RESPONDING to that post on ECB attitudes towards Greece, notably towards the possibility of triggering credit default swaps, Kevin Drum asks whether this is "yet another reason we should be wary of CDS."

One of the big knocks against CDS has been that although it's theoretically a perfectly fine idea, in practice it can act as a huge multiplier, turning a bad default that hurts thousands of people into a catastrophic, systemic payout that hurts millions. In this case, it would turn tens of billions of dollars of Greek default (bad) into hundreds of billions of dollars of rolling CDS payouts (really, really bad). But is this really the case?

I haven't read the kind of detailed research Mr Drum is looking for, but I found this speech that ECB executive board member Lorenzo Bini Smaghi gave last week fascinating. Mr Bini Smaghi's general thesis is that neither market incentives nor even strict regulations or common codes of ethics will reliably prevent disastrous outcomes, because even measures that are highly reasonable and responsible at the individual level can provoke systemic catastrophe. One example he picks is credit default swaps. I'm going to reprint a long chunk because it's hard to encapsulate. (My emphases.)

The development of sophisticated instruments, such as credit default swaps (CDSs), helps to better safeguard against certain risks and to propagate the use of certain financial instruments. It is easier to invest in a government bond from a risky country if it is possible to get protection against the risk of insolvency. CDSs therefore increased the liquidity of the market to the advantage of both the issuer and the investor. CDSs can be purchased even without holding the underlying bond. This means being able to safeguard against the risk of default by a company, a bank or a country, even without having invested in them. This creates an incentive to bet on the failure of companies, banks or entire countries. When the number of market participants using such instruments increases, in the short run ceteris paribus premia rise, signalling an increase in the possibility of default and, in turn, sparking greater demand. In the summer of 2008, for example, shortly before the bankruptcy of Lehman Brothers as well as in the weeks following, each financial market participant tried to survive the market collapse through speculative operations which essentially consisted of bets on the failure of other market participants that were in difficulty. This created a spiral effect that contributed to the worsening of the crisis. In short, in today's markets, you not only decide which financial activities to invest in, but also which ones to invest “against”. Moreover, the probability of success depends on the capacity to mobilise other forces in the same counteractive direction in order to induce the price of the bond to fall until bankruptcy is declared. It is therefore no surprise that key investment companies make public their opinions on the quality of various types of investment, perhaps with the intention of encouraging others to do the same. The fight to survive, which in a capitalist system should reward the company with the best product, is changing in nature. Particularly in a period of economic difficulty, when returns are limited, those who survive are those who bet on the failure of others and who manage to convince the market that such a failure is inevitable. It is no longer about Schumpeter's “creative destruction”, but “destructive destruction”, where the one who survives is the one who bets, rather than the one who innovates and produces. The same is true for countries, on which one can bet and cash in the premium in the event of default. The probability of collecting the premium is greater, the more there are who bet against the country. Default by a country brings economic depression, with severe consequences for society and the democratic structure. This system creates incentives to behave in a manner that is not in line with the set of ethics on which the capitalist market system is based.

Again, I don't see the detailed research to back this up, but the way the thesis is put together certainly seems to make sense. Mr Bini Smaghi was also one of the early voices to warn against attempts to pressure the private sector to go along with reprofiling Greek debt. It's interesting to me that a call which seemed on the surface to be a defence of creditors' interests was coming from someone who's actually pretty radically sceptical that market autonomy and freedom of financial innovation always lead to optimal outcomes, rather than quite consistently leading to disaster.