There is an outrage in the euro zone countries about the financial markets. No one likes the bearer of bad tidings. The messenger is blamed for the message itself. Thus, for the difficulties in managing the Greek and other budgetary crises, EU politicians have decided that the crisis is all got up by the traders in CDS and rating agencies. Rating agencies downgraded Greek debt sometime ago and have now done the same to Spain. The CDS market has been up and down as far as the premium on Greek debt is concerned. Before the first bailout for Greece last month, Greek debt was paying 700-800 basis points above the German debt. When the news arrived that the euro zone leadership was about to act decisively, the premium went down. But as it emerged that there was little content behind the talk, the premium went up again.
European politicians decried the behaviour of the debt markets. They argue that a CDS is not like an ordinary insurance contract. Here people are betting?taking out insurance?against someone whose house may burn down. But it is not the house of the insurer, but that of a total stranger. They say this is impermissible. But there is no reason why one should not be free to do so, if they wish. It may be a neighbour?s house. I may wish to insure against anything happening to President Obama since my business may suffer if he was to be removed for some reason. Yet, the argument is that this is unnatural. Indeed, it is insinuated that taking out insurance like that makes it more likely that the house will burn down.
Yet, the same markets that bet against Greece being able to pay its debt, treat German debt with great respect. So the spread that Greek debt has to bear above German debt is reflective of some real fears. After all, it is well known that Greece has been a serial debt defaulter over the last 200 years. Why should people not use such information merely because sentimentality made the euro zone leaders overlook such obvious facts?
But it is not only governments that suffer from markets. Private companies do as well. Satyam was caught out by its New York shareholders when Raju proposed a merger that made no business sense. It was that which exploded his schemes. Prudential Insurance has had a similar experience. Its new CEO, the dynamic Tidjane Thiam, a rare high achiever who became one of the best known African faces in the global marketplace bid for AIG?s Asian business. Pru as the company is fondly known in London, valued AIA at $35 billion. But then its own shareholders began to have doubts. The AIG board rejected its own CEO?s recommendation that AIG accept a reduced $30-billion bid, since Pru had to listen to its shareholders. But the board was aware that AIG has already suffered a bad bout of doubt about its capacity to survive, not all that long ago, and did not want a repeat collapse in its price.
So, the deal is off. It will cost Pru around $1 billion merely in the fees to be paid to bankers, brokers, lawyers etc. AIG may get away with paying only $250 million. Thiam may not survive the failure of the bid merely six months after his appointment. He thought a gamble on Asia could not fail but the markets ruled that the price he was paying was not right. So he will go out unless the board of Pru faces up to its own responsibility and makes it clear that it was a collective decision in which case the shareholders may not ask for their collective resignations.
Even more salutary is BP?s experience. The oil spill in the Gulf of Mexico is one of the largest such spillages in recent years. Obama has said that it is the US?s biggest environmental disaster. He wants to sue BP since any weakness on his part as to how to deal with BP will harm him and his party in the next elections. The markets have now decided that BP needs to be punished even before American courts do anything. BP has lost nearly $50 billion in its stock market value. Markets are not normally thought to care for the environment. Yet, the sellers of BP equity clearly expected BP to have taken precautions and not mess up in the way it has done. Tony Hayward?s job is on the line. It is quite likely that within six months BP may cease to exist as an entity, as the entity it is now.
If only one could get fiscally irresponsible governments out as efficiently, the problems of the euro zone could be solved. But don?t hold your breath.
?The author is a prominent economist and Labour peer