French balloon shot down over Berlin

Predictably, if sadly, Sarkozy’s idea of a Berlin summit to discuss what should be done if a Eurozone member were to get into trouble has been dismissed by Berlin. Discussing such things ex ante, on a purely theoretical basis of course, will turn out to be preferable to discussing them ex post, if ex post ever arrives. The German reasoning is that some things just shouldn’t be talked about in public:

A Berlin, un porte-parole du gouvernement, Thomas Steg, a estimé qu’une telle rencontre n’est “pas nécessaire dans l’immédiat. L’expérience nous a appris qu’il y a certains sujets relevant de l’Eurogroupe dont il vaut mieux ne pas discuter en public”.

Whether saying publicly that there are certain things that you shouldn’t talk about publicly is in fact reassuring, is probably something that one could debate.

Working for Recovery from within the euro zone

In this article in today’s Irish Times, I explain why EMU is neither a primary source of our current woes nor an obstacle to recovery.

How to Fix the Economy

Alan Ahearne is today’s contributor to the Irish Times series: “Income Tax Rates Will Need to Rise.” (As usual, headline does not give full flavour of the article.)

The fiscal plan of Fintan O’Toole is also worth reading: “Government Reaction to Crisis Needs to be Credible.” A longer version of this article would have been even more interesting, in which the economic consequences of the pay element of his plan might be explained in more detail.

Issues in The Sovereign Credit Default Swap (CDS) Market: Guest contribution by Dan Donovan

I am pleased that Dan Donovan (a highly-experienced trader in the financial markets) has taken the time to write an explanatory note on some of the most important features of the sovereign CDS market. See his contribution below.
From Dan Donovan:

As the current malaise in the credit markets unfolds one of the rapidly emerging issues has been the markets concern about various sovereign solvency issues, most particularly with regard to the ability or otherwise of countries to be able to pay for the varying forms of bank guarantee’s they have proffered.

Most agents seeking to express views that sovereigns would be unable to meet their commitments and or that the cost of doing so will escalate have been doing so via the Credit Default Swap market; buying “insurance” against the default of the named sovereign. It is note worthy how quickly and dramatically the cost of this insurance has escalated.. Ireland as can be seen below (ex Iceland) has borne the brunt of this position taking.

5y                  10y
Port     134/144       130/150
Ital      177/187       172/182
Gree    260/290       255/285
Spa     148/158       145/160
Irel      260/300       240/290
UK      140/150       137/147
Denk    109/119       108/120
Swe      110/125       115/130
Aust      145/155       145/145
Ger           56/66            56/66
Fran          63/73             64/74
Finl           55/65             57/67
Belg     115/135       113/133
Neth     105/125        105/120
Iceland  925/975          800/1000

Source JP Morgan.

It is tempting to dismiss such moves as merely a thin market overreacting to the current zeitgeist, for instance it now costs roughly 3 times as much to insure against a default of the UK government as it does to insure against the default of Cadburys! There are however some important issues to consider regarding the implications of such moves.

Price Setting: Many participants in the market are able to switch between writing CDS insurance and buying Government bonds. As such the CDS market which is more active than the underlying market can have the effect of defining the cost of borrowing for sovereigns despite the fact that there is very little in the way of transparency regarding who the agents in this market are and what volumes have been traded. Governments could be forced by virtue of this market to pay unnecessarily high (perhaps punitively high) borrowing costs.

Agency Issues:  The existence of the Sovereign CDS market may change, considerably, the motivation of traditional suppliers of credit extension to sovereigns.

Whilst the CDS market is a zero sum game, it is however conceivable that certain groups can accumulate considerable positions in the CDS (buying insurance) of a given Sovereign without holding any underlying positions in the securities referenced by such a CDS. It would then be optimal for such agents to fail to support the issuance programmes of the country in question. The reason being that this will benefit the CDS they own via the spread moving wider or in the extreme technical default of the Sovereign triggering the CDS contract. Under normal circumstances this issue would be so remote as to be irrelevant, but these are far from normal times and as such these issues need consideration.

Possible Solutions: It is certainly arguable that CDS contracts have been far from a force for good in these times and have done more damage than good and should be outlawed. It would be difficult to “put the Genie back in the bottle” however and as is the case in banning short selling may have severe unintended consequences. One simple strategy would be to enforce disclosure of all agents Sovereign CDS positions. Such transparency could be delivered in a very short time frame and would enable Issuers and the market in general to understand and interpret the actions of the varying market constituents more clearly.

The New York Times on the Euro

The New York Times has an article on the adjustment difficulties facing peripheral members of the euro area that have seen booms turn into busts. The article is here.

This graph of sovereign debt spreads is especially striking.