Won't somebody PLEASE think of the speculators?

[Prateek_Sanjay]

A man whose articles I otherwise enjoy, Lord Robert Skidelsky, suddenly released a collection of old cliches:

http://www.project-syndicate.org/commentary/skidelsky40/English

LONDON – “Shorting” is a tactic well known among the financial cognoscenti. It means betting against an asset with borrowed money in the expectation of making a profit when its value goes down.

A speculator can “short” a government by borrowing its debt at its current price, in the hope of selling it later at a lower price and pocketing the difference. For example: on January 1, 2010, I think to myself that the game will soon be up for the Greeks. I borrow, at face value, €10 million of the Greek government’s 2016 bond, which is then trading at €0.91, from Goldman Sachs for six months. For this, I have to pay Goldman Sachs the yield that it would receive from the bond – around 5% annually at that price, so about 2.5%, or €250,000 – during the six-month term.

I immediately sell that bond in the market, for €0.91, so I get € 9.1 million (€0.91 x €10 million at face value). Fortunately, my bearish view comes to fruition in May, when the full extent of the country’s fiscal problems becomes clear. By June 30, when I am due to return the €10 million in face-value Greek 2016 bonds to Goldman Sachs, the bond is trading at only around €0.72. So I go into the market, buy €10 million at face value for at €0.72, or €7.2 million, and return the bond certificates to Goldman Sachs as per our agreement.

My profit for correctly taking this bearish view is therefore €1.65m – the €9.1m I got by selling the bonds when I borrowed them on January 1, minus the €7.2m that I had to pay to repurchase them on June 30, minus the €250,000 in interest that I had to pay Goldman Sachs for the six-month loan. Voilà – a successful “short” trade.

Of course, a single short seller cannot “make” the price of an asset (unless he is George Soros, whose famous bet against the British pound in 1992 made him a billionaire and forced Britain out of the European exchange-rate mechanism). But if a bunch of speculators decide (rightly or wrongly) that a government’s debt is overpriced, they can force down its price, thereby forcing up its yield (the interest rate that the government must pay).

If the attack persists, speculators can force a government to default on its debt, unless it can find a way to finance its borrowing more cheaply. The bailout fund created last year by the International Monetary Fund and the European Central Bank to enable Greece and other distressed sovereigns, like Ireland and now Portugal, does exactly that, but on the condition that they implement austerity programs to eliminate their deficits over a short period of time.

“Eliminating the deficit” means, quite simply, eliminating a lot of jobs, in both the public and private sectors, whose existence depends on the deficit. The economic and human costs of deficit reduction in a weak economy are appalling, and the targets won’t be met, either, because the spending cuts will erode the government’s revenue as aggregate demand falls.

So what is the role of elected politicians in the face of a speculative attack? Is it simply to accept the market’s will and impose the requisite pain on their people? This would be a reasonable conclusion if financial markets always, or even usually, priced assets correctly.

But they do no such thing. The financial collapse of 2007-2009 was the result of a massive mispricing of assets by private banks and ratings agencies. So why should we believe that the markets have been correctly pricing the risk of Greek, Irish, or Portuguese debt?

The truth is that these prices are “made” by herd behavior. John Maynard Keynes pointed out the reason many years ago: “the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made.” When you don’t know what to do, you do what the next person does.

This is not to deny that some governments have been living beyond their means, and that shorting their debt is how financial markets hold them accountable. But, in the last resort, it is voters, not markets, which hold governments to account. When these two accounting standards diverge, the popular standard must prevail if democracy is to survive.

The tension between democracy and finance is at the root of today’s rising discontent in Europe. Popular anger at budget cuts imposed at the behest of speculators and bankers has toppled leaders in Ireland and Portugal, and is forcing the Spanish prime minister into retirement.

Of course, there are other targets: Muslim immigrants, ethnic minorities, bankers’ bonuses, the European Commission, the ECB. Nationalist parties are gaining ground. In Finland, the anti-European True Finns party has shot up from nowhere to the brink of power.

