The Chastening, by Paul Blustein

Paul Blustein’s The Chastening has a lot to say about moral hazard, for instance this quote within a quote:

If unsuccessful hedge funds are not allowed to fail, if brokerage firms believe they will somehow be protected from the effects of far too liberal margin requirements, if banks believe help will be forthcoming should loans go sour during unsettled market conditions, how will we discipline future decisions of investors and lenders? Will such intervention make our financial system even more fragile later … Anything that weakens the effect of market discipline and that lessens the punishment the market affords speculators when they have made incorrect decisions is likely in the long run to lead to more instability.

The whole last part of the book is full of this kind of contemplation, and warnings for the future and the need to change the financial system. Unfortunately the book was written in 2001 (the quote above comes from 1998) about the series of financial collapses which happened first in south-east Asia, then in Russia, finally leading to the collapse of the firm Long-Term Capital Management and the staving-off of complete financial meltdown by various bail-outs (or so it is said, but who knows in the crazy world of global finance?), and nothing much was in fact changed.

Today we have a country like Greece, whose bailout dwarfs those of the countries mentioned in this book. In recent times, Greece’s 10-year bond yield has reached as high as 48.6%, meaning this would be your annual return if you invested in it. This high yield is a reflection of the theoretical risk of Greece defaulting (and therefore you losing all the money you’ve given them), but – as in the cases mentioned in this book – if the ECB, IMF etc. are going to bail out Greece no matter what, then this risk is indeed only theoretical for investors, and so they can merrily gamble on this expectation – they can get their high return without the high risk. If they couldn’t rely on this back-stop, they probably wouldn’t take the gamble at all, and Greece would be forced to default – and thus everyone would lose all their money (Blustein’s book demonstrates quite comprehensively how companies are incapable of realising a solution other than default is in everyone’s best interests and reaching an agreement around this).

Hence why, in this book, one can’t help but be amused when, to everyone’s chagrin, the IMF decides it’s fed up bankrolling a corrupt Russia just for the sake of the profits of Western investors and lets it default on its debt. And Russia was paying interest of over 100% on its bonds, so you think, no, that’s fair enough: you knew the risks; and now you’re paying for being wrong. But for some reason the investors moaned about it, and said it wasn’t fair, and if people weren’t going to play fair, they’d take their ball home with them and not play any more.

Which leaves us wondering about Greece and its eternal back-stop: a country which has no control over its monetary policy (inflation, interest rates, the value of its currency), whose debt is ever increasing as its GDP decreases, which has no hope and which one day inevitably will have to default on its debts (it has already defaulted on some of them, though perhaps not technically – but it doesn’t seem to have helped much), and leave the Euro too.

Anyway, the next book I have by Blustein is called And the Money Kept Rolling In (And Out), and it’s about Argentina in 2002. As someone who enjoys investors getting their comeuppance, it should be a right laugh (some of them are still fighting in the US courts over this to this very day); but also an instructive case for how defaulting on your debt can lead to you getting your economy back on track (see Argentinian GDP figures).

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