Credit default swaps are harmless to all but those who sell them.

There is a meme going around that because some financial players own CDS on Greek debt and the prices on those swaps have increased, that the actual risk of default is now higher as a result of the price increases. See this article in the New York Times, which is dependably ignorant of and hostile towards markets:

Bets by some of the same banks that helped Greece shroud its mounting debts may actually now be pushing the nation closer to the brink of financial ruin.

Echoing the kind of trades that nearly toppled the American International Group, the increasingly popular insurance against the risk of a Greek default is making it harder for Athens to raise the money it needs to pay its bills, according to traders and money managers.

This is akin to saying that when the price of a weather derivative on say a cold Florida winter increases, the actual chance of frost on the orange trees is higher, simply because some traders have a vested interest in that outcome.

Actually, if anything, the availability of swaps on credit cheapens the cost of that credit, benefiting the borrower, since lenders are able to shift some or much of the risk to third parties. The fact that some buyers of CDS do not own the underlying bonds only serves to add liquidity to the market and even further reduce the cost of insurance.

I suspect that when players like Angela Merkel blame swaps for Greece’s situation, they are being disingenuous and simply trying to extort hedge funds and other players in the market and win points with the public. In the case of Greek politicians, it is a very convenient way to shift blame.

Some thoughts on government debt during deflation

A question of Keynes vs. Kondratieff

Until recently, the sovereign debt of nearly all governments would rally during panic episodes as stocks and commodities fell. This makes sense, as strong sovereign debt is cash for big boys, and investors are forced to reach further and further out for yield as short-rates are driven to zero or negative. However, starting with Greece, this pattern may change, as bonds are likely putting in a secular top in the 2008-2016 window. Their last bottom of course was the early 1980s, and their last top was 1946-47. The indebtedness and unabashed Keynesianism of all of the world’s governments seem to virtually guarantee higher interest rates in the coming years, even though US, German and Japanese bonds are still finding a bid during panics.

We have already seen the beginnings of this development in municipal bonds and the crappiest sovereign debt, but the market may slowly realize that it is all crap, beyond the short-term credit of the strongest governments.

Prechter makes the point in Conquer the Crash that higher rates on risky long-dated sovereign debt are part and parcel of deflation, an increased preference for the safest cash and cash alternatives. Steepening yield curves fit right into that trend. If the long bond sells off hard, this does not mean the end of the dollar, but the opposite. All else being equal, if T-bonds fell with stocks this year, it would just mean that the US government would finally feel the same pinch as everyone else.

Now for the tricky part. We have to keep in mind that interest rates are more than just a mechanical product of fiscal deficits, savings rates and politics. They are a kind of natural social phenomenon, a reflection of forces I can’t fully understand. They are not rational: why were short-term rates in the low single digits during the second world war when the US had just abandoned the gold standard, had a debt:GDP ratio of over 100% and inflation was running at 8-12%? Why were they still double-digit in the mid-1980s when the economy was good and inflation was 3-4%? (For some charts and discussion of the long-term rate cycle, see this post). The only answers that make any sense are that it was time for rates to bottom and then it was time for them to top.

We are certainly entering what *Kondratieff described as winter, when debts are called in and defaulted upon and cash is at a premium. This is associated with low interest rates, reflecting a low demand for credit, provided that the monetary unit retains value, which it tends to do since this unit is how debts are denominated and settled. And with deflation very much a reality, low rates can provide a high real yield so long as the credit is sound. With housing and wages falling by large percentages and every consumer good on sale, what is the real yield on a 10-year note priced at 3.6%?

There is no telling how long rates will stay low or how low they will go. See Japan, 1990-

Those are the market rates on the credit of a horribly indebted nation with terrible demographics that has been trying to spend its way out of recession for 20 years. Is there a better way to explain this than Kondratieff winter?

If social forces demand that governments start to shift towards frugality and default like the rest of society (and government is a reflection of social mood), this would be very supportive of the current fiat regimes. Think about it: what would happen to the Euro if Greece defaulted (which is what they should do)? Billions in euro-denominated balances would go “poof” and the remaining euros would be worth more.

What if younger generations of Americans, the ones who most enthusiastically support Ron Paul and even phonies like the new senator from Massachusetts, start to exert pressure for the rolling back of that $70+ trillion in retirement and health-care promises? Those are contracts that the government can’t honor, so by definition, it won’t. It will try to pretend otherwise, but it won’t. In effect, much of the debt will be repudiated.

