Encefalus

Hi there people,

This time, I am going to talk about a subject that’s the main focus of half the conversations that take place in the country where I live in: Greece. For those of you who don’t read the news, Greece has been on the verge of economic collapse in the last few months. People who had no idea about the economy, or bonds, or bond spreads, suddenly are talking all day long about the economy. The goverment announced big changes in every sector of the state, and everyone is pretty much stressed about the days to come.

The causes that lead to this point are many. I don’t know if there is any solution to the problem. There have been many political discussions and agreements between the members of the European Union, before they agreed on a bail-out plan. Today, Greece agreed to ask the International Monetary Fund for help. It is obvious that the times are tough.

Greece and its neighbours, from Google Earth

However, two things are for certain: economy is a complex system and psychology plays a central role in the economy.

But for some reason, most people seem to have missed that point.

In the last few months, the only thing I hear about on the news are the spreads. Let me explain for a bit what is going on here. The spreads in the European Union are determined as the difference of the bond yields between Germany and another state. A bond  is simply a way for a state or a firm to borrow money from investors.

Greece has a huge debt, a corrupt disfunctional state and needs money in order to make changes and investments. Therefore, it must issue bonds. The problem is that, if the spreads are too high, then it will end up borrowring at interest rates at 5% or 6% which will drive future debt even higher.

So, how are spreads determined? Spreads and interest rates are determined (to make it simple, this is not the exact mechanism) by the relative risk of investment. So, investors believe that Greece is very likely to default on its debt and not return the money it owes to the investors. So, the investor requires a higher interest rate in order to compensate for higher risk.

Greek bond spreads

So, you might think that the spreads and the interest rates are calculated according to some special mathematical formula. Well, those people who have watched this whole story closely, will notice that the main factor that determines spreads has nothing to do with mathematics. The main factor that influences spreads is far simpler, yet produces far more complex results.This factor is simply human psychology.

Men are not rational as neo-classical economics would have us believe. Men are animals. I don’t know all the laws that govern human behavior, but one thing we surely know from psychology is that psychology is characterized by trends that have nothing to do with rationality.

Human psychology…

I have discussed this topic in previous articles (Behavioral economics revisited in the face of the recent economic crisis , A different view on economics: maybe all we really need). It is good that this realization concerning economics has gone mainstream, as I have witnessed through quite a few articles lately. One recent development that caught my attention was George Soros’ new Institute of New Economic Thinking.

George Soros is spending about $50 million to create the Institute of New Economic Thinking. Soros is a proponent of the theory that markets are irrational. In fact, he has attributed his whole success to this belief. Financial Times offer a series of lectures given by Soros at the Central European University at http://www.ft.com/indepth/soros-lectures. Unfortunately, Financial Times requires you to suscribe to read more than 9 articles per month.

George Soros

Soros discusses how his teenage years and his father’s experiences affected his view on life. Soros shows a deep interest in philosophy. However, as it seems, most people didn’t find his philosophical theories so attractive, so, at some time, he decided to stop dealing with philosophy and just make money, believing that maybe his theory was not so good after all. The recent crisis however, he says, has reinvigorated his belief that maybe he was right after all.

His main philosophy which he calls General Theory of Reflexivity revolves around how the environment, as we perceive it, affects us, and how, in turn, we affect the environment. It is certainly not the only such philosophical theory that exists and I am not going to deal with it right now. What I find more interesting, is how more and more people realize that psychology is a main factor in economics.

Three more articles from Financial Times bring to the front how faulty is the assumption that economics can be analyzed only by mathematics alone, and are trying to bring the problems that economic theory faces to the front: Mathematicians must get out of their ivory towers , Economics may be dismal, but it is not a science , The emotional markets hypothesis and Greek bonds.

All this makes me somewhat depressed about the economic situation in Greece, in Europe and in the world in general.

It’s not just the problems that economics face as a science that make me worry. It is how the whole economic and financial system is structured upon wrong beliefs. The global monetary system is not structured upon mathematical models that converge to an equilibrium. The global monetary system is structured upon the psychology of people, upon the psychology of the herd that feels fear, shock, awe, rage and creates bull and bear markets, booms and busts.

I’ve watched the markets the last few months that Greece is trying to borrow money in the form of bonds. The slightest rumour has the power to catapult the spreads or lower them. Greece has fighting with the markets in a constant fight to borrow money. But the markets are like an ancient greek god with a short and volatile temper, whose intentions and mood are hard to decifer.

The markets are pretty much like like Liam Neeson in "Clash of the Titans"

Furthermore, Greece is not a firm. Greece is a country and is comprised of 11.000.000 or so, people. How can a country’s prosperity depend on the mood of a bunch of corporpate vultures, investment banks and the occasional speculator? Today, that Greece agreed to ask help from the IMF, I heard that a basic factor in this decision was that Moody’s decided to downgrade Greece’s credit rating. What kind of system is this that allows a bank or any financial institute to have that much power over a country? In the end, at whose benefit does this system work for?

I really don’t know.

Well, we don’t have any kitty… maybe you could spare a dime…

This entry was posted on Friday, April 23rd, 2010 at 6:27 pm and is filed under Economics. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.