NAKED SELF - INTEREST / THE ECONOMIST ( HIGHLY RECOMMENDED READING )

Buttonwood

Naked self-interest

Feb 18th 2010
From The Economist print edition

Politicians blame the speculators again


Illustration by S. Kambayashi

A LITTLE boy was arrested yesterday for saying that the European emperor had no clothes. “This kind of speculation only causes panic and should be stopped,” said a minister, who refused to comment on reports that the emperor was being treated for hypothermia.

Hans Christian Andersen’s tale is worth remembering as politicians apportion blame for sovereign-debt scares. Take suggestions that the market in sovereign credit-default swaps (CDSs) should be restricted. These instruments allow investors to hedge the risk that a country reneges on its debt and let others bet that such a default will happen.

Christine Lagarde, the French finance minister, has suggested that the “validity” of these contracts should be looked at. There are certainly some issues that need to be examined. To reduce risk to market participants, the contracts should be traded on an exchange or via a central counterparty. Investors should also ask whether it makes sense to insure against a default on Treasury bonds. If the American government defaults, which bank will still be good for the insurance claim?

But you suspect this is not what Ms Lagarde meant. She probably thinks that “speculators” are manipulating the prices of these swaps. In turn, the higher cost of default insurance pushes up the bond yields of European debt and makes the plight of weak governments even worse.

Are CDSs driving the market? Trading activity in European sovereign CDSs jumped to almost $60 billion in January, making it the most active month so far, according to Barclays Capital. But a rise in volumes is hardly surprising since the headlines have been dominated by sovereign risk. Turnover in government bonds rose as well. Barclays calculates that only in Portugal are CDS trading volumes bigger than 10% of cash-bond volumes. The bond and CDS markets tend to move together, rather than one moving the other. JPMorgan says net euro-zone bond issuance this year will be €425 billion ($580 billion); net CDS positions (removing offsetting contracts) are just €64 billion.

Politicians rarely concede that adverse market movements are driven by a rational assessment of the economic fundamentals. Harold Wilson, a British prime minister, used to blame the “gnomes of Zurich” for attacks on the pound. Nowadays the Spanish government mutters darkly about a conspiracy involving the “Anglo-Saxon media”. According to El Pais, its intelligence services are investigating the plot. Perhaps they have not read the bile being directed against British and American economic policy in the local press. But Buttonwood would say that, wouldn’t he? The editor of The Economist presides over leader meetings while stroking a white cat and dispatches dissident journalists, via a trapdoor, into a shark tank.

Go back a decade and speculators were much more helpful to the euro project. One of the biggest market bets in the late 1990s was the “convergence trade” under which investors bought the government bonds of habitually high-inflation European economies (Greece and Spain included) on the grounds that yields would fall to German levels once the euro zone was in full swing. Back then speculators were lowering the debt costs of many European nations, which seemed happy enough to accept their money.

In fact investors have been remarkably tolerant of fiscal deficits in recent years. The bond-market vigilantes who so intimidated the Clinton administration either were asleep or were overwhelmed by the actions of Asian central banks, which seemed prepared to buy some government bonds regardless of yields.

But the credit crunch has transferred debt from the private to the public sector and has made investors ponder whether all governments will be able to bear the burden. Understandably they have focused on the euro zone, where several countries have high primary deficits and debt-to-GDP ratios and no monetary room for manoeuvre. As Greece’s finance minister, George Papaconstantinou, remarked this week: “People think we are in a terrible mess. And we are.”

A counterpart to this focus on sovereign risk has been a decline in the euro against the dollar. This market movement has been welcomed by one euro-zone minister, who remarked that: “We have always said we want a strong dollar. The US dollar has appreciated in the last few days and European exporters can only be pleased about it.” A big cheer, then, for the speculators from the politician in question, one Christine Lagarde. When markets move the way governments want, the “validity” of trading is not an issue.

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