SPINNING ECONOMIC DATA

CLICK ON : http://www.etfdigest.com/

Chile's earthquake

In need of repair

Mar 1st 2010 SANTIAGO
From Economist.com

Chile counts the cost of a devastating earthquake and makes plans for recovery


RELIEF was the initial reaction in Chile to what seemed relatively limited damage given the scale of the earthquake that shook the centre and south of the country in the early hours of Saturday February 27th. That picture has been replaced gradually by dismay as the full extent of the cost begins to emerge. By Sunday evening, the number of confirmed deaths had reached over 700 and is still likely to rise, according to President Michelle Bachelet. This is still a low toll, however, for a quake of 8.8magnitude, one of the largest in the world since 1900.

Felt throughout almost all the country, the quake hit most strongly in six central regions, from the capital, Santiago, and the nearby port of Valparaiso in central Chile to the city of Temuco in the Araucanía region of the south. These parts of the country are home to about 60% of Chile's 17m inhabitants and account for around 70% its GDP. An estimated 1.5m homes are thought to have been damaged and around a third may have to be demolished.

The greatest damage and loss of life, however, appears to have been caused not by the earthquake itself but by a subsequent tidal wave that washed over fishing towns on the coast of south-central Chile. In one such town, Constitución, rescue workers found over 300 bodies on Sunday. Much of the only town in the Juan Fernández archipelago in the Pacific Ocean, which belongs to Chile and is best-known as the place where Robinson Crusoe was marooned, was also destroyed.

Chile has developed an efficient disaster-response system to cope with what Ms Bachelet has described as “a history plagued with natural disasters”. However, looters, particularly in the southern city of Concepción and other nearby towns, have dented the image of a country swinging into action to relieve its suffering people. Though some looters may have merely been in search of scarce food and water others were out for what they could take. As a result, on Sunday, the government imposed a curfew in some of the worst-affected areas.

The earthquake struck just as the Chilean economy was beginning to recover after an estimated contraction of 0.9% in 2009. The after-effects will hamper the exports that drive the country's growth. Copper, Chile's biggest earner abroad, is produced mainly in the north of the country which was unscathed. But damage to ports further south may hamper shipments of forestry products, including wood pulp, while exports of fruit, now at the height of the harvest season in the southern hemisphere, will face delays as a result of damage to the main roads of central Chile.

Despite the earthquake’s likely impact on growth in the first and, possibly, the second quarter, it may actually provide a boost for the economy in the medium term as the government spends heavily to repair the damage. This is welcome news for the country’s president-elect, Sebastián Piñera, who is set to take office on March 11th and was voted in on an ambitious promise of average economic growth of 6% annually over his four-year term.

Until assessment of the damage is complete, it is hard to estimate the cost of reconstruction. Eqecat, an American catastrophe-management company, has suggested that it could total as much as $30 billion, equivalent to 20% of Chile’s GDP in 2009. Part of the cost can readily be financed out of the public purse, drawing on savings accumulated while copper price boomed between 2005 and 2008.

However, Mr Piñera, who has indentified increased private investment as one of the most important components of higher growth, has indicated that the government will not do all the work. He expects Chilean companies to play an important role in the reconstruction through a “Lift Chile” plan, which he outlined on Sunday. This may well include a revival of a public-works-concession scheme that Chile successfully launched in the mid-1990s precisely to build many of the motorways that were damaged by Saturday’s earthquake.

Copyright © 2010 The Economist Newspaper and The Economist Group. All rights reserved.

US and UK can handle decades of debt

By Andrew Scott

Published: February 28 2010 20:00

One way the financial crisis of 2007-08 will have a lasting impact on the economy is that government debt will remain high for decades. Short-term forecasts suggest UK gross government debt will double from 47 per cent of gross domestic product in 2007 to 94 per cent by 2011, while US debt will rise from 62 per cent to 96 per cent. The rapidity of this increase, the high levels of debt and the fact that fiscal deficits in the UK and US are expected to still be around 13 per cent and 10 per cent of GDP respectively in 2011 have led to financial and political pressure for urgent fiscal adjustment. High debt is seen as a serious problem – as Adam Smith warned more than two centuries ago: “The practice of funding has gradually enfeebled any state which has adopted it”.

