Knowing and Making

Martin Wolf has described  the eurozone rescue package for Greece, correctly, as "a fudge". However, he thinks this is a bad  thing. Here's why it might not be. One of the key goals in designing a rescue package is to avoid creating moral hazard  - the risk that other countries look at the bailout, assume that they will be rescued too and therefore continue to borrow. If the rules for the bailout are clearly stated, that creates an anchor  which encourages people to trade up to it. The most obvious example is the Maastricht treaty rule which stated that countries in the EU must keep their fiscal deficit below 3% of GDP. Guess what size of deficit most countries ended up with? Around 2.9% was a pretty common figure. So if the rules for the rescue were made explicit, it would give governments very clear guidance on exactly what risks they could take. Inevitably, some would be tempted to push it to the limit - and fall over that limit, in the knowledge that the ...

I heard an astonishing fact yesterday at the LJDM seminar . Or is it a fact? I'd be grateful for confirmation. Apparently, if you move into a new bed in a British prison, you become responsible for the debts of the person who was there before you. The opportunities this offers for abuse or gaming of the system are immense. If you know you're going to be moving out, you have every incentive to run up a huge debt before you leave. Is there a credit checking system? Gambling is rife in prisons and this system allows you to borrow, gamble in the hope of winning big; and if you don't, stick some other poor sap with the losses. In fact, now that I put it that way...it reminds me of something similar in another world . There must be more to this. Who is doing the lending in this system? What about the sucker who moves into the bed? Do prison officers influence who gets which bed? What are the amounts at stake - is the debt 20 cigarettes, £3 or £3000? What is £3 in prison w...

There's been a movement - reminiscent of the anti-short-selling campaign - against buying "naked credit default swaps". The idea of a CDS is to provide insurance against default on a corporate or national bond; and a naked CDS is one which is bought by someone who doesn't own the original bond. The objection to this is based on a kind of moral hazard argument - the idea that if I buy insurance against your house burning down, I'll have an incentive to leave piles of leaves and open cans of petrol near it. So one proposal, according to this article in the FT , is to prohibit people from buying a CDS if they don't own the underlying bond. ( Update : Felix Salmon points out Wolfgang Munchau's more in-depth article proposing the same thing) Sounds like it makes sense at first glance. But one big question arises: what if I want to sell the bond afterwards? Do you prohibit me from selling it without also selling the CDS? If so, I am suddenly left with...

In defence of Greece, I pointed out to a colleague the other day that the cost of a Greek CDS is only 4% for a five year period - meaning that you only need a 0.8% interest premium to make a Greek bond worthwhile, or that the market only gives Greece a 1/125 chance of defaulting each year. He responded with the valid observation that this is all very well, but who's offering this insurance policy and will they be around to pay it if Greece does default? After all, AIG wasn't. In fact, the 4% is not  the spread between the chances of Greece defaulting and a risk-free bond, as it's commonly presented. It is actually the spread between the chances of a Greek default and an  insurance company  default. It's a lot easier for an insurance company to go bust than it was two years ago. Not only have risk conditions deteriorated, but after AIG, Citi and the rest, it would be immensely tough politically to bail out another big insurance company or bank which had issued CDS...