So far, none of this has shaken democracy, but when enough people become vexed at several things simultaneously, one has the makings of a toxic political brew. Nationalism is the classic expression of thwarted democracy.

For politicians, the important thing is not to avoid taking hard decisions, but to do so of their own volition and at their own pace. When an elected government is under assault from the bond markets, it is essential for the political class to remain united.

It is natural for opposition politicians to want to exploit a government’s difficulties to win power. But a fiscal crisis calls for political self-restraint. Opposition parties should refrain from shorting their government politically at a time when markets are doing so financially.

Ideally, there should be a time-limited all-party agreement on a plan of action, which would represent the limit of what is politically feasible. Unfortunately, political disunity in the face of financial pressure always ends up being far more damaging to democracy and the economy than instinctive patriotism.

Look, if this were Stiglitz or some other partisan economist, I could understand. But this is an otherwise restrained person making these points, and I am reminded that even the most intelligent economists can be easily corrected by us unwashed laymen when politics determines their views.

1. Even George Soros can not drive the market. Soros is a billionaire. The bond market trades in trillions of dollars. Soros is a small fish. Soros lost big in Russia, despite political connections, and we are to think that his billions of dollars can make a dent in the market? Of course not!

2. Short trades are so risky, most traders don’t do it. It is dangerous to bet on an upside. It is even more dangerous to bet on the downside, especially since the long run trend of financial markets is always upwards. I know; I have traded derivatives myself. Acting like a shorting is a regular feature of the market ignores that such bets are made only when the trader is much more certain than normal, and even then he takes more risk than normal. That Greece bet was not nearly as clean as it is made out to be.

3. Speculators don’t force down prices. The speculators are only responding to a potential fall in prices. That is why they made the speculation in the first place. Speculators don’t force down prices on bonds that were going to up anyway, unless they want to clean their trading account down to zero. They are fish smaller than Soros, and even they can’t force the market.

4. The austerity condition is completely meaningless. If you read this post, you will die. If you do not read this post, you will die. Eventually, some day. Reading this post has absolutely no effect on you dying. No more than the bailout fund has on reduced increases in public spending. Guess what Greece was doing before the bailout fund was ever put in place? That’s right, it was proposing a smaller increase in public spending i.e. “austerity”. The bailout fund was not responsible.

5. The austerity condition is still completely meaningless. Why? The IMF has never ever implemented austerity. The IMF does not have the power to implement anything. It is not a government. When IMF was lending to Indonesia, Suharto did not implement a single condition asked of him. And he still kept receiving money. Russia too never implemented a single condition in the 1990s. And because it was politically profitable to keep throwing money to them, the other governments that comprise IMF never stopped lending to Russia or Indonesia.

6. If pricing was done by herd behaviour, nobody would profit. If everybody were shorting, the gain from shorting would disappear. This was not herd behaviour, this was somebody having better information than others. Other economists frequently deride financial markets for information assymetry, but economists now will also deride markets for herd behaviour. Well, which one is it?!

7. Does anybody really believe proposed changes in public spending in Greece or Portugal are causing racist, xenophobic parties to come up in Sweden or Finland? Really?

8. Popular anger at budget cuts is popular anger at a fiction. No government in this world can fix in advance how much money they can spend on any given activity, unless they freeze the prices of everything across the world and freeze the production level of everything. None of the budgeted allocations are ever precisely adhered. Budgets are just political drama, and any proposed budgetary measure is a symbolic change in a fictional future. These budgets were just for placating markets and testing what is politically feasible. Not a single one of the cuts need ever materialize.

9. Saying there is tension between democracy and finance is like saying there is tension between a car and its depleting gas tank. All governments run on capital. Including democratic governments. When capital runs out, there is no more government. As capitalist institutions, governments can only borrow capital at prices set by the market, purchase goods at prices set by the market, and sell goods at prices set by the market. They are only limited to what natural reality can provide. No amount of voting can somehow can increase the amount of funds available for the government.

