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Who Helped Greece Cheat?

By James H. Nolt

Beware of bankers bearing gifts. Officials of the previous Greek government, out of power since January, might have heeded this paraphrase of an old adage and saved the country a load of trouble. Private financial institutions were giving Greece advice as early as 2005 on how to conceal its accumulation of public debt far in excess of EU targets.

According to the reputable British newspaper The Guardian, EU officials knew at least by 2009 that this was going on, but helped facilitate and cover it up.

The Greek crisis was not “discovered” until the time was ripe for it to be revealed, i.e., after the financiers advising the Greek government had tipped off their best clients that Greece was in trouble and it was prudent to short Greek debt. This is a very common pattern: crises are “discovered” when investors are ready to profit from that discovery, and thus, the “news” is leaked to the major media by insiders in a position to profit.

I invented a Machiavellian adage, “Corruption is a constant, but scandal is a variable.” This applies to government as well as private dealings. Lots of profitable insider positions are always being set up and exploited, but we rarely hear about them or their consequences until it is in the interest of someone powerful to leak the news. Such leaks can be a source of great profit.

Let’s back up a bit to see how in this case. First of all, broadly speaking, be aware that there has been a massive bond bubble worldwide since 1981-82. Remember, bond prices are the inverse of bond yields, or interest rates, so that if a $10,000 10-year bond with 9 years left until maturity is sold for $4,000 in 1982, the effective yield to maturity (1990) is 19.31 percent. A lucky (or prescient) investor who bought such bonds in that year of peak interest rates would have earned a very high return until 1990. Even the real, inflation-adjusted return would have been very high because worldwide inflation was coming down rapidly during the 1980s.

Suppose this investor, having turned $4,000 into $10,000, now buys a 10-year Greek government bond around 1990 when the yield on Greek bonds was over 18 percent. Keeping the coupon consistent at 5 percent, the market price of a $25,000 10-year bond would have been about $10,000 in 1990. By the year 2000, you redeem the bond for $25,000. Capital grows quickly in a bullish bond market.

If this complexity confuses you, just remember that when interest rates (bond yields) are high, the price of the bond will climb a lot to its maturity value. Conversely, when interest rates are low, bond prices will increase only a little from time of purchase to maturity. The ideal situation for a booming bond market is ever-rising bond prices, meaning ever-falling interest rates. Never before in world history have interest rates fallen as consistently worldwide as they have since 1982. This is bond market paradise.

Another way to think about this is to remember that when interest rates are high, bonds are sold at a steep discount. As rates fall, bond prices increase quickly. Thus bond buyers want to buy when interest rates are high and sell then they are low. In most business cycles, when bond prices get “too high” according to the yield preferences of bond owners, they start to sell their bonds. Selling pressure causes bond prices to fall and thus interest rates to rise again. The cycle then repeats.

This cycle since 1982 has been truly extraordinary because bond prices have continued to rise for decades. Few have fallen in price. Yields have gotten extraordinarily low, lower than ever before in world history . . . and have stayed low for years. Low yields mean that borrowing by governments and corporations is very cheap today. Greece, along with many governments, corporations, and investment funds have loaded up on debt. Among the most debt-leveraged institutions in the world today are not governments, but private financial companies.

Chronic addiction to cheap debt is not confined to Greece. This is the real reason Greece is a bellwether. Highly-leveraged entities worldwide are looking with concern at whether the Greek default is a signal that the decades-long bull market in bonds is finally coming to an end. If so, the problems could be global and catastrophic. The future of Greece may be the future of us all.

Most countries and many private companies cannot afford the debt they already have today if the price of debt rises significantly, as the price of Greek debt did. During recent months Janet Yellen, chair of the U.S. Federal Reserve, has said that a rise in interest rates is necessary and overdue. She is right. Doubtless, she hopes it will be a small and steady rise, giving debtors time to adjust. If it is not, all hell breaks loose. Collapsing bond prices would devastate the world economy. Yet if history is any guide, it is not a question of if, but when and how fast. Then public spending in every country will be cut drastically to pay down increasingly unbearable debt.

Greece became a test case when the festering problem of ballooning Greek debt was announced in the world media about 5 years ago. As I said, the problem was long known by insiders who helped hide it until the time was ripe, and investors were positioned to profit from the announcement of a crisis.

As my example above illustrates, during the 1990s foreign investors were snapping up discounted Greek bonds in anticipation of their rise in value as Greek interest rates converged toward the lower rates typical of northen EMU members careened toward EMU membership. Greek bond yields fell from around 20 percent in the early 1990s, to briefly hitting 3 percent in 2002, before stabilizing in the range of about 5 percent until the world financial crisis of 2008.

Many investors who had bought Greek bonds at a discount during the 1990s began dumping them once it was clear that Greek interest rates had stabilized and were not likely to go lower. Panic selling of Greek debt ensued after 2008. Bond prices collapsed again to surpass the yields of the early 1990s, reaching over 30 percent by 2011. At such high interest rates, Greece must default. No amount of belt-tightening could have allowed them to rollover such a large debt at such extreme interest rates.

Investors knew this too. Many, again, bought Greek bonds when they were at extreme discount. Yes, there was risk of losing everything if Greece defaulted, but when the EMU bailed out Greek debt, those bonds rose sharply. The investors who bought them at a discount profited richly. As mentioned last week, at that time that the EMU did rescue “Greece” once again, as the European central bank bought lots of Greek bonds as part of QE and prices soared so that by 2014 Greek bonds were again yielding around 5 percent. Any investors who bought discounted Greek debt during 2011 were the real winners. They were bailed out. Greece was not. Its debt merely grew as its economy shrank.

Greek bond prices have been on a rollercoaster, one propelled largely by interests beyond the control of Greece itself. The EMU “solution” is the same as last time: save those investors who snapped up Greek debt when it was deeply discounted, but at the cost of reducing employment, salaries, and pensions in Greece while saddling the country with even more unsustainable debt. Sooner or later Greece must default. The only issue for bankers is to make sure that their favored clients are shorting Greek bonds when it does.

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James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.

[Photo Courtesy of Wikimedia Commons]

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