The difficulty with this alarmist view is that economics does not tell us what is a “high” level of debt. Without such knowledge, it is impossible to say that debt is too high or to announce that debt reduction should be an urgent short-term priority. It is true that such huge increases in government debt reflect serious economic problems. But, given the enormous financial shock the economy has experienced, we may be better off with high debt for a long period of time. In fact, although economics is quiet on the issue of what it means for debt to be too high it does tell us that in the face of large temporary shocks the optimal response is for debt to show large and long-lasting swings. Debt should act as a buffer to help the government respond to shocks.

The logic is simple. The UK and US governments have the ability to borrow long term and the option to roll over their borrowing. Rather than abruptly raising taxation and cutting government expenditure, they should adjust fiscal policy over the long term. Fiscal adjustment in the short run is not enough to produce a surplus, so debt must rise for a significant period. The required increase in debt may appear unsustainable for years. But, in the very long term, fiscal adjustment brings down the level of debt.

The potential magnitude and duration of these increases in debt can be substantial. Markets have financed much larger levels of debt than are predicted for the UK and US. The largest increases are related to war but, as Japan’s recent experience shows, this is not always the case. In the UK, between 1918 and 1932, debt increased from 121 per cent of gross national product to 191 per cent – it was not until 1960 that debt returned to its 1918 level.

If adjustment occurs over the long run, how is this achieved? The good news from studying the Group of Seven leading industrialised countries over the period 1965-2008 is that very little seems to be done through inflation. Measures of debt, deficit or general fiscal imbalances have no role to play in forecasting inflation at any horizon. The adjustment instead comes from changes in the primary deficit (the deficit excluding interest payments). In Italy, between 1972 and 1997, the average total deficit was 9.6 per cent of GDP and was never below 6 per cent. During this period, the primary deficit fell from a high of 8.6 per cent in 1975 to 3.3 per cent by 1989 and to a surplus of 5.4 per cent in 1997. In other words, adjustment is through the primary balance and over a very long time. In the interwar period the UK only ran a total surplus in five years and even then it was small. However, every year between 1920 and 1938 saw a primary surplus that helped check the rise in debt and achieve longer-term solvency.

Governments should, of course, look at long-term fiscal solvency and articulate clearly how they intend to achieve debt stability. However, forcing governments to achieve specific numerical targets by certain calendar dates is a mistake. If further shocks occur or the crisis continues it will be necessary to revise these targets. Debt is the means by which governments accommodate shocks – changing policy to meet previously fixed fiscal targets puts the cart before the horse. Too much current debate takes the form of asserting that fiscal discipline is a good thing. Of course it is. But what markets, credit-rating agencies and deficit hawks need to engage in is a realistic debate that recognises that government debt will and should remain at its elevated level for a very long time and the required adjustment is for the long haul. Fiscal discipline and solvency is not inconsistent with decades-long shifts in debt.

Smith may have warned that debt can enfeeble a nation but he also remarked in 1776 that “Great Britain seems to support with ease a debt burden which, half a century ago, nobody believed her capable of supporting”. Debt rose even further in the decades after. Markets and governments in the UK and US have proven before that they can maintain very high levels of debt and should be open to the possibility that they can once again.

The writer is a professor of economics at London Business School

Copyright The Financial Times Limited 2010.

February 27, 2010

Your Money

Preparing for the Inevitable Bursting Bubble

By RON LIEBER

Financial bubbles are a way of life now. They can upend your industry, send your portfolio into spasms and leave you with whiplash. And then, once you’ve recovered, the next one will hit.

Or so you might think, as a veteran of two gut-wrenching market declines and a housing bubble over the last decade.

There’s plenty of reason to expect more surprises, given the number of hedge funds moving large amounts of money quickly around the world and the big banks making their own trades.

