. I don’t think you are fully coming to grips with the mis-allocation of resources here. Capitalism is supposed to be a system of effective capital markets. A system that allocates resources to the areas of greatest wealth creation. Is that what we are seeing when these bozos are financing the Greek government deficit? When they are financing land inflation as opposed to small business expansion?

    Clearly something is terribly wrong here. And yet you and Andrew seem to want to carry on with the delusion that this is a functioning free enterprise industry.

    These people have failed. They are not smart. Some of them are incredibly rich. But there is a difference between being smart and being rich. At least in this industry there is. A fool and his money may soon be parted. The exception being if you are a rich banker. Because thats a heads-I-win, tails-you-lose situation. Rent-seeking requires only political instincts. It does not require the high intelligence of wealth creation. Hank Paulson is not Steve Jobs. In fact Hank is a real dummy.

    These issues are important. Its hard to think of any other industry, the reform of which, could lead to greater improvement in our living standards. Medicine perhaps. But in any case there is a lot of work to do. A lot of reform to be had. Any idea that these bankers are doing a good or acceptable job will get in the way of that.

  28. Graeme Bird
    February 25th, 2010 at 15:06 | #28

    “Ernestine,
    I would have thought a more credible option would be to default on the debt and off balance sheet financing that was not made public (if indeed you are right). That would penalise the financiers that provided the funds that were provided in a less than transparent manner and show that the new government was determined to clear things up.”

    Why not default on all of it Andrew? If lent in plain sight or off the books, its all bad lending. Is it really the case that these people will get punished for any of their wrongdoing or incompetence? We haven’t seen that lately have we? Here we have these people who ought to have been cleansed and bankrupted. But two years later they are still getting in our face. Giving our governments horrendously bad advice. For example is that rail sell-off still going ahead in Queensland?

  29. Ernestine Gross
    February 25th, 2010 at 15:36 | #29

    Andrew Reynolds :EG,Looks like we crossed comments, there.A forward contract, whatever you want to call it is a derivative, as are swaps (another form of forward contract) and so are many other things – such as the “getting the loans off your books” style contracts you are talking about. They are all forward contracts.If you are going to continue this discussion, then please let me know what you are talking about, as you seem unclear.If you do not regard forwards as derivatives, then CDOs are not derivatives. Que?

    This is off topic. Perhaps you confuse futures contracts with future contracts. I suggest you write down the contractual relationship of a future contract, using the language of mathematics, and you’ll see that a future contract has the same structure as a plain vanilla debt contract. Moreover, all the important information fits into a financial accounting framework. Do the same for an option and you’ll see the difference.

  30. February 25th, 2010 at 15:40 | #30

    Ernestine,
    You may prefer to, but I disagree. I do not see it solely or even mainly from the standpoint of an accounting entity, despite the fact I have considerable accounting knowledge on the Standards relevant to a banking or insurance entity – enough to know that your micro analysis is faulty as well.
    For a start, you have not reconsidered your manifest misunderstanding of what a derivative actually is. Please clarify on this. If you do not see forward contracts as derivatives, then the CDS instruments that our host here (in another post) is talking about as a problem are not derivatives. If they are not, what are they?
    If you want to stick with micro issues, then perhaps we can look at another area where my applied knowledge may be useful to help evident misunderstanding. Let’s look here:

    The ‘legitimate’ (regulatory) reason are known as capital adequacy ratios (accounting type ratios). By getting loans ‘off their balance sheets’ the said banks are using the same amount of equity more than once to generate accounting profits (and bonuses) by means of lending more.

    (Emphasis mine)
    This, if I may say, is nonsence. The only way you can get these things off your balance sheet (legitimately at least) is by actually selling them – i.e. through the introduction of a new entity (with its own equity) to which you are selling the assets. The precise wording in the relevant accounting standard is to “…transfer substantially all the risks and rewards of ownership…” (IAS 39 para 20(a), with similar wording in the US FAS 133). Regulators have a slightly lower standard (not greatly lower), but all of them involve the introduction a new entity (with its own equity and assets) into the structure to which you are selling them and all of them require the introduction of valuable assets into the selling entity. If the asset introduced is not cash or an equivalent then there is no capital relief as the new debt to you attracts a capital requirement – in fact there may be additional capital required.
    Sorry, EG, but on either macro or micro I cannot see how your argument stacks up.

