"On Asymmetry, Reflexivity and Sovereign Default"

Rajiv Sethi draws a connection between reflexivity theory, risk/reward asymmetry, and the question of whether naked credit default swaps should be restricted:

On Asymmetry, Reflexivity and Sovereign Default, by Rajiv Sethi: One of the most rewarding aspects of blogging is that it gives me the opportunity learn from those who read and comment on the ideas expressed here. ...Macroeconomic Resilience ... left a couple of very helpful comments in response to my recent post on credit default swaps.

MR pointed out that the idea of multiple self-fulfilling default probabilities plays a key role in George Soros' theory of reflexivity, and linked to an article in which Soros interpreted the Lehman bankruptcy in precisely these terms. In fact, it is a combination of reflexivity and a particular kind of risk/reward asymmetry that gives rise to what Soros calls self-validating bear raids:...[long Soros quote]...

Soros' point about risk/reward asymmetry directly answers one objection to curtailing purchases of naked credit default swaps, namely that such contracts "provide identical leverage both to the optimistic and the pessimistic side of the transaction." Leverage may be considerable on both sides of the contract but this does not mean that market clearing prices reflect optimistic and pessimistic beliefs in equal measure, because the spreads at which sellers are willing to enter the contract must offer them adequate compensation for the significant downside risk that they face.

MR does not consider reflexivity to be a routine problem in credit markets, arguing that "only when the entity is in a state of low resilience that markets are sufficiently reflexive to push it over the edge." This is also David Merkel's view of the matter:

... if a company or government has a strong balance sheet, and has a lot of cash or borrowing power, there is nothing that speculators can do to harm you. You have the upper hand. But, if you have a weak balance sheet, I am sorry, you are subject to the whims of the market, including those that like to prey on weak entities. Even without derivatives, that is a tough place to be.

But what causes a balance sheet to become weak? In the case of sovereign states, it could be widespread tax avoidance and excessive spending relative to revenues, as has been alleged in the case of Greece. But it could also be a significant decline in economic activity that reduces the tax base and triggers automatic stabilizers. This is how Paul Krugman interprets the experience of Spain, which had a budget surplus three years ago, but "is running huge deficits now [as] a consequence, not a cause, of the crisis: revenue has plunged, and the government has spent some money trying to alleviate unemployment."

Any attempt to raise taxes or cut spending in this environment could make it even harder for the country to meet its near term debt obligations. ... As a result, raising tax rates or trimming expenditures (such as unemployment benefits) in the face of severe deficiencies in aggregate demand can worsen rather than improve its balance sheet position.

Under such circumstances, it is terribly important to determine whether the looming threat of default is simply one of several possible equilibrium paths. As Felix acknowledged in his response to my post, it is true in principle that "a company or country can find it easy to repay debt when spreads are low, thereby justifying the low spreads, while finding it hard to repay debt when spreads are high, justifying the high spreads." Default under these conditions would be terribly wasteful, and I can see no reason why attempts to avoid it should not be pursued vigorously.

Paul Krugman also discusses "the possibility of multiple equilibria in sovereign solvency."