Fri, 20 January 2017
What follows is an edited partial transcript of my conversation with George Bragues of the University of Guelph-Humber. We discussed his new book, Money, Markets, and Democracy: Politically Skewed Financial Markets and How to Fix Them. This is his second appearance on this show, you can hear the first one here.
Petersen: So your book looks at the interaction between Democratic politics and financial markets. In your introduction, you quote the Greek Prime Minister Alexi Tsipras, who claimed that "democracy cannot be blackmailed." And this was in the context of the 2015 bailout referendum that would have helped pay some of the massive Greek debt but at a cost of forcing them to adopt fiscal austerity. So, can you talk a little bit about that situation and how it played out and also what it tells us generally about the relationship between democracy and finance?
Bragues: Yes, sure. That situation has its origins about a year or two after the financial crisis of 2008. The financial crisis of 2008 initially arose out of the subprime mortgage sector in the United States. It affected banks worldwide that were holding or otherwise exposed to the subprime mortgage assets.
But then as one of the spillovers of this crisis we had pressure on countries in southern Europe including Portugal, Spain, and Greece. And so it all came to a head in 2010 and back then it was Nicolas Sarkozy and Merkel, Germany's chancellor---who's still around---was a player, and they came up with a framework to bail out these countries including Greece.
So, as part of those bailouts, Greece had to comply with various conditions including the fiscal austerity measures that you mentioned, there was a privatization that had to be done but it didn't go so well and so in early 2015---if I remember these dates correctly---Tsipras is leading what was then a sort of outsider party, one of the two major parties in Greece. And so they thought that they would take a different approach to the previous Greek government which was to play ball with mainly Germany and instead of playing ball with Germany and trying to use measures to get their budget under control they thought that they would try to essentially threaten the breakdown of the financial system. a breakdown of the euro unless Greece were forgiven their debt or otherwise given more lenient measures.
The European establishment wasn't buying into that. So this is when Tsipras went to a vote, a referendum on a bailout package. He won that vote, that is to say, the Greek people voted resoundingly against the European establishment of the time, but that ended up not really mattering. The European establishment said basically we want our debt paid, we're willing to renegotiate the debt and you have to comply with these conditions.
And so that was a situation where democracy and the markets came into play. The Greek government was hoping that by creating a crisis in the markets through a democratic act, one of the most democratic acts you can imagine, which is a referendum---because in a referendum the people vote directly on a policy---that they were hoping that democracy would have its way---through the markets---would have its way. It didn't work out.
So, I start my book off with that event because it nicely and dramatically---the Greek situation is still ongoing---but it nicely illustrates how politics and the markets interact. And politics today in most of the developed world means democracy and this interaction between politics and markets, while known, while recognized, I don't think its full implications have been recognized and that's why I decided to write a book.
Petersen: So, with the bailout referendum---this is a massive debt---I believe it was 177% of Greece's GDP?
Bragues: That's correct, yes. It's probably different now. It's probably higher now, I haven't looked at the latest numbers.
Petersen: Even if they paid their entire output and didn't eat or consume anything, it would still take them almost two years to pay it off, which of course is unfeasible. And then they were trying to refuse to pay it off and I suppose they were hoping that markets would have a big reaction and then when they didn't their leverage was gone. They didn't have the bargaining power they thought they had.
Bragues: That's correct. The markets the next day---the referendum took place on a Sunday---and the next day the markets were down---not down significantly, specifically those in Europe, which would be more closely impacted---and the euro which was the key financial instrument in this entire drama barely reacted at all to the referendum result.
Now, part of that was because by this point---I mentioned before that this is a drama that had started back in 2010---the reason why the markets' reactions were muted by this time, much of the debt that the Greeks held were no longer held in private hands. In other words, they were not held by private market players, whether that be pension funds, commercial banks, hedge funds, and other institutional investors but they had been effectively transferred to the government, whether to taxpayers or to central banks who had started---even though this goes against the Maastricht Treaty that brought the euro into being---the Central Bank started buying European bonds, and I'm talking here specifically about the European Central Bank.
So, that's how it's played out. It's still currently playing out because Greece is back in the news because part of the deal that was made in the aftermath of the 2015 referendum is that Greece would still have to comply with various fiscal policy requirements and in order to get additional disbursements from the so-called troika, and the same party is in power, Tsipras continues to be in power and they still as you'd expect they would rather pay less debt or at least pay the debt on less onerous terms.
Petersen: The odd thing is that people keep lending them money when they're so resistant to paying back their loans.
Bragues: Yes, and that brings up the larger question I talk about in the book which is the role of the bond markets. The bond market is it is one of the biggest of the financial markets.
In the book I go through the main ones. These would include the stock market, the derivatives market, which has grown dramatically since the early 1970s, I go through the currency market, which is the biggest one, at least on a per-day trading rate. But the bond market is huge.
The bond market is a lot bigger than the stock market, it doesn't get as much public attention as the stock market does. It is not the subject of a cocktail party conversation the way the stock market is, but the bond market is huge. It is a major lifeline for governments---most governments today. It's hard to think of an exception among the democracies now---most governments today do not finance their expenditures, their infrastructure, their social programs through taxes. They run deficits and those deficits have effectively become perpetual.
If you go back to the early 1970s---and we can come back to the issue why the early 1970s is such a critical date---but you go back the early 1970s, you do find countries from time to time running fiscal surpluses, or running balanced budgets, but for the most part they're running deficits, and so as a result since then we've seen a sustained increase in the level of public debt as a percentage of GDP. And so we're getting close to levels that we haven't seen since World War Two among the OECD nations.
