JOIN USThe deflation-depressionary spiral is often talked about in contemporary macroeconomics textbooks. In this article, I am also talking about debt-deleveraging (Double-D).
Usually, the correct rule of thumb is that in a depression, policies that are the opposite of so-called serious hardheaded policies, based on common sense accounting principles, work best. This means that countries are not treated as households and cutting your coat according to your cloth is the worst solution. Indeed, this is precisely because the government has ownership of the sowing machine (printing presses) and can make as much cloth (money) as it likes.
Not so in Greece. In Greece, as I wrote in my last column in these pages, the sovereign government has surrendered its economic sovereignty to the European Central Bank (ECB), which seems set on following tight-money policies. In this scenario then, is Greece to be considered a household? And, if so, what economics are we to use?
Double-D macro seems out of the question as fiscal and monetary policy are effectively in the hands of the ECB and the European Commission. Therefore, I ask, what do households who get into too much debt – indeed, more debt than they can possibly pay back at current income levels – do?
This clearly seems like a zero-sum game. Either the household defaults entirely, or at best, the creditor takes a haircut and it’s business as usual. However, this is misleading. There is one other option that entirely turns the picture on its head. Convert debt to equity. Now, I know that households don’t have equity and neither do countries – only companies do. But the analogy to equity for a country, as Joseph Stiglitz has pointed out in The Guardian is GDP-linked bonds.
This would imply the same stakes as a debt-equity swap involved in the restructuring of a company, wherein the creditor gives up his debt for an equivalent portion of equity, the company (country) is then deleveraged and ready to grow again, and both sides now claim ownership of the mess that they both created and jointly try to grow their way out of the hole. Thus, a zero-sum game is converted overnight into (potentially) a one of those win-win situations that economics is, rightly, so famous for.
Even better, there will be the real possibility of a self-reinforcing bubble wherein individual investors know that the only way to truly profit from buying such bonds on the secondary market is for Greek to exceed expectations. This could also be highly profitable for creditors of Greece if there is, as I believe to be the case now, irrational pessimism over the possibility of a Greek recovery.
Debt-equity swap
This, I base on the fact that a majority of Greek debt comes due in the distant future (over a decade away), the fact that the near-term debt-GDP ratio is under 50 per cent and until the election of this Left-wing government, yields on government bonds were at 5.5 per cent. If this is the case, then one sign that a Greek recovery could well be on the way, even within the Eurozone, is if creditors agree to what is essentially a debt-equity swap that makes everyone winners rather than everyone losers.
This would also have the side benefit of increasing the pressure on the ECB to submit to truly inflationary policies because now it would be in the German banks’ interest for Greece to recover, for which a higher inflation rate is essential. And since Greek debt is denominated in Euros, this has the double benefit of reducing the real value of the debt.
Ah, you see the catch that I was trying to sweep under the carpet, you clever reader you. Of course! If Greece is even partially allowed to inflate its debt away, this represents an effective haircut on the lenders part – and this becomes a zero-sum game again, at least partially, you say. Well, this ignores the risk of default.
Sovereign Credit Default Swaps are currently pricing in 70 cent risk of Greek default. Right now, that risk is entirely borne by the creditors. If this plan is implemented, this would drastically reduce the risk of a Greek default and exit from the Euro. Therefore, assuming the banks have hedged against the risk of default, that entire expense goes away magically.
And, when the debt-GDP-linked-bond conversion happens, not only does the cost of hedging risk comes down for the creditors, they also get a stake in the upside as is the case with equity. Of course, there is bound to be disagreement on whether this plan could work.
The beauty of capitalism means that it allows loud-mouths such as myself to put their (imaginary) money where their mouth is. Therefore, upon the announcement of this radical plan, quite well discussed as of now in the open and in the dark netherworld of the internet, I would bet on CDS rates coming down, Greece recovering and I would buy the Greek stock market index on the assumption that there exists irrational pessimism. Let’s wait and see whether my imaginary money multiplies.