There are huge caveats to the above, such as radical socialism or expanded warfare, but there are going to be real deflationary undertones to social mood that may effect policy and prolong the current paper regimes for longer than almost anyone suspects. Kondratieff winters are not short episodes, but generational, and if the last two turning points in the interest rate cycle are a guide, there could even be another ten years to the bottom.

That is hard to believe right now, but it is possible if social forces demand default. I can’t gauge the odds very well, but I have to consider this longer-term bull case for treasury bonds and a few strong currencies. Bottom line — history has not been kind to paper money and government bonds in times of crisis, but the nature of deflation may give them a longer life than we have assumed.

If you just can’t wait to short some sovereign debt, try Japan before America. They may be a generation ahead of the west in the rate cycle, and really, how much lower could they go?

*Kondratieff waves in the US (click image to expand):

[email protected], 1.23.09

One thing that strikes me in the above chart is how huge the latest wave is compared to the others. At 60 years and running, it is the longest, and prices, rates and stocks have gone up so much more than during any of the previous three. Just out of proportionality, it would be perfectly fitting if rates and prices fell for another 5-10 years.

Here’s a clearer view of the Aaa corporate bond rate from 1919 to 2010:


Also see Rothbard and then Mish on Kondratieff theory. As Rothbard makes clear, winter is not necessarily an awful time to be alive, judging from the strong economic growth of the 1830s-40s and 1880s-90s. This means that prolonged unemployment and war can’t be blamed merely on the credit cycle, but that fingers must be pointed at the socialists, Keynesians and fascists who’s actions directly brought about the nightmare of 1929-1945.

Default, Greece, default.

All government debt is a racket, and should be repudiated.


Widely read investment advisor John Mauldin favors the continued enslavement of the Greek public to corrupt politicians, greedy unions, and German banks. He had this to say today in his email publication:

…if Greece defaults it does not necessarily mean they have to leave the EU, any more than if Illinois defaulted they would have to leave the United States. Greece could still use the euro and life could go on. EXCEPT. The markets would no longer lend the Greek government money at anything close to a livable rate. Greece would be forced to balance its budget. Since they are part of the euro, devaluing the currency is not an option. The results of controlling their fiscal deficit would not initially be pretty and would almost insure a serious prolonged recession or depression in the Greek area, with fall out in the region. It would be a sad decade for Greece. But in the long run, it is a better option than default.

Further, and more important to the rest of Europe and the world, the results of a Greek default would be financial turmoil. 250 billion euros (and maybe 300!) of Greek debt is in international bond funds, pension and insurance companies, and above all at banks. Think German banks. Already undercapitalized banks. Also, think of all the investment banks who have been selling relatively cheap (given the apparent risk) credit default swaps on Greece, in an unregulated market, exposing their balance sheets. What should be a simple, if sad, matter for the Greeks, becomes a problem for the world, just as subprime debt in the US caused a world credit crisis. And the risk of contagion from Portugal, Spain, et al is serious. 2 trillion euros of debt could get downgraded by the bond market in very short order. It could be a replay of the last credit crisis, just with new actors as the prime problem.

Bailing out Greece without serious and credible deficit reductions by their government over the next few years would simply delay the problem, and it is not altogether clear the bond markets would go along for very long. At the end of the day, it may be the bond market which forces the Greek government and its people to take some very bitter medicine. Stay tuned. This is just the beginning of what will be a series of sovereign debt crises over the coming decade. It is important for the world that we get this one solved right, or the consequences will be quite severe.

I respectfully disagree with Mr. Mauldin. I believe that default would be the best outcome for the Greek people and the rest of Europe, as well as the financial system. It is ironic that Mauldin does not support this outcome himself, since he claims to be a fan of von Mises, Hayek and Rothbard, all of whom would be appalled at the prospect of perpetuating the racket in Athens. Rothbard specifically advocated the repudiation of government debt, since it serves only the interest of politicians and special interests at the great expense of the society at large:

In the famous words of the left-Keynesian apostle of “functional finance,” Professor Abba Lernr, there is nothing wrong with the public debt because “we owe it to ourselves.” In those days, at least, conservatives were astute enough to realize that it made an enormous amount of difference whether—slicing through the obfuscatory collective nouns—one is a member of the “we” (the burdened taxpayer) or of the “ourselves” (those living off the proceeds of taxation)…

