A speculator can “short” a government by borrowing its debt at its current price, in the hope of selling it later at a lower price and pocketing the difference. For example: on January 1, 2010, I think to myself that the game will soon be up for the Greeks. I borrow, at face value, €10 million of the Greek government’s 2016 bond, which is then trading at €0.91, from Goldman Sachs for six months. For this, I have to pay Goldman Sachs the yield that it would receive from the bond – around 5% annually at that price, so about 2.5%, or €250,000 – during the six-month term.
I immediately sell that bond in the market, for €0.91, so I get € 9.1 million (€0.91 x €10 million at face value). Fortunately, my bearish view comes to fruition in May, when the full extent of the country’s fiscal problems becomes clear. By June 30, when I am due to return the €10 million in face-value Greek 2016 bonds to Goldman Sachs, the bond is trading at only around €0.72. So I go into the market, buy €10 million at face value for at €0.72, or €7.2 million, and return the bond certificates to Goldman Sachs as per our agreement.
My profit for correctly taking this bearish view is therefore €1.65m – the €9.1m I got by selling the bonds when I borrowed them on January 1, minus the €7.2m that I had to pay to repurchase them on June 30, minus the €250,000 in interest that I had to pay Goldman Sachs for the six-month loan. Voilà – a successful “short” trade.
Of course, a single short seller cannot “make” the price of an asset (unless he is George Soros, whose famous bet against the British pound in 1992 made him a billionaire and forced Britain out of the European exchange-rate mechanism). But if a bunch of speculators decide (rightly or wrongly) that a government’s debt is overpriced, they can force down its price, thereby forcing up its yield (the interest rate that the government must pay).
If the attack persists, speculators can force a government to default on its debt, unless it can find a way to finance its borrowing more cheaply. The bailout fund created last year by the International Monetary Fund and the European Central Bank to enable Greece and other distressed sovereigns, like Ireland and now Portugal, does exactly that, but on the condition that they implement austerity programs to eliminate their deficits over a short period of time.
“Eliminating the deficit” means, quite simply, eliminating a lot of jobs, in both the public and private sectors, whose existence depends on the deficit. The economic and human costs of deficit reduction in a weak economy are appalling, and the targets won’t be met, either, because the spending cuts will erode the government’s revenue as aggregate demand falls.
So what is the role of elected politicians in the face of a speculative attack? Is it simply to accept the market’s will and impose the requisite pain on their people? This would be a reasonable conclusion if financial markets always, or even usually, priced assets correctly.
But they do no such thing. The financial collapse of 2007-2009 was the result of a massive mispricing of assets by private banks and ratings agencies. So why should we believe that the markets have been correctly pricing the risk of Greek, Irish, or Portuguese debt?
The truth is that these prices are “made” by herd behavior. John Maynard Keynes pointed out the reason many years ago: “the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made.” When you don’t know what to do, you do what the next person does.
This is not to deny that some governments have been living beyond their means, and that shorting their debt is how financial markets hold them accountable. But, in the last resort, it is voters, not markets, which hold governments to account. When these two accounting standards diverge, the popular standard must prevail if democracy is to survive.
The tension between democracy and finance is at the root of today’s rising discontent in Europe. Popular anger at budget cuts imposed at the behest of speculators and bankers has toppled leaders in Ireland and Portugal, and is forcing the Spanish prime minister into retirement.
Of course, there are other targets: Muslim immigrants, ethnic minorities, bankers’ bonuses, the European Commission, the ECB. Nationalist parties are gaining ground. In Finland, the anti-European True Finns party has shot up from nowhere to the brink of power.
So far, none of this has shaken democracy, but when enough people become vexed at several things simultaneously, one has the makings of a toxic political brew. Nationalism is the classic expression of thwarted democracy.
For politicians, the important thing is not to avoid taking hard decisions, but to do so of their own volition and at their own pace. When an elected government is under assault from the bond markets, it is essential for the political class to remain united.
It is natural for opposition politicians to want to exploit a government’s difficulties to win power. But a fiscal crisis calls for political self-restraint. Opposition parties should refrain from shorting their government politically at a time when markets are doing so financially.
Ideally, there should be a time-limited all-party agreement on a plan of action, which would represent the limit of what is politically feasible. Unfortunately, political disunity in the face of financial pressure always ends up being far more damaging to democracy and the economy than instinctive patriotism.
Robert Skidelsky, a member of the British House of Lords, is Professor Emeritus of Political Economy at Warwick University.
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