Individuals, as always, may be tempted to make their own financial bets, too. Last time, they bought overpriced homes with too much borrowed money. Next time, who knows what the bubble will be? And that’s the problem, as it always is. How do you identify the next thing that will pop? Is it China? Or Greece? Or Treasury bonds? It is difficult to predict and make the right defensive (or offensive) moves at the correct moment to save or make money.

Still, if you want to better insulate yourself from bubbles — however often they may inflate — there are plenty of things you can do. Your debt levels matter, and you may want to consider a more flexible investment strategy. But perhaps most important, this is a mental exercise that begins and ends with an honest assessment of your long-term goals and how you handle the emotional jolts that come from the bubbles that burst along the way.

FIXED EXPENSES


Start with the basics. The less you have to pay toward monthly obligations, the better off you are, and that’s especially true at a time of economic disruption. You certainly wouldn’t want any bills increasing, so now’s a good time to refinance to a fixed-rate mortgage.
Whittle down student loan and credit card debt, too, and pay cash for your car if possible. “Flexibility is priceless in a time of panic,” said Lucas Hail, a financial planner with Foster & Motley in Cincinnati.

SELF-RELIANCE


Then take a hard look at how much you should rely on promises from the government. Social Security and Medicare may not fit the traditional definition of bubbles, but that hasn’t stopped Rick Brooks from advising his financial planning clients to expect less from both programs. “Something that is not sustainable will not continue. It just can’t,” he said of Medicare.

Mr. Brooks, the vice president for investment management with Blankinship & Foster in Solana Beach, Calif., said anyone under 50 should assume that Medicare will look nothing like it does now and examine private health insurance premiums for guidance as to what may need to be spent on health care in retirement. Meanwhile, the firm advises current retirees to assume a 20 percent cut in Social Security benefits at some point.

Bedda D’Angelo, president of Fiduciary Solutions in Durham, N.C., has an equally stark outlook on long-term employment risk. If there are two adults in the household, your goal should probably be to have two incomes instead of one. “I do believe that unemployment is inevitable,” she said, adding that people who think they are going to retire at 65 should save for retirement as if they will be forced out of the work force in their mid-50s.

PORTFOLIO TACTICS


Perhaps you did what you thought you were supposed to during the last decade. You got religion and stopped trading stocks. Then, you split your assets among various low-cost mutual funds and added money regularly. And the results weren’t quite what you hoped.

Tempted to make big bets on emerging markets or short Treasury bills? You’ve landed in the middle of the debate between those who favor a more passive asset allocation and those who prefer something called tactical allocation.

The first camp sets up a practical mix of investments, according to a target level of risk, and then readjusts back to that mix every year or so.

They frown on the hubris of the tactical practitioners. To make a tactical approach work, they note, you need to know what the right signals will be to buy and sell everything from stocks to gold, during every future market cycle. Then, these tacticians need to have the discipline to act each and every time. This is extraordinarily hard.

The tacticians, however, believe they have no choice. “What consumers need to know is that no matter how comforting it is to believe a formulaic approach or prepackaged investment product will allow them to put their financial future on autopilot, our current and future financial environment will require advice, diligence, education and responsiveness, which takes into account strategic consideration of geopolitical and economic relationships,” as Ryan Darwish, a financial planner in Eugene, Ore., put it to me this week.

Mr. Darwish scoffed at the notion of mere bubbles and said he thought that more fundamental and far-reaching shifts were under way, like the transfer of economic power from the United States to China and other nations.

A growing number of financial planners are embracing a middle, more measured approach: If diversification across stocks, bonds and other asset classes has proved to be a good thing in most investing environments, why not diversification around investment approaches?

“I am not a financial genius, but the geniuses are even worse off because they’re anchored on one philosophy,” said David O’Brien, a financial planner in Midlothian, Va. So he and a growing number of his peers have added some strategies to their baseline portfolios aimed at losing less during bubbles while still gaining in better times. “We’re not trying to shoot for the moon,” he added.

These tactics can include managed futures, absolute return funds, merger arbitrage and other approaches that will get their own column someday.

The embrace of all this even led one investment professional I spoke with this week to express the ultimate sacrilege: It really is different this time.