If sanctity of contracts should rule in the world of private debt, shouldn’t they be equally as sacrosanct in public debt? Shouldn’t public debt be governed by the same principles as private? The answer is no, even though such an answer may shock the sensibilities of most people. The reason is that the two forms of debt-transaction are totally different. If I borrow money from a mortgage bank, I have made a contract to transfer my money to a creditor at a future date; in a deep sense, he is the true owner of the money at that point, and if I don’t pay I am robbing him of his just property. But when government borrows money, it does not pledge its own money; its own resources are not liable. Government commits not its own life, fortune, and sacred honor to repay the debt, but ours. This is a horse, and a transaction, of a very different color.

For unlike the rest of us, government sells no productive good or service and therefore earns nothing. It can only get money by looting our resources through taxes, or through the hidden tax of legalized counterfeiting known as “inflation.” …

The public debt transaction, then, is very different from private debt. Instead of a low-time preference creditor exchanging money for an IOU from a high-time preference debtor, the government now receives money from creditors, both parties realizing that the money will be paid back not out of the pockets or the hides of the politicians and bureaucrats, but out of the looted wallets and purses of the hapless taxpayers, the subjects of the state. The government gets the money by tax-coercion; and the public creditors, far from being innocents, know full well that their proceeds will come out of that selfsame coercion. In short, public creditors are willing to hand over money to the government now in order to receive a share of tax loot in the future. This is the opposite of a free market, or a genuinely voluntary transaction. Both parties are immorally contracting to participate in the violation of the property rights of citizens in the future. Both parties, therefore, are making agreements about other people’s property, and both deserve the back of our hand. The public credit transaction is not a genuine contract that need be considered sacrosanct, any more than robbers parceling out their shares of loot in advance should be treated as some sort of sanctified contract.

I highly recommend reading the whole Rothbard essay on, since the ideas therein have never been more timely for the US, among a great number of other countries.

It is almost always in citizens’ best interest for their government to repudiate the debt it has accumulated in their names. Politicians take out debt to spend more than is prudent or ethical, in order to buy votes, very often union votes. This is the case in Greece, where repeated strikes by teachers, dockworkers, farmers and others have been met with greater and greater pay and benefits. This system is a racket that rips off the silent majority of taxpayers.

Why should generations have their earnings stolen (make no mistake, taxation is theft, the involuntary taking of property under threat of force) to continue to support politicians, bankers and union thugs?

A default would indeed cripple the government’s ability to borrow, and would thereby end the racket. Politicians would no longer be able to offer something for what seemed like nothing: if they wanted to raise union pay, they would have to raise taxes at the same time, not at some future date beyond the next election.

Yes, a default would hurt bondholders. Duh. That’s perfectly just, since Greek (and Italian, Portugese, Spanish and Irish — GIPSI) bonds pay higher yields than those of Germany or Switzerland. These investors took a gamble, as did those who wrote default swaps on such debt. They deserve to lose money, and frankly, the astute buyers of default swaps deserve it more than they. Besides, as Rothbard makes clear, the creditors are a party to theft, guilty of receiving stolen goods.

I am tired of this nonsense that somehow banks and investors losing money means the end of the world. That is a fiction fed to a credible and ignorant public in order to justify the transfer of their assets to the most powerful banks. What is the end of the world?  War: the uniquely governmental institution of cities and industry bombed to rubble, crops burned, and whole generations enslaved, blown up, starved and displaced. A banking crisis? My god, that’s nothing, unless the government turns it into prolonged stagnation through theivery (and even worse if they take advantage of the resulting conditions to agitate for war). Factories, roads, bridges, and offices still stand; and human beings still have their lives, talents and freedom to use them. Assets change hands, that’s all. Nobody needs to starve, and unemployment only needs to be brief, unless of course the government prevents the defaults necessary to transfer assets to productive ownership by shifting the losses to the public. In that case, capital is wasted, assets stay idle and jobs disappear.

The Greek public should send a message to their politicians: “We won’t pay. Default away.” If unions can stike, why can’t taxpayers? The fact is, the debt is unpayable anyway, because the taxes necessary to service it would cripple what’s left of enterprise in that socialist economy. Just get it over with and don’t sign up for the lost decade(s) club.