  31. February 25th, 2010 at 15:53 | #31

    EG,
    Again, your last comment crossed mine – but I feel the confusion is yours. A futures contract is a special type of forward contract, one traded in a standardised way on a futures exchange. A futures contract is just as much of a forward contract as any other.
    Let’s just look at some definitions, EG. It may help.
    In a forward contract the two (or occasionally more) counterparties agree to exchange certain items of value in the future. Neither has the option to back out of the deal under normal circumstances. Into this category falls such instruments as vanilla forward contracts, interest rate swaps, credit default swaps, collateralised debt obligations and such. These derive their value from some underlying – in the case of a currency forward it is the difference between two spot currency rates and the relevant bond rates and in the case of a CDO it is the expected future cashflows from the subject debt obligations.
    The option contract gives the holder the right, but not the obligation, to enforce delivery in the future of a fixed or determinable amount of some underlying. Into this cateory falls such instruments as vanilla options, swaptions and many more exotic derivatives. Personally, I have always liked the binary payout ones, but that is not relevant here. Inthe case of an option it derives its value from the underlying, the optionality and the time to run.
    .
    The ones that our host here and, IIRC, you have been most vocal about are forward contracts – the CDS and CDO style derivatives that are just as much a forward contract as a plain vanilla boring old currency forward. Are these not derivatives, then? If so, your argument is nonsensical.

  32. Ernestine Gross
    February 25th, 2010 at 16:59 | #32

    Andrew R.
    You are taking this way off topic. But given your statements I see a need to reply.

    I said @23 that I would not classify a forward contract as a derivative. At 28 I talked about a ‘future’ vs ‘futures’ contracts. The term ‘future’ contract is a theoretical concept while ‘futures’ are securities currently issued and traded. The empirically existing forward contracts have properties akin to a future contact. A forward contract specifies the amount of cash paid by the buyer of the contract at time t to the seller of the contract in exchange for a contractually fixed amount of something, say 1 unit of y, to be delivered by the seller of the contract at time t+k at a predetermined price. The amount of cash paid at time t is the price of the forward contract. (The theoretical concept of a future market contract specifies the price at time t for delivery of 1 unit of y at time t+k. Surely this makes it clear that a forward contract is akin to the theoretical concept of a future contract). A forward contract is clearly a risk management contract for which it is not difficult to see why both sides of the market have a purpose. Similarly, a plain vanilla debt contract specifies the amount of cash (currency) the buyer of the contract pays at time t in exchange for an amount of cash (currency) to be delivered by the seller (issuer) of the contract at time t+k. (The difference in the two amounts can be expressed as an interest rate.) The structure is the same. Now, write down in this plain language (in the comfort of your privacy) what the contract of an option is and you’ll see the difference. Financial contracts are governed by one simple question: Who gets which amount when and under which conditions? Remove the many words and the wool can’t be pulled over people’s eyes. CDOs, rated by your beloved rating agencies as investment grades involve a lot of wool over people’s eyes. The actual contract is akin to saying I sell you something which I don’t know how to write down in your balance sheet but, believe me, it is as good as a debenture issued by BHP.

  33. Graeme Bird
    February 25th, 2010 at 17:13 | #33

    The literal answer to the question of what Greece should do, is to cut spending. Not slice of all old age pensions. Or trash every last dollar of defense spending. Not fail to repair roads. Or fail to have some persistent but patient, ongoing program of infrastructure spending. Not auction all the public goods, without a good plan for a subsequent non-cronyist industry.

    But rather Greece should line up all those departments that they may like and find helpful, but that they can do without, and just get rid of them. In other words Greece ought to do what we ought to be doing. They ought to be far more ruthless with spending. Not ruthless or cruel with aged welfare recipients. But with all that spending that you can get rid of and nobody is likely to die as a result.

    Once they are on a clear path to surpluses they can and must repudiate their bank and government debts. They will be doing everyone a favour if it brings down dysfunctional lending institutions when they do so.