I simply emphasise these points, because Skidelsky’s goal with this piece are political, not academic. The most basic textbooks on financial markets, written by people of all schools of thought, would only repeat these points. Perhaps so would a mostly nonpartisan person like Skidelsky. When it is politically unprofitable to repeat these points in more pervasive public media, economists do not.

[Smiling_Dave]

Nice post

[Prateek_Sanjay]

Thank you.

I don’t think I made a single novel point. Hell, I stuck to the fundamentals.

That’s what I wonder about, sometimes. Up there at the top, fundamentals don’t matter. They are back to repeating the standard talking points, made by journalists and angry people at bars.

[Frederique_Bastiao]

I don’t know why you’ve enjoyed other articles by him in the first place, he seems to be just another random economic illiterate parroting keynesianism.

And you’re right on your analysis, by the way.

[EmperorNero]

But if a bunch of speculators decide (rightly or wrongly) that a government’s debt is overpriced, they can force down its price, thereby forcing up its yield (the interest rate that the government must pay).

And we wouldn’t want that to happen, would we? Oh noes, then the government couldn’t get free money!

As I see it, shorting is just a method that keeps assets in the market priced correctly. Banning it might be one of the reasons why assets are overpriced and prone to busts.

[DanielMuffinburg]

@Lord Robert Skidelsky

LONDON – “Shorting” is a tactic well known among the financial cognoscenti. It means betting against an asset with borrowed money in the expectation of making a profit when its value goes down.

??? Short selling (then covering) is when you borrow a security, sell it, then buying it back. I’m not going to bother to read the rest of the article.

[Prateek_Sanjay]

@Frederique Bastiao

I don’t know why you’ve enjoyed other articles by him in the first place, he seems to be just another random economic illiterate parroting keynesianism.

And you’re right on your analysis, by the way.

Actually, I don’t see anything about Keynes that made him averse to speculation. I am not sure if Keynes was ever against speculation.

The way I see it, complaining about scheming speculators is just a desparate tactic of leaders of broken governments in Latin America, Africa, and Southern Europe. Most economists, of whatever school of thought, have had the good sense to refrain from agreeing with them. Most have done so, for the longest time. But after this crisis in Europe, I have started to see even intelligent economists turn against speculators, because it seems to be fashionable in such a time of crisis. Had we been in the pre-2007 period, I don’t think we would have seen them do the same.

Paul Krugman, on the other hand, is still smart enough to see blame games against speculators to be pure political posturing. He criticized many activist radicals for thinking that speculation is causing the 2009-2011 era food price inflation. And he is arguably one of the most partisan economists out there. So it makes less sense for a relatively less partisan person like Skidelsky to start blaming speculators.

But his intentions are clear enough near the end of the article. As a member of the political class, this House of Lords member does not want to see other members of his class fall apart during a crisis. Unite them against financial markets, a common enemy, and rally them under the slogan of democracy, and thus we have this article. Krugman, who is not a politician, would not feel as compelled to do the same.

[resist272727]

@Prateek Sanjay

@Frederique Bastiao

I don’t know why you’ve enjoyed other articles by him in the first place, he seems to be just another random economic illiterate parroting keynesianism.

And you’re right on your analysis, by the way.

Actually, I don’t see anything about Keynes that made him averse to speculation. I am not sure if Keynes was ever against speculation.

Keynes spoke against speculation in chapter twelve of The General Theory, saying people invested the same way they gambled. He said that this was dangerous when a bubble was created by “a whirlpool of speculation.” He wanted a government transfer tax and some sort of regulation to make people more dedicated to long-term investments. Because he was all about market stabilization.

[Prateek_Sanjay]

I just wanted to make a quick correction in this topic.

The man is NOT Lord Robert Skidelsky.

He is actually Baron Robert Skidelsky.

That is all.