Thomas C. Meyer of Meyer Capital Group in Marlton, N.J., noted that many of these alternative strategies were not even available in mutual-fund form three to four years ago. So that’s different. He’s now putting 30 percent of his clients’ equity portfolios into such investments.

The big change, however, is that the baby boomer money is getting older. People are further along in their careers than they were during the market crash in 1987, and they can’t rely on pensions as so many more near retirees could in the 1980s (while shrugging off stock market volatility). And the boomers don’t have as much time to make up lost ground, especially if they’re already retired.

“Losing less means a lot right now,” Mr. Meyer said. “So we want to suck volatility out where we can.”

MATTER OF THE MIND


But can you live with less volatility — and the permanent end of occasional portfoliowide returns in the teens or higher? Markets run on greed and fear; bubbles expand and deflate thanks to outsize versions of each. One of the few things you can predict about bubbles is that they will test your conviction on where you sit along the fear-greed continuum.

And once they pop, you’ll know a bit more about how your mind works than you did before.

This last downturn was severe enough that about 10 percent of Steven A. Weydert’s clients realized that they had overestimated their own risk tolerance. “Ideally, with an asset allocation, you never want to look back and say you’re sorry,” said Mr. Weydert of Bowyer, Weydert Wealth Planning Partners in Park Ridge, Ill.

So rather than trying to predict the number and type of bubbles, it may make more sense to look inward when trying to predict the future. Bob Goldman, a financial planner in Sausalito, Calif., said that clients often looked at him blankly when he asked them what it was they imagined for themselves in the future. Sometimes, they need to go home and figure out what sort of life it is that they’re saving for — and how much (or little) it might cost.

“People come in and talk about how we all know that inflation is going to explode next year,” Mr. Goldman said. “Well, we don’t all know that. We don’t know anything. But we can know something about our own lives, and there is a person we can talk to about that. A person in the mirror.”

Copyright 2010 The New York Times Company

Do not even think about bombing Iran

By Michael O’Hanlon and Bruce Riedel

Published: February 28 2010 19:58

For years, the US has retained the option of a military strike against Iran’s nuclear facilities. Not preferred by either George W. Bush or Barack Obama, it has nonetheless survived the US presidential transition as a last resort should diplomacy and economic sanctions fail to persuade Tehran to put its nuclear programme back under proper restrictions and inspections. As an option, however, it should not become a self-fulfilling prophecy. We need instead to develop a long-term strategy for dealing with a nuclear Iran and not box ourselves into war.

The threat of a military strike is seen as increasing American leverage. In this view, not only does it supposedly intimidate Iran, but it also helps Washington and like-minded western nations persuade other countries to tighten and enforce official sanctions. The US can argue that sanctions are preferred to military force, but that they will only work if all co-operate.

The strike option, however, lacks credibility. America is engaged in two massive and unpopular military campaigns in the region. Given Iran’s ability to retaliate against the US in Iraq and Afghanistan, it is simply not credible that we would use force in the foreseeable future. Tehran, Moscow and Beijing know this.

There is also a technical reality: even a massive strike would not slow Iran’s progress towards a bomb for long. We cannot be sure we know where all existing Iranian facilities to enrich uranium are located – as the revelation of yet another previously unknown site near Qom last year reminded us. Even if we did strike most or all existing facilities, Iran can rebuild fairly fast and would surely expel inspectors and burrow further underground when building its next facilities. It would be even harder to find, and strike, those assets.

If there were any real chance of major political reform in Iran within a couple of years, buying that much time might be worth the cost. But the unrest in Iran since last year’s stolen election is not likely to bring about regime change, given the regime’s control of the military. Nor is a strike by an outside power likely to help the cause of Iranian reformists.

Generally, those who argue against a military strike stop 10 yards short of the finish line. After concluding that a strike would not make sense, they still tend to tolerate leaving it as a last resort. There are dangers to such an approach. Mr Obama may some day come under pressure to employ it when all else has failed – and we think this would be a mistake, not only for the specific matter of Iran policy but more broadly for his effort to recast the US as a country playing by international legal norms.

