Illogical Derivatives

Ever since the financial crisis began in 2007, we have heard just about every component of the economy targeted at least once by someone as the cause of our problems. Most of those targeted components however, hardly ever include the right one, but among them is often found these "very scary" insurance-like contracts known as credit-default swaps. The most recent example of public sentiment towards this specific derivative is found in German Chancellor Angela Merkel, who said, "Credit-default swaps, where you insure your neighbor’s house just to destroy it and make money from it, that’s exactly what we have to curb."

It is probably helpful to continue using Chancellor Merkel's "neighbor's house" metaphor, in order to prove her sentiment is without merit. A credit-default swap is a type of derivative that, as she says, is a form of insurance, just like any other. Where Chancellor Merkel goes astray is in making the statement that first you bought the derivative, and then you burned your neighbor's house down. This is in stark contrast to the more reasonable scenario of first knowing that maybe your neighbors play with fire all day and then thinking it wise to buy insurance on their house. What is the equivalent of Merkel's event causation (first buy insurance, then force disaster) when it comes to Greece? Many institutions did indeed purchase insurance against Greece defaulting on its debt, but how did those same institutions also make Greece potentially default on its debt? Do banks and speculators now determine the level of government spending and tax policy in Greece?

The missing element here is by what process does Greece's level of indebtedness get determined. As revolutionary as it might sound, the answer is straightforward. It is not an institution like a bank, whose assets might be in Greece and whose concerns therefore might include Greece's level of indebtedness, that determines how indebted Greece is; rather, it is the Greek government, which controls Greek fiscal policy, that controls the level of Greek indebtedness. Rest assured, if Greece's fiscal situation were not as bad as it is, nobody would be interested in buying these derivatives on Greek debt. Similarly, if you live in an area extremely prone to flooding, you are not making yourself more likely to get hit with a flood by buying lots of flood insurance. The level of flooding is determined by something else called the weather. And if a place is not very prone to flooding, rest assured there won't be many people buying flood insurance on their homes.

The Greek government's fiscal irresponsibility is responsible for Greece's debt problem, not the institutions who were concerned about what they saw happening and who were acting accordingly to protect themselves against it.