So, the bond market is a key player. I argue in the book that the bond market is an enabler of the worst fiscal habits of democratic states, that democratic political systems have an inherent tendency to overspend, and that the bond market becomes a very enticing place that politicians look to in order to finance the spending that helps them get them elected.
And so then the question arises why do the bond markets keep on buying the bonds of these increasingly indebted states? I'm not sure I have the complete answer to that question. That was one of the questions that really got me thinking as I was writing the book. I think tentatively the factors are these: the key one is the desire for safety that seems to be very strong in the human psyche. So, I think we have to go into psychological explanations for this.
The thing about government bonds, unlike bonds that you would buy, say, from a corporation, which is the other major sector of the bond market, government bonds are backed by taxes and taxes have to be paid. They are coerced from people. You don't pay your taxes, you'll either get fined or in a worst case scenario you end up doing time. A corporation doesn't have the same ability to gather money. It has to rely on the voluntary decisions of the buyers of its products. So, if you buy a bond in General Motors, or you buy a bond in Bell Canada or something like that, your ability to get money from that bond---and a bond is effectively, by the way, a loan that an investor extends to an entity, a government or corporate entity---so you buy a bond from Bell Canada or from some other private company, you've got to rely on the fact that they're going to be able to get people to buy their goods and services voluntarily.
When you buy a government bond, you have the assurance that the entity who is supposed to pay you back the money has the power to force people to give it money and so that makes government bonds safer, in general, all else being equal than corporate bonds. And since people do crave safety, they do crave security---I don't want to get too much into the depths of human psychology here---but there's a deep-seated desire to avert risk and this is well known. Among financial academics we talk about it all the time, we talk about it in terms of risk aversion as being part of the model that we used to depict investor behavior.
So, this is such a powerful desire to have safety when you invest your money, to know that if you plunk 1,000 dollars now and you're promised 2% interest, you will get that money back and a 2% interest at some future point in time. So, I think that's the most powerful driver for the demand of government bonds and that demand is so strong that investors will overlook the fiscal health of the countries to which they are effectively lending to.
I think the other factor is legislation. There you look at the regulations specifically pension funds but also banks and so on have to operate under, if they're required to have a certain percentage what are deemed to be safe investments in their portfolios---by the way this also includes insurance companies---and safe investments invariably encompass and tend to get restricted to government bonds and so there's a built-in legislatively driven demand for government bonds and this plays out
significantly with the commercial banks because they have to show to regulators that they have a certain level of core equity in their balance sheets. You look at these regulations---these are the Basel regulations---they have traditionally incentivized banks to buy their country's bonds. So, you've got a situation where Greek commercial banks tend to own a disproportionate amount of Greek government bonds or Italian commercial banks own disproportion amount of Italian government bonds. So, you have the banking sector effectively forced through legislation to have to finance the country's debt.
Petersen: So just as a part of doing business, if you're a bank, you have to show that you're safe. There was this issue during the financial crisis of these AAA rated mortgage securities and if you think about it in terms of just supply and demand and all these things, it's not clear why the rating is so important. But then when you think about needing to prove to a third party that I am safe, then what others think that your assets are worth or how safe others think they are, becomes really important.
And at least there's sort of a perverse element here where if you're lending to Iceland or Greece you can maybe get a higher return while still maybe appearing safe because you say, "well I've got all these government bonds," but the fact that they're not safe is why they can give you that higher return. And if you're managing a bank you want to earn a high return but you still want to appear safe and if you lose money you want to lose money when everyone's losing money so that you can say "hey it's not my fault, not personally at least."
Bragues: That's another factor too that everyone---and John Maynard Keynes, I don't agree with everything he says, but he's pretty good on this point, on the behavior of investment managers. You have a huge incentive as an investment manager to go with the crowd because if you're right with the crowd you can bask in the general adulation that all investment managers are receiving at that point in time, you're generating nice returns for folks. But if things go awry, the crowd becomes more important as a kind of protection device against criticism because you can always say---as you point out---that this is a systemic issue, I couldn't do anything about it everybody else also was adversely affected.
And so that does tend to work in favor of government bonds and does tend to over inflate the level of demand for government bonds relative to what they should get if you had a truly free market, people were just free to buy whatever bonds they thought would fit their risk return preferences. I think that's a key factor as to why I believe that bond markets end up not being vigilantes.
There's this line Edward Danny, a well-known analyst on Wall Street, came up with this phrase 'bond market vigilantes'. I believe it was in the 1990s and it supposedly referred to this group of people in the bond market who were always on the lookout for countries that were running fiscal deficits, that were doing the wrong things economically, and that these bond market vigilantes would pick on these countries by selling their bonds, shorting their bonds, and then putting those countries in a bind supposedly by raising the interest rates that they would have to pay any time they issued bonds again.
But the reality is that the bond market vigilante---if it exists---it exists too late. You look at the history of the bond market---we're talking a couple centuries now the bond market is actually older than the stock market---you look at this market and the vigilantes only come up really late in the game when it's pretty obvious that the government in question cannot pay and so the bond market doesn't do---I would argue---the job that it advertises: namely, always keeping yields in line with risk. It does tend to underestimate the level of risk, specifically with when it comes to governments.
This is a partial transcript only. For our full conversation, listen to the episode.