In addition, keeping the option of force requires US diplomats and military officials to take preparatory steps that may distract from our current efforts in Iraq and Afghanistan, and complicate a number of regional bilateral alliances. Some states in the Middle East, such as Saudi Arabia and the United Arab Emirates, are generally worried about Iran. But few are anxious to support moves towards war. We will be better positioned for a sustained tightening of regional alliances if we remain resolute yet fundamentally defensive in our orientation and strategy.

There is a better way: sanctions, deterrence and containment. To be sure, another nuclear-armed state in the Middle East, especially one touting the extremist views of the current Iranian regime, would be bad for regional security. But Iran would be suicidal to attack a US ally in the region – especially one such as Israel, which has a formidable nuclear arsenal by all accounts. Iran has already proved its willingness to wage proxy and terror wars against the US and Israel. It is doubtful that a small nuclear arsenal would offer it many more options than it has already.

We should structure a sanctions regime so that it could evolve into containment of a nuclear-armed Iran, focusing on high-technology goods and weapons transfers. We should also pledge to provide a nuclear umbrella over Israel and other threatened states. In other words, we would use the techniques of containing the Soviet Union and communist China from the cold war to handle this newer, serious yet smaller, threat. It is not a great option. But it is much better than war.

The writers are senior fellows at Brookings. Michael O’Hanlon is co-author of the new book ‘Toughing It Out in Afghanistan’, and Bruce Riedel is author of ‘The Search for al Qaeda‘

Copyright The Financial Times Limited 2010.

Emerging market rate risk unnerves investors

By David Oakley in London

Published: February 28 2010 18:55

Investors are pricing in big interest rate rises in emerging market economies this year, sparking fears of a stock market sell-off and prompting worries over the global recovery, which has been driven by the developing world.

With the withdrawal of cheap central bank money in the industrialised world coupled with the increasing tensions in the eurozone because of the Greek debt crisis, sharp rate rises in emerging markets could deliver a further blow to the growth outlook.

(TO ENLARGE CLICK ON : http://www.ft.com/cms/dc095c1e-249a-11df-8be0-00144feab49a.JPG)


Investors are concerned that emerging market central banks might be forced to tighten monetary policy quickly to keep a lid on the build-up of inflationary pressures.
“Although central banks are right to introduce policies to restrain inflation, they must not tighten too far, too fast,” says Nigel Rendell, senior emerging market strategist at RBC Capital Markets.

Significant rate increases are being forecast in Brazil, Turkey, Mexico and India. Brazilian forward markets are pricing in a 256 basis point rate increase to 11.50 per cent by the end of the year.

Turkish markets, meanwhile, are pricing in a 186bp rise to 9.05 per cent and Indian markets a 119bp increase to 4.66 per cent. Mexican markets are currently pricing in a 115bp rise to 5.81 per cent by the year-end.

In China, bank lending rates are not expected to rise sharply. But Beijing is restraining its economy by raising capital reserve requirements for commercial banks.

The renminbi is also expected to appreciate as much as 5 per cent against the dollar by the end of the year, slowing export growth.

A sharp tightening of monetary policy is normally seen as being bad news for equity investors as it takes the steam out of stocks.

Emerging market equities have rallied strongly in the past year, sharply outperforming the developed world, so many investors expect a correction.

Emerging market bond markets, which have seen spreads against US Treasuries tighten dramatically, could also suffer a pull-back.

However, fears that aggressive tightening could jeopardise the global recovery may be overdone, particularly as China is still forecast to grow by 10 per cent this year.

The expected monetary tightening should also boost Asian emerging market currencies.

This could in turn help the world economy as it makes US and European exports more competitive, boosting growth in the industrialised world.

Gary Jenkins, head of fixed income research at Evolution, says the emerging markets are pricing in big interest rate rises, bigger than many analysts expect.

But he adds: “The key point is that this is a return to more normal interest rate levels. We should not worry too much over aggressive tightening.”


Copyright The Financial Times Limited 2010.

