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Financial Crisis - Cds and Greece

Essay by   •  February 13, 2012  •  Research Paper  •  5,068 Words (21 Pages)  •  1,767 Views

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1. Introduction

The recent financial crisis has made it clear that there are many issues that need to be examined again. Are countries' economies fairly rated by the ratings assigned to their debt by rating agencies?

There was a time when politicians, academics and professionals were crying for more deregulation and less control form government authorities. The credit default swaps controversy and the grey zone within which their trading was taking place, maybe is an indicator that regulations need to tighten again or that a new system of checks and balances is needed.

In the first part of the paper a historical review is given starting from the gold standard. In the second part key indicators are defined that are used to assess a country's economy and its creditworthiness, followed by the role of rating agencies and the controversy of credit default swaps.

What follows is a closer examination of the Greek economy that was the epicenter of the world's attention, regarding its statistics and the CDS spreads on its sovereign debt.

2. Gold Standard and Bretton Woods

It used to be the case that, gold was used as the medium of exchange because of its properties. Gold is durable, it can be stored, it is portable, and easy to divide and standardize. Mining gold is expensive which makes it more difficult for governments to manipulate its stock. But its most important property was that it offered long term price stability since what it will buy in terms of other goods and services will equal its long run cost of production. These were the reasons why most currencies not in the so long distant past used it gold to define their relative values or exchange rates.

The countries that used the gold standard had to peg essentially the price of their domestic currencies to exact amounts of gold, and they maintained the price of their currency by selling a buying gold at that particular price. (Shapiro A. C., Atulya S., 2009).

The price stability offered by gold was such that price levels during the break out of World War I were roughly the same as they had been in the late 1700s (Mitchell B.R European Historical Statistics Bureau of the census of the United States in Shapiro A.C Multinational Financial System 1996 p. 82).

Governments, under the gold standard could not print money at will. Gold had to be bought before printing. Therefore, the value of the newly printed money was equal to the cost of the obtained gold. Under the classical gold standard disturbances in the price level in one country would be wholly or partially offset by an automatic balance of payments' adjustments called the price-specie-flow mechanism. (Advantages of the Gold Standard". The Gold Standard: Perspectives in the Austrian School. The Ludwig von Mises Institute. Retrieved 8 December 2011. Bordo, Michael D. (2008). "Gold Standard". http://www.econlib.org/library/Enc/GoldStandard.html.)

After the Second World War, a system similar to a Gold Standard and sometimes described as a "gold exchange standard" was established by the Bretton Woods Agreements. Under this system, each government maintained a fixed exchange rate for its currency relative to the dollar or gold. One ounce of gold was set to $ 35. In other words once fixing a currency's gold price, its exchange rate relative to the dollar was also set. The Bretton Woods agreement removed at least a great deal of uncertainty from international trade and investments transactions of the participating countries, thus promoting growth for the benefit of all participants.

Also the functioning of the system imposed a degree of discipline on the participating nation's economic policies. For example a country that followed policies leading to higher rate of inflation than that experienced by its trading partners would experience a balance of payments deficit as its goods became more expensive, reducing its exports and increasing its imports. The consequences would be an increase in the supply of the deficit country's currency on the foreign exchange markets. The excess supply would depress the exchange value of that country's currency, forcing its authorities to intervene. The country would be obligated to buy with its reserves the excess supply of its own currency, effectively reducing the money supply. Moreover as the country's reserve were gradually depleted through intervention the authorities would be forced sooner or later, to change economic policies in order eliminate the source of the reserve draining deficit. The reduction in the money supply and the adoption of restrictive policies would reduce the country's inflation, thus bringing it in line with the rest of the world.

But this was in theory, since the price stability of Bretton Woods was largely the responsibility of the United States. As long as the system remained intact, all currencies were subject to the same rate of inflation as the U.S dollar. If the United States kept the price of gold at $35 an ounce, it would stabilize prices around the world. Unfortunately the Federal Reserve did not arrange monetary policy to keep gold at $35 an ounce. The U.S government had succumbed to the temptation of printing more dollars than it could back by its reserves, despite taking other measures to keep the price at $35 an ounce (issuing nonmarketable Treasury bonds as a substitute for redemption of foreign gold holdings; prohibiting U.S citizens from holding gold abroad as well as at home, eliminated private redemption of gold etc).

Because of the excess printed dollars, and the negative U.S. trade balance, other nations began demanding fulfillment of America's "promise to pay" - that is, the redemption of their dollars for gold. Switzerland redeemed $50 million of paper for gold in July. France, in particular, repeatedly made aggressive demands, and acquired $191 million in gold, further depleting the gold reserves of the U.S.

On 5 August 1971, Congress released a report recommending devaluation of the dollar, in an effort to protect the dollar against foreign price-gougers. To stabilize the economy and combat runaway inflation, on August 15, 1971, President Nixon ordered U.S authorities to terminate convertibility even for central banks and the same time devalued the dollar to deal with the U.S deficit. (Shapiro A.C Multinational Financial System 1996 p85-86, P.D Michaels , F.L David and M.G Peter " Bretton Woods II still defines the International Monetary System'' National Bureau of Economic Research 2009, www.bullion.com Oct 12 2010).

The removal of the gold backing from the US dollar was rapidly followed by the abolition of

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