Necessary and Sufficient

In an ACM journal a little while back was a reprint of a very interesting academic paper addressing the problem of allocating a large order efficiently across a number of "dark pools" (alternate trading exchanges).

The approach the authors use is an exploration-exploitation loop whereby they treat the "demand" at each dark pool as a (censored) random drawing from an unknown distribution in the exploration phase, using modified Kaplan-Meier maximum likelihood estimators in the process, and then employ a greedy algorithm to exploit the current information.

It's a very clever approach and worth a read. You can find the paper here. I'm sure it hasn't gone unnoticed by Hedge funds, investment banks and prop-trading outfits!

Legendary investment sage, Warren Buffer, was speaking to a journalist about the financial crisis of 2008 when he came out with a fairly accurate summary of how good ideas go bad. Buffet said... there's a "natural progression" to how good new ideas go wrong. He called this progression the "three I's." First come the innovators, who see opportunities that others don't. Then come the imitators, who copy what the innovators have done. And then come the idiots, whose avarice undoes the very innovations they are trying to use to get rich.

I reckon that cycle applies to many new ideas not just those dreamed up by traders at investment banks.

You can read more on the Harvard Business Review website.

To understand the current sovereign debt problems in Europe one has to understand the monetary policy options available to the government of a sovereign state. Basically, there are several options available to manage national debt:

1. Print More Money
2. Devalue the Currency
3. Raise Taxes
4. Raise More Money
5. Default

Let's run through each of these options and consider how it applies to the current Greek situation, and perhaps soon to Spain and Portugal.

Print More Money

The majority of Greece's public debt is denominated in Euros - the "local" currency - which means that it could simply print more money to pay off its large debts (you can't do this if your debt is denominated in foreign currencies). Printing more of the local currency does have consequences - it causes inflation which effectively reduces the nominal value of all other debt denominated in the local currency.

However there is a problem here. Although technically and legally a sovereign state, the Greek government doesn't have all the fiscal options usually available to an independent nation. Because it uses the Euro, and that is a shared currency with other nations, it cannot simply print more money because that's controlled by the monetary union of the euro zone. This restriction is in place to prevent other member nations from suffering currency devaluations should a member nation decide to print more of the shared currency (Euros).

Problem one.

Devalue the Currency
A government can devalue its local currency to make the domestic currency cheaper relative to other currencies. There are two implications of a devaluation. First, devaluation makes the country's exports relatively less expensive for foreigners. Second, the devaluation makes foreign products relatively more expensive for domestic consumers, thus discouraging imports. This may help to increase the country's exports and decrease imports, and may therefore help to reduce the current account deficit.

However, for the same reasons stated above - the usage of a shared currency - Greece is unable to devalue its "local" currency because its not in control of the Euro.

Problem two!!

Cut Public Spending and Raise Taxes
To increase its revenue intake the Government can raise taxes in an effort to help pay down the public debt. This is politically unpopular and thus most governments are reluctant to consider it, unless backed into a corner. Greece is doing this, but due to the magnitude of public debt it's going to find it quite difficult to raise enough money fast enough using just this option. It's been reported that Greece owes 300 billion euros which represents a public deficit of 14% of the GDP.

Problem three!!! Now into the "options of last resort"...

Raise More Money
Despite having debt problems, in order to service debts falling due Greece needs to raise more money through issuance of Government Bonds however this is a short-term solution at best. Its been reported that Greece needs to raise some 30+ billion Euros just to meets its obligations for the next 12 months. Taking on new debt obviously doesn't solve the problem of indebtedness long term, and flooding the market with sovereign bonds at a time when many investors think a default is likely causes investors to demand higher yields which makes debt raising a very expensive option.

Problem four!!!!

Default on its Debt
Defaulting on its debt would cause Greece's sovereign credit rating to decrease causing it have to pay more for future borrowings, and industry also suffers. But because Greece is a member nation of the Euro zone any default on its behalf also affects other euro-nations like Germany, Spain, Portugal, and Italy.

A default is likely unless a sufficient large bailout package from the IMF and/or other Euro-nations gets put in place along with other measures. The 3-year 110 million euro package currently on offer courtesy of the IMF is a good start!

Conclusion
Moral of the story... if you let your debt get out of control you are in for a lengthy period of financial hardship to recover. Indeed, that is what Greece currently faces, and its citizens will have little respect for the politicians responsible for monetary policy for letting such an unpleasant situation happen in the first place.