March 1, 2010

Op-Ed Columnist

Financial Reform Endgame

By PAUL KRUGMAN

So here’s the situation. We’ve been through the second-worst financial crisis in the history of the world, and we’ve barely begun to recover: 29 million Americans either can’t find jobs or can’t find full-time work. Yet all momentum for serious banking reform has been lost. The question now seems to be whether we’ll get a watered-down bill or no bill at all. And I hate to say this, but the second option is starting to look preferable.

The problem, not too surprisingly, lies in the Senate, and mainly, though not entirely, with Republicans. The House has already passed a fairly strong reform bill, more or less along the lines proposed by the Obama administration, and the Senate could probably do the same if it operated on the principle of majority rule. But it doesn’t — and when you combine near-universal Republican opposition to serious reform with the wavering of some Democrats, prospects look bleak.

How did we get to this point? And should reform advocates accept the compromises that might yet produce some kind of bill?

Many opponents of the House version of banking reform present their position as one of principle. House Republicans, offering their alternative proposal, claimed that they would end banking excesses by introducing “market discipline” — basically, by promising not to rescue banks in the future.

But that’s a fantasy. For one thing, governments always, when push comes to shove, end up rescuing key financial institutions in a crisis. And more broadly, relying on the magic of the market to keep banks safe has always been a path to disaster. Even Adam Smith knew that: he may have been the father of free-market economics, but he argued that bank regulation was as necessary as fire codes on urban buildings, and called for a ban on high-risk, high-interest lending, the 18th-century version of subprime. And the lesson has been confirmed again and again, from the Panic of 1873 to Iceland today.

I suspect that even Republicans, in their hearts, understand the need for real reform. But their strategy of opposing anything the Obama administration proposes, coupled with the lure of financial-industry dollars — back in December top Republican leaders huddled with bank lobbyists to coordinate their campaigns against reform — has trumped all other considerations.

That said, some Republicans might, just possibly, be persuaded to sign on to a much-weakened version of reform — in particular, one that eliminates a key plank of the Obama administration’s proposals, the creation of a strong, independent agency protecting consumers. Should Democrats accept such a watered-down reform?

I say no.

There are times when even a highly imperfect reform is much better than nothing; this is very much the case for health care. But financial reform is different. An imperfect health care bill can be revised in the light of experience, and if Democrats pass the current plan there will be steady pressure to make it better. A weak financial reform, by contrast, wouldn’t be tested until the next big crisis. All it would do is create a false sense of security and a fig leaf for politicians opposed to any serious action — then fail in the clinch.

Better, then, to take a stand, and put the enemies of reform on the spot. And by all means let’s highlight the dispute over a proposed Consumer Financial Protection Agency.

There’s no question that consumers need much better protection. The late Edward Gramlich — a Federal Reserve official who tried in vain to get Alan Greenspan to act against predatory lending — summarized the case perfectly back in 2007: “Why are the most risky loan products sold to the least sophisticated borrowers? The question answers itself — the least sophisticated borrowers are probably duped into taking these products.”

Is it important that this protection be provided by an independent agency? It must be, or lobbyists wouldn’t be campaigning so hard to prevent that agency’s creation.

And it’s not hard to see why. Some have argued that the job of protecting consumers can and should be done either by the Fed or — as in one compromise that at this point seems unlikely — by a unit within the Treasury Department. But remember, not that long ago Mr. Greenspan was Fed chairman and John Snow was Treasury secretary. Case closed. The only way consumers will be protected under future antiregulation administrations — and believe me, given the power of the financial lobby, there will be such administrations — is if there’s an agency whose whole reason for being is to police bank abuses.

In summary, then, it’s time to draw a line in the sand. No reform, coupled with a campaign to name and shame the people responsible, is better than a cosmetic reform that just covers up failure to act.

Copyright 2010 The New York Times Company

Time to outlaw naked credit default swaps

By Wolfgang Münchau

Published: February 28 2010 20:22

I generally do not like to propose bans. But I cannot understand why we are still allowing the trade in credit default swaps without ownership of the underlying securities. Especially in the eurozone, currently subject to a series of speculative attacks, a generalised ban on so-called naked CDSs should be a no-brainer.

