Hehe, you are too kind – I suspect you may have talked me into buying it in the past!

I have heard the Cochrane course is great, when it comes to financial regulation I always enjoy his blog posts!

Yes, exactly, I knew someone with your keen eye for trade-offs, preferences and incentives would see that!
That’s the book, when you do get around to reading it please let me know what you think, I’m sure you’ll have a different view from me. Actually he has two courses both good. Another good one is John Cochrane’s Asset Pricing course.

I did know Gorton was involved in that way, but would have viewed someone involved in the creation of the vehicles as having a unique insight into what is going on. However, I can also see how it is possible he may be involved in some “ex-post justification” of his work.

Perry Mehrling you say, is it this book you are mainly thinking of: http://www.amazon.com/New-Lombard-Street-Became-Dealer-ebook/dp/B004QOB45Q/ref=la_B001JSATPI_1_1?s=books&ie=UTF8&qid=1395205338&sr=1-1

I have purchased it, but didn’t get around to reading it before I switched my focus – I will have to one day! I see he has a course on Coursa as well, love those!

Hi Jim,

Interesting stuff. Although I am most of the way there, I am not sure I buy the final bit:

“Policies that result in low interest rates and low costs of default provide incentives for a government to gamble for redemption. The interventions taken to date by the EU and the IMF – lowering the cost of borrowing and reducing default penalties – encourage Eurozone governments to gamble for redemption.”

The key thing is that the behaviour of the national government here reminds me of Lehman Brothers in the year leading up to their crash. They realised they were insolved and made highly leveraged bets knowing that if it blows up it doesn’t cost them anything – but if it works they don’t go bankrupt! In that environment it doesn’t matter what the interest rate is, it is the asymmetry of treatment and expectations of a bailout.

In the case of government sovereign debt we would have a similar dynamic where governments did not expect they would have to take on the liability. As you say, the idea of reducing default penalties will worsen this, but the actual cost of credit may not be an issue.

There were significant institutional issues in Europe, and I have much less of a background looking at that than looking at the specifics of the US end of the GFC. I’ll have to have a peek at the book sometime 😉

The Greeks initially did a fine job in gambling for redemption. Squeezing huge subsidies and debt write-offs by threatening to default! The Irish played by the rules, guaranteed bank bond holders to which that had no obligation and got screwed.

See http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=4877&ref=mobile for “In Chronic Sovereign Debt Crises in the Eurozone, 2010–2012”.

Arellano, Conesa, and Kehoe explain that the deep and prolonged recession in many Eurozone countries creates an incentive the gamble for redemption. This is betting that the recession will soon end. Sell more bonds to smooth government spending in the interim, and, if the economy recovers, reduce the enlarged debt.

Under some circumstances, this policy is the best that a government can do for the citizens of its country, but it carries a risk! If the recession continues too long, the government will have to stop increasing its debt or default on its bonds.

Policies that result in high interest rates on government bonds and high costs of default provide incentives for a government to reduce its debt and avoid sovereign default.
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Policies that result in low interest rates and low costs of default provide incentives for a government to gamble for redemption. The interventions taken to date by the EU and the IMF – lowering the cost of borrowing and reducing default penalties – encourage Eurozone governments to gamble for redemption.