By Brandon Keim
A new analysis of the Greek debt crisis claims to have quantified what many people intuitively believed: That a spike in debt prices in 2011 didn’t reflect a rational market appraisal of the country’s economy, but a panic that worsened an already dire situation.
It’s still a preliminary analysis, and not something on which policy should be based, but the underlying premise is intriguing. Perhaps it’s possible to determine precisely when markets tip from equilibrium, a state in which prices reflect supply and demand, into irrationality.
“It’s not enough to have a sense that they might not be in equilibrium,” said Yaneer Bar-Yam, president of the New England Complex Systems Institute and co-author of the new analysis, released Sept. 27 by NECSI. “You have to be able to quantify it. That’s what we’re after.”
Over five months following the summer of 2011, the value of Greek bonds — financial instruments predicated on Greece’s ability to repay its loans — plummeted from 57 percent to 21 percent of face value, signaling a crisis of confidence among banks and investors. The market had spoken, driving up interest rates on existing loans, making it harder for Greece to borrow more money, and increasing the likelihood of Greece defaulting altogether on its debt.
Unresolved was the extent to which the bond market’s precipitously low valuation of Greek bonds actually reflected the country’s underlying problems, its decades of political misrule and culture of tax evasion, and how much was a self-perpetuating, self-fulfilling panic.
“You look at the decline and say, ‘This just doesn’t make any sense!’ The economic conditions in Greece didn’t change that much. If the market’s evaluation of the probability of default in August was 1 in 3, how can it become 4 in 5 just five months later?” said Bar-Yam. “What do you do to scientifically disentangle this?”
‘The interest rates should have increased more rapidly, but they shouldn’t have gone haywire.’
Bar-Yam and co-author Marco Lagi started by trying to find a baseline, long-term relationship between bond prices and the various factors that might influence them: the size of Greece’s debt, the strength of its economy, consumer volatility, and so on. If they could find such a relationship, it would ostensibly show how the market behaved while in equilibrium.
Looking at the last decade, Bar-Yam and Lagi measured a very close correlation between bond prices and the ratio of Greece’s debt to its economic productivity, or gross domestic product. This debt-to-GDP ratio is one of many metrics used to assess national solvency, but Bar-Yam and Lagi found that it mattered more than any other.
This allowed them to infer how bond markets had estimated Greece’s risk over time. The risk had risen in a relatively linear pattern since 2002, and followed a trajectory that pointed to default in 2013. Until 2011, bond prices had predictably followed this risk.
According to Bar-Yam and Yagi, the sudden divergence between bond prices and default risk late in 2011, more than a year before default was imminent, signified the market’s transition from rational calculation to irrational herd panic, with individual investors reacting to each others’ jitters rather than economic fundamentals.
“The interest rates should have increased more rapidly, but they shouldn’t have gone haywire. They should have continued to follow the curve,” Bar-Yam said. “It’s natural for people to panic together, but now the market’s out of equilibrium.”
The implication, said Bar-Yam, is that Greek austerity programs — budget cuts, reductions in social services, and other belt-tightening national measures — were perhaps harsher than they needed to be, and may not have been so desperately required as markets suggested.
Similar lessons might be applied to debt crises in Spain, Italy, Portugal and Ireland. Moreover, to the extent that a Greek credit default threatened the entire global economy, the threat had been partly based on a panic.
“The potentially devastating consequences of a nation’s default for itself and the global community demonstrate the urgent need for quantitative models” of market behavior, wrote Tobias Preis, a professor of finance and behavioral science at the University of Warwick, in an email. Preis called the analysis “new and illuminating.”
Jeffrey Fuhrer, researcher director at the Federal Reserve Bank of Boston, struck a cautionary note. “I wouldn’t ever take the predictions from a single exercise like that too literally,” Fuhrer said. “Proving deviation from equilibrium is a tricky thing to do.”
With that caveat, Fuhrer applauded the analysis. “They uncover what is an intuitively appealing relationship. It helps you quantify some of the things that people believe are happening qualitatively,” he said.