Beware of Greeks Bearing Scrips

12 September 2011

A financial bond or note is a promise to pay some fixed amount at some given date. Two things, beyond the promised amount of payment, determine the price of a such an instrument.

First, there is the associated danger of a default. A possibility of default turns the bond or note into a sort of lottery, in which the actual pay-off could be the full, promised value, or nothing, or anything in-between (at least, anything reaizable in terms of the minimum division of the payment), or even some new pledge, promising a later payment of some sort. Each of these outcomes has some associated plausibility, and the lottery is valued accordingly.

Second, there is also the fact that the instrument is a promise of future payment; since pay-off cannot itself be put to immediate use (as consumption or as investment), its price is discounted to reflect time-preference and the forgone productivity of assets used to buy it.

Just to get the gist of that clearly, imagine that the value of a lottery were simply that of the mathematical expectation of its pay-off. The price of a bond would then be discounted expected pay-off.

So far, the causality here is just flowing one way. Possible-pay-offs and their probabilities determine an expectation or something like that, and then time-preference and productivity determine the present value of that expectation or expectation-like value, and that's the price of the instrument. And if the pledge were issued by a private institution, that would generally be it.

On the other hand, when such instruments are issued by a state, politics can make things interesting.

The Greek state is going to default on repayment of its borrowing. Its citizens are simply not willing to accept the costs to them of full repayment. In fact, they're not willing to fully repay what remains after politically possible subsidies from other states. Those who have lent money to Greece will receive less than they were promised.

The price of bonds issued by the Greek state already reflects the expectation of default. This reduced price is going to be used against bond-holders, both against those who are paying it now, and against those who paid a higher price and have held onto their bonds even as value dropped (as they gambled that the Greek state would not default or at least not default as much as some expect). What will happen is that populists, anti-rentiers, and opportunists will argue as if all bond-holders had paid that steeply discounted price, and as if those who paid that price lose nothing if they only recover the nominal purchase price.

And what makes that interesting is that it means that causality should now be flowing cyclically, where present price pronouncèdly affects the relative plausibilities of possible pay-offs, even as these continue to affect present price.

I've not sat down to work-out a formal model. But, while I don't expect that the equilibrium price of a Greek bond would be zero, I don't know that one can rule that out. (On the other hand, while economic equilibria are useful in understanding and approximating, the world is never in equilibrium.)

I do think that something might be said here about the ethics of sovereign debt.

It isn't heads of state or of government, or treasurers, or legislators as such who repay this debt. It isn't voters as such who pay-off this debt. It is tax-payers as such who pay-off sovereign debt (except where it is paid by selling assets such as territory and state enterprises). Sometimes the tax-payers weren't even born when the state went into debt. Moral claims against them for repayment are thin at best. I once read buying sovereign debt compared to buying shares in pirate ships (which one could at one time do openly in some places, and can still do quietly in some places), and I think that comparison quite apt.

On the other hand, it is plain that most of the Greeks protesting against austerity measures are signally unconcerned about the welfare of the Greek tax-payer; they just want any resources drawn from him or her to be directed to them.

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