Greek Games

I haven't made up my mind yet about the wisdom of the latest plan to secure the financial viability of Greece within the eurozone, but as a piece of financial engineering it has some very intriguing features.

Current bondholders have the option of exchanging their assets for new issues that promise less and deliver later, but are considerably more secure. There are four new issues to choose from, varying with respect to maturity, interest rate, and the proportion of principal that is guaranteed (by highly rated zero coupon bonds or funds held in an escrow account). But these options are designed to be roughly equivalent in present value terms, and it is expected that they will be selected in approximately equal measure by those who choose to participate in the exchange.

Participation is voluntary, so current bondholders can simply choose to do nothing. For this reason, the financing offer does not trigger payouts on credit default swaps.

What makes the mechanism strategically interesting is that the payoffs from participation are highly sensitive to the overall participation rate. The higher the participation rate, the greater will be the ability of Greece to meet its financial obligations not only on the new issues but also on the outstanding ones. Participation by some raises the value of the assets held by the remainder. If the target participation rate of 90% is met, then those who decline to participate will find themselves holding bonds that are much less likely to default than is currently the case. In anticipation of this effect, yields on Greek bonds (and the cost of insuring them with credit derivatives) fell sharply following the announcement.

It's interesting to think about who gains and who loses from this. Contrary to most accounts in the media, current bondholders benefit from the existence of the financing offer, regardless of whether or not they choose to participate. Those who decline to participate experience a capital gain on their assets (relative to the status quo without the offer). And those who participate are choosing to forgo this capital gain and must therefore be even better off. Of course, there will be many bondholders who purchased their assets at times when Greek default was considered highly unlikely, and they will experience a loss on their original investment. But this loss has already been inflicted on them: the financing offer just gives them an opportunity to capitalize it in a manner that eases Greece's debt burden, as an alternative to selling their bonds in the open market. 

The fact that credit default swaps are not triggered by the offer, coupled with the lowered likelihood of default on current bonds, benefits sellers of protection on Greek debt. In fact, such sellers have strong incentives to buy up Greek bonds and participate in the exchange, thus lowering the probability that a credit event will arise in the near future. I would not be surprised if some of the buying that raised prices on the heels of the announcement came from such sources.

So who loses as a result of the financing offer? First and foremost, those who bought naked credit default swaps, thus making a directional bet on a credit event that is now less likely to occur. It is quite conceivable that the plan was designed to have precisely this effect. Speculators betting on sovereign default have come in for a fair amount of public criticism by political leaders in Europe, and stand accused of raising the cost of borrowing and the likelihood of default. (I have argued in joint work with Yeon-Koo Che that there is some theoretical basis for this claim.)

Costs will also be imposed on the countries of the eurozone core, who are providing the collateral to guarantee principal on the new issues (Greece remains solely responsible for all interest payments). But these countries are motivated by the belief that a formal default by Greece would have contagion effects across the periphery, leading to a chaotic collapse of the currency union. The biggest risk entailed in the current initiative is that it may not, in the end, be enough to prevent this.

Some Thoughts on the Unthinkable

In his April 4 letter to Congress on the urgent need to raise the debt limit, the Secretary of the Treasury made the following claims:

As the leaders of both parties in both houses of Congress have recognized, increasing the limit is necessary to allow the United States to meet obligations that have been previously authorized and appropriated by Congress. Increasing the limit does not increase the obligations we have as a Nation; it simply permits the Treasury to fund those obligations that Congress has already established.

If Congress failed to increase the debt limit, a broad range of government payments would have to be stopped, limited or delayed, including military salaries and retirement benefits, Social Security and Medicare payments, interest on the debt, unemployment benefits and tax refunds. This would cause severe hardship to American families and raise questions about our ability to defend our national security interests. In addition, defaulting on legal obligations of the United States would lead to sharply higher interest rates and borrowing costs, declining home values and reduced retirement savings for Americans. Default would cause a financial crisis potentially more severe than the crisis from which we are only now starting to recover.

For these reasons, default by the United States is unthinkable.

Unthinkable as it may be, it's worth giving this a little thought.

Strictly speaking, the Treasury could continue to make payments on all obligations authorized by Congress, simply by sending out checks as they come due. Commercial banks would undoubtedly accept these from depositors, confident in the knowledge that the Fed would create the reserves necessary to credit their accounts. If the Fed were concerned about the resulting expansion of the monetary base, it could neutralize this by selling bonds on the open market. The result would be an increase in the debt held by the public, with no change in the monetary base, which is exactly what would transpire if the deficit were financed by the issue of new bonds.

The problem, of course, is that the Treasury's account at the Fed would then be vastly overdrawn and the debt limit thereby exceeded. Instead of borrowing from bondholders, the Treasury would be borrowing, so to speak, from the Federal Reserve. I'm quite certain that in the current political climate this would be treated by Congress as a usurpation of its power, resulting in a constitutional crisis and possible impeachment. Not surprisingly, the Treasury Secretary is reluctant to go down this road.

The only alternative is for the Treasury to meet some of the obligations authorized by Congress while failing to meet others. For this to happen, someone in the executive branch would have to decide which prior appropriations made by Congress to respect, and which to ignore. Interest and principal on the debt would probably receive the highest priority, given constitutional imperatives. But everything beyond that, it seems, would be fair game. By respecting one law -- the debt ceiling -- the Treasury would be forced to disregard others. Payments to contractors, congressional and agency staff, state and local governments, social security recipients, and health care providers would all need to be prioritized. This is a bizarre and highly undemocratic manner of repealing legislation.

I doubt very much that it will come to this. If the Treasury were able to communicate its priorities credibly to the public, making clear exactly who would get paid and who would not, I suspect that we would have an agreement in short order. But even if we get past the current crisis unscathed, the same scenario is likely to be repeated whenever government is acrimoniously divided in the future. Accordingly, it's worth thinking about the kind of structural changes that could help us avoid a periodic repetition of this farce.

One possibility is to absorb an increase in the debt ceiling into any legislation that has budget implications, and to do so in a manner that allows for all the implied borrowing needs to be met. Any tax cuts or increases in appropriations should be accompanied by an authorization of borrowing so that all anticipated shortfalls in revenues relative to expenditures could be accommodated.

This would be very imperfect solution, because severe shortfalls in revenues relative to expenditures are often unanticipated. Unusual economic conditions (such as those we are currently navigating) can devastate revenues just as expenditures are rising sharply, thus pushing the deficit outside bounds that were forecast when the legislation was enacted.

The only sure way to eliminate the contradictions implicit in current laws would be to repeal the debt ceiling itself. This is what common sense would dictate. But expecting common sense to guide the legislative process in the present climate... now that is truly unthinkable.