Naked CDSs are the instrument of choice for those who take large bets against European governments, most recently in Greece. Ben Bernanke, the chairman of the Federal Reserve, said last week that the Fed was investigating “a number of questions relating to Goldman Sachs and other companies in their derivatives arrangements with Greece”. Using CDSs to destabilise a government was “counter-productive”, he said. Unfortunately, it is legal.

CDSs are over-the-counter contracts negotiated by two parties. They offer the buyer insurance on a bundle of underlying securities. A typical bundle would be €10m worth of Greek government bonds. To insure against default, the buyer of a CDS pays the seller a premium, whose value is denoted in basis points. Last Thursday, a CDS contract on five-year Greek bonds was quoted at 394 basis points. This means that it costs the buyer €394,000 per year, for five years, to insure against default. If Greece defaults, the buyer gets €10m, or some equivalent. What constitutes default is subject to a complicated legal definition.

A naked CDS purchase means that you take out insurance on bonds without actually owning them. It is a purely speculative gamble. There is not one social or economic benefit. Even hardened speculators agree on this point. Especially because naked CDSs constitute a large part of all CDS transactions, the case for banning them is about as a strong as that for banning bank robberies.

Economically, CDSs are insurance for the simple reason that they insure the buyer against the default of an underlying security. A universally accepted aspect of insurance regulation is that you can only insure what you actually own. Insurance is not meant as a gamble, but an instrument to allow the buyer to reduce incalculable risks. Not even the most libertarian extremist would accept that you could take out insurance on your neighbour’s house or the life of your boss.

Technically, CDS are not classified as insurance but as swaps, because they involve an exchange of cash flows. The CDS lobby makes much of those technical characteristics in its defence of the status quo. But this is misleading. Even a traditional insurance contract can be viewed as a swap, as it involves an exchange of cash flows. But nobody in their right mind would use the swap-like characteristics of an insurance contract as an excuse not to regulate the insurance industry. The fact that, unlike insurance, CDSs are tradeable contracts does not change the fundamental economic rationale.
The whole idea of modern financial products is to replicate the payment streams of other, more traditional instruments, while offering better conditions. Selling a CDS is like buying a bond. Buying a CDS is a way of shorting a bond – or of insuring against its default. But that does not change the fact that once you strip away the complex technical machinery, you end up with a product that offers insurance – even though it is a lot more versatile than a standard insurance contract.

Another argument I have heard from a lobbyist is that naked CDSs allow investors to hedge more effectively. This is like saying that a bank robbery brings benefits to the robber. A further stated objection to a ban is that it would be difficult to police. There is no question that a ban of a complex product, such as a CDS, involves technical complexities that commentators like myself probably underestimate. It is conceivable, for example, that the industry might quickly find a legal way round such a ban. Then again, we would not consider legalising bank robberies on the grounds that it is difficult to catch the robber.

So why are we so cautious? From conversations with regulators and law-makers, I suspect they are not always familiar with those products, to put it kindly, and that they may be afraid of regulating something they do not understand. They understand, or think they do, what a hedge fund is. Restricting hedge funds is something they can sell to their electorates. Hedge funds were not at the centre of the crisis, but they are a politically expedient target. Banning products with ugly acronyms that nobody understands seems like unnecessarily hard work.
I do not want to exaggerate the case for a ban. This speculation is neither the underlying cause of the global financial crisis, nor of the eurozone’s underlying economic tensions. But naked CDSs have played an important and direct role in destabilising the financial system. They still do. And banks, whose shareholders and employees have benefited from public rescue programmes, are now using CDSs to speculate against governments.

Where is the political response? The Germans want to bring it to the Group of 20, but they hesitate to do anything unilaterally. Christine Lagarde, the French finance minister, was recently quoted as saying: “What we are going to take away from this crisis is certainly a second look at the validity, solidity of sovereign [credit default swaps].”

A second look? I wonder what they saw when they looked the first time.

Copyright The Financial Times Limited 2010.