Commentary | The Great Greek Tragedy

Why the bond market culture needs to change

Like a Greek tragedy, the sovereign debt crisis in Greece captivates us with the downfall of the culpable tragic hero whose misbehaviour is disproportionately punished by the wrath of the Gods (the bond market). Yet, the deus-ex-machina of the European Union and International Mondetary Fund bailouts fail to elicit a moment of “catharsis” for most. To learn from this tragedy then, is to understand the circumstance surrounding Greece’s downfall and the unforgiving, sometimes irrational and arbitrary nature of the bond market.

A bond is like an IOU where the seller promises to pay the buyer back how much it owes plus interests. In the Greek case, both institutions and individuals bought bonds from the Greek government with the expectation that these bonds would be paid back with interest.

In this instance, Greece’s peril can be attributed to three fatal flaws that were aggravated by the bond market: its onerous government expenditure, weakness in tax collection, and an uncompetitive economy. For countries, as for individuals, loans will have to be taken out to make up the shortfall if expenditures exceed income. As government spending soared while tax revenues failed to keep up – due in part to widespread tax evasion – the Greek government had to increase its borrowing by issuing more bonds. Normally, this isn’t a cause for concern, as the private sector could pick up the slack. An increasing public debt dwarfed by an increase in national income of greater proportion isn’t worrisome. Unfortunately, Greece’s trade volume relative to intra-EU trade is miniscule and stagnant. Access to the EU’s common market did not stimulate Greece to restructure its economy to be competitive and exploit the free flow of goods, labour, and capital. What it offered Greece, though, was cheap credit – the interest rate demanded from Greece was, at one point, just slightly above Germany’s. With cheap credit also came little pressure to change the status quo.

But why were the Cassandras crying foul over the previously ignored situation? As it were a calibrated political agenda, entrenched in populist sentiments gave rise to the greatest Ponzi scheme ever devised. When credit stopped flowing in as a result of bondholders’ paranoia, panic took over and Greece was suddenly in danger of default.

True, Greece is culpable for its own demise. Yet, the arbitrary and irrational nature of the bond market is equally untenable. In assessing the solvency of a country, (i.e. whether it is able to repay its debt) bondholders are fixated with a risk statistic known as the debt to GDP ratio.  As Robert Shiller articulated it in “Debt and Delusion,” the fixation with the debt to GDP ratio is both arbitrary and irrational. Simple arithmetic tells us the debt to GDP ratio is merely a measurement in units of time. But why are we worried that a nation is not able to pay off all its debt within a year? Even banks do not expect any homeowners to pay off their mortgages in a year.

The sudden lack of bondholder confidence was comparable to a game of musical chairs, where one person changes their behaviour and everyone else panics.  Similarly, the sudden stop in Greek bond purchasing and panic selling of these bonds lowers their price falling, leading to a higher interest rate for the Greek government, creating a danger of the Greek government defaulting on its debt obligation. This threat of default forced Greece to accept loans from the IMF and the EU in exchange for austerity measures.

The austerity pill Greece is forced to swallow is in a “positive feedback” mechanism that does not do anyone good. Austerity measures depress the economy, which in turn jeopardised the growth prospect of Greece, which in turn made the bonds held by investors fall in value, which leads to the false confidence in austerity measures as a solution. What we’ve learned after the housing bust was foreclosures, which depressed house prices further, were actually much more costly than restructuring the mortgages of homeowners. The same lesson can be applied here, demanding pounds of flesh from Greece may be more costly than restructuring its debt (having matured bonds rolled over into new bonds, negotiating an extended maturity date etc.) Perhaps the interest of all stakeholders is better served through debt restructuring, after all the best solution is to let Greece get back on its feet again.

Keat Yang Koay is a U1 Joint Honours Economics and Finance student. You can reach him at keat.koay@mail.mcgill.ca.


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