  34. February 25th, 2010 at 17:55 | #34

    Ok – let’s look at a typical option contract. This is one that one of my clients took out.
    They are gold miners in WA. They calculated their likely gold production a number of years forward and looked at their likely costs to mine and process that gold. The total cost was, say $x at time t, $y at time t+1 and so on. The gold price at the time was $x + $400 or so.
    They decided to hedge their risks but did not want to unduly limit the potential upside, as they were (and, incidentally remain) very bullish on the future price of gold.
    They decided to take out put options on gold at a strike of $x + $100 for time t+1 and at $y+$100 for time T+1 and so on out to the limit of projections.
    As these contracts were deep out of the money they were very cheap.
    So, for those very cheap options, they effectively ensured (short, obviously of the collapse of the bank counterparty) that they will have a profitable business for years to come.
    I suggested that, to reduce the possible impact of the collapse of the bank that they could take out another forward contract (a CDS on the bank) to cover on the risk of the default of the bank, but that as this risk was minimal it was possibly not worth it.
    Was that a good illustration of how to use an option contract, Ernestine?
    .
    The ratings agencies are not “beloved” of me in the same way that academic texts seem to be for you. They are, as I have said many times, run by humans and subject to error (for whatever reason) just like anyone else.
    The CDOs were a waterfall instrument (and a forward contract – sorry to point that out again, but you still seem to think them as some kind of option) and everyone who looked at them seriously knew that (if you are unsure what a waterfall instrument is, please just ask and I would be happy to help, as usual). The fact that the ratings agencies evidently got the ratings wrong (and may have been collusive in the error with the issuers) does not change the fact that they were not options.
    There was no “wool” under these contracts, Ernestine – but there is plenty of woolly thinking about them.

  35. February 25th, 2010 at 17:56 | #35

    Oops – that should of course be “…a strike of $x + $100 for time t…”, not “…a strike of $x + $100 for time t+1…”.

  36. Alice
    February 25th, 2010 at 18:27 | #36

    @Andrew Reynolds
    Andrew..you said to Ernestine…
    “The ratings agencies are not “beloved” of me in the same way that academic texts seem to be for you.”

    Id call this comment for what it is…an attempt to compare the conduct of ratings agencies with those compiling academic texts.

    There is no comparison. They march to the beat of a different drum. One nobler than the other.

  37. February 25th, 2010 at 18:57 | #37

    Alice,
    Interesting to see your implied praise of nobility, but nobler or not, given the arguments advanced here and the economics textbooks I remember from many years ago I know which is more error-prone.

  38. TerjeP (say tay-a)
    February 25th, 2010 at 19:16 | #38

    Philips curve anybody?

  39. Alice
    February 25th, 2010 at 19:21 | #39

    @TerjeP (say tay-a)
    Dont you mean the Laffer stock curve Terjay?

  40. Ernestine Gross
    February 25th, 2010 at 19:27 | #40

    Andrew R. You are again taking this thread way off topic. But given what you wrote, I see a need to reply.

    Where or when did I say that a CDO is an option? I did not. I did say that a CDO is a derivative (but a forward contract is not) and I did say that a European call (or put) is the simplest example of a derivative.

    You are giving me a standard commerce textbook illustration of how to use a put option from the perspective of one accounting entity without giving me the conditions under which this is consistent with financial system stability. Your example looks like an over-the-counter option deal.

    As for financial stability, you are bringing water to JQ’s mill regarding the desirability of narrow banking when you reveal so nicely that banks are acting as speculators when they provide insurance for business risk (and in doing so they provide conditions to substitute debt for equity because the future net cash flow stream is nicely bounded and the corporation can buy back equity with money borrowed from, yes, a bank, just after share options have been issued to management – not manipulable at all, eh? Sorry, your words are ‘integrated’. There is more to economics than introductory micro, macro and accounting.)

    May I ask you to now stop this conversation because it is totally off topic.

