Europe Should Not Curtail Credit Default Swaps

Greek Prime Minister George Papandreou claims to have discovered the culprit behind his country's economic misery, and last week he laid out his indictment. In a speech in D.C., he blamed hedge funds and other speculators for driving up the borrowing costs of his cash-strapped nation. In particular, credit default swaps--financial derivatives that act like insurance for bondholders--are a "scourge that haunts Greece and all of us," he said. By mid-week, German Chancellor Angela Merkel and French President Nicolas Sarkozy took up the baton and published a letter urging the European Commission to consider a ban on CDS speculation.

But if Europe curtails the use of these and other derivatives, it will hurt, not help, the continent's sickly economies. To start, there is simply no evidence that swaps were really to blame for the Greek crisis. The German financial regulator, BaFin, said as much when it released a report on Greek credit default swaps last week. It turns out the volume of activity in the Greek swaps market stayed constant at about $9 ­billion since mid-January. If there had been any meaningful speculation going on, that number would have spiked.

Instead, it seems that the swaps had been used exactly as they were intended: as a hedge against a country whose balance sheet looks more like that of a emerging-market basket case than a mature European power. Papandreou might complain of the pressure imposed by these hedgers, but other EU leaders would have had a much harder time forcing Greece to undergo essential--but painful--reforms without the market's cajoling. After all, despite the common currency, Brussels can't force Greece to slash spending or raise taxes without the consent of Athens. "The one option that Europe's leaders really had," says Jon Levy, an analyst at the Eurasia Group, "was to beat Greek officials over the head with the yield spreads and CDS prices." In other words, the EU was able to persuade Greece to submit to European budget requirements only after the market got a good whiff of the country's balance sheet--and held its nose in disgust. Now, as the sovereign debt crisis moves on to new countries, expect to hear leaders in Portugal, Spain, and beyond angrily denounce "speculators." In Brussels, however, officials should be quietly cheering them on.