  41. February 25th, 2010 at 20:31 | #41

    So – you want me to end it with the errors in the last comment uncorrected and giving the appearance that you were correct? You have little chance of that.
    For a start, you have not corrected yourself on (or attempted to give a workable definition of) what in fact a derivative is. A forward contract (even a plain vanilla forward) is, without question, a derivative in every single textbook or practical application of the word. If you seek to redefine derivative, please at least have the courtesy of providing (and perhaps justifying) that definition.
    Also as a point of fact CDOs does not meet some of the classic definitions that would classify it as a derivative – as what they represent is an entitlement to future cashflows, rather than being an instrument that derives its value from that of another instrument. Let’s be charitable, though, and agree that it is (keeping in mind, though, that there is that doubt).
    A European put (option) is not the simplest type of derivative, EG, but it is the simplest type of option-style derivative. The simplest type of derivative is (according to every definition I have ever seen) is a vanilla forward and, in the absence of another, non-standard definition of what a derivative is, it remains so.
    .
    If you wanted a description of how an option contract contributes to financial system stability, perhaps you could have indicated that is what you wanted.
    As I am always happy to help, I will do so.
    OK – this is not a difficult example, but it may take a few words.
    Bank A wants to lend some money to Country B, a country with a notoriously unstable history of repayment, but who is willing to pay high interest to compensate for that risk. Bank A has its primary operations in Country A, and its main currency risk is also there. It therefore knows that it really should have the currency component of the risk priced in currency A, rather than currency B.
    Bank A could take out a forward contract for the currency risk, but it knows that it may not get paid by Country B and so, if that happens, it would have a substantial open currency risk.
    The solution to this should be obvious – a vanilla currency put option would be an easy one (a swaption would be better, but let’s keep it simple) as the option allows them to not deliver if they do not receive the money from Country B.
    So, Bank A’s risk is reduced by the use of an option, where it may have actually been increased by the use of the forward contract.
    But, of course, the seller of the put option is getting a raw deal, huh? Not necessarily. They can put in place a call option with a person that is say, exporting from Country B to Country A at a slightly different strike price that results in very little exposure to them.
    Net result? Financial system risk has been reduced and, in the real economy trade is improved. Country B also get a credit line it may not have otherwise received.
    Good all round.

  42. Ernestine Gross
    February 25th, 2010 at 21:08 | #42

    Andrew R. I don’t have to correct myself, whether you like it or not. You still give examples of what is possible assuming that the financial system works. (Rest assured I know all this. Perhaps I should mention that I taught Finance subjects across all levels, including post-grad at the School of Banking and Finance, UNSW, for 8 years and I do live in the real world and therefore have access to publicly available information and I do still have contacts with some of my previous students who work in the finance industry. I hate to write this but it seems this is the only card I have left to stop this discussion. This discussion is at best tangentially relevant to the thread – ie background information.) The question of the conditions under which the financial system works, the way you require for your illustrations, and the stability of such a system requires different methods. I suggest you continue reading Prof. Quiggin’s threads. Every so often he has something on stability issues.

  43. February 25th, 2010 at 21:10 | #43

    EG,
    So you maintain that forward contracts are not derivatives, yet do not give a definition? Odd – at best.

  44. Graeme Bird
    February 26th, 2010 at 21:02 | #44

    “Bank A wants to lend some money to Country B, a country with a notoriously unstable history of repayment, but who is willing to pay high interest to compensate for that risk.”

    The loan ought not go ahead. Simple as that. This is an example of a bank destroying wealth. Governments who might rightly take a loan would be one whose budget, net of infrastructure spending, was strongly in surplus. But the infrastructure spending brings it into medium term deficit. Thats a good loan. Most loans to government are bad loans. Loans that would not be made were the banks authentically working under a free market, and unable to create new money.

    Wealth creation through debt, for the most part, is where loans are made with the clear and present danger of improving cash flow. At least cash flow after interest, perhaps not including principle repayments. If this is not what is going on most of the time this is wealth destruction. We’d be better off chartering a socialist bank if you guys are not capable of putting your house in order.

  45. Ernestine Gross
    February 26th, 2010 at 22:57 | #45

    @Graeme Bird

    Apologies for the late acknowledgement. I didn’t see your post @28 until now. Its so far up the thread now that it might be useful to copy an excerpt. You wrote:

    “I would have thought a more credible option would be to default on the debt and off balance sheet financing that was not made public (if indeed you are right). That would penalise the financiers that provided the funds that were provided in a less than transparent manner and show that the new government was determined to clear things up.”

    There is an article in yesterday’s Australian Financial Review reporting on talks in the US about the Goldman-Sachs Greek deal. This article provides further information on the inadequacy of the financial reporting system to the extent that information on the exact nature of the deal is still not public. There are also concerns about who knew about what when and who prevented disclosure to whom at the time of the AGI bailout. As a consequence of lack of adequate financial transactions information, it isn’t possible to work out the effects of any default, not even approximately. It is a right-royal mess.

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