European leaders have denounced speculators for fuelling economic woes, but the evidence suggests other factors are responsible, writes Proinsias O'Mahony

HAVE SPECULATORS driven up the cost of debt in Greece and other troubled European states through the use of opaque financial derivatives? Politicians certainly appear to think so.

The leaders of Germany, Luxembourg, France and Greece have demanded an inquiry into the matter. European Commission president José Manuel Barroso has said he is considering banning such activities, while Greek prime minister George Papandreou has slammed the unprincipled speculators driving the debt crisis.

The mood in Spain is uglier still. Its National Intelligence Centre is investigating whether there is something sinister behind investors’ attacks and the aggressiveness of some Anglo-Saxon media, with one minister protesting that Spain was the victim of an international conspiracy designed to destroy the country’s economic status and, then, the euro.

The controversy centres on trading in credit default swaps (CDS), which offer a type of insurance against bond default. By driving up the cost of CDS insurance, critics allege, traders are causing sovereign bond yield spreads to widen. The rising cost of borrowing then makes default more likely, a scenario that would net big bucks for speculators who have bet against Greece.

The one problem with this scenario is that there’s absolutely no evidence to support the theory.

An investigation by BaFin, the German financial regulator, last week found that there was no massive speculation in Greek CDS, with the net volume of outstanding contracts unchanged since early January.

Data shows there are just $9 billion (€6.6 billion) in Greek CDS outstanding, compared to more than $400 billion in Greek government bonds. A year ago, the figure was $7.4 billion, implying no surge of speculative activity.

Almost three times as much money ($26 billion) is tied up in the Italian CDS market. The Bank for International Settlements says Portugal carries the greatest proportion of CDS positions relative to government debt, although given that the percentage remains tiny (5 per cent), it’s difficult to imagine how CDS traders could exert undue influence on bond movements.

Looking at 10 European states, including the infamous PIGS (Portugal, Ireland, Greece and Spain), the US Depositary Trust and Clearing Corp found that there was $109 billion in outstanding swaps – less than 1 per cent of their combined debt.

A fundamentally unjustified speculative attack would imply that Greek bond spreads are way above fair value. However, research firm GaveKal estimates that sovereign spread movements are nearly perfectly aligned with the levels of fiscal constraint imposed on euro-zone members by the Maastricht Treaty. In other words, the market is doing the job that policymakers could not tackle.

Despite this, George Papandreou demands that Greece has the right to have similar rates of borrowing as other countries.

Riskier borrowers have always paid higher interest rates, however. Greece’s external public debt-to-GDP ratio is the highest in the world, according to former IMF chief economist Simon Johnson.

Its credit rating is the lowest in the euro zone.

A well-publicised history of massaging official figures means that bond investors are wary. There are lies, damned lies and Greek statistics, as commentators increasingly like to note, referring to Greece’s past use of currency swaps to hide the extent of its deficit (these swaps have absolutely no connection to credit default swaps, contrary to what some misinformed critics imply).

Still, politicians continue to shoot the messenger. Many believe there have been malicious rumours. Mr Papandreou said last week that an elected government was being undermined by concentrated powers in unregulated markets, and that interest rates were at record highs despite deep reforms. The reality is that Greek CDS have fallen noticeably since the recent announcement of a €4.8 billion austerity package.

It is eerily reminiscent of 2008, when wild accusations of market manipulation were hurled at short-sellers who had the cheek to question the health of financial institutions. Short-sellers, who profit when share prices fall, were unfairly blamed for the troubles afflicting HBOS, Anglo Irish Bank, Lehman Brothers and a host of other over-leveraged banks.

Indeed, Mr Papandreou and European Socialist Party president Poul Nyrup Rasmussen continue to link the Lehmans fall with short-selling activity.

That notion was rubbished in last week’s 2,200-page report into the bank’s collapse, however, which concluded that Lehmans’s fall was entirely self-inflicted, and that even the short-sellers underestimated the scale of Lehmans’s accounting shenanigans.

So-called speculators were also lashed by Icelandic authorities in early 2008 after CDS movements for Iceland’s banks ballooned. The country’s financial regulator announced an investigation into negative and false rumours about the Icelandic banks and financial system, a sentiment that was echoed by central bank governor and former prime minister David Oddsson (there is an unpleasant odour of unscrupulous dealers who have decided to make a last stab at breaking down the Icelandic financial system, he snarled).

The latest bout of moral outrage appears just as misplaced. The work of Kenneth Rogoff, the celebrated macroeconomist and author of This Time is Different: Eight Centuries of Financial Folly, makes clear that sovereign debt crises typically follow banking crises. Authorities don’t like it when markets police unsustainable fiscal policies, but banning or severely limiting CDS trading will not suddenly bring Greek bond yields into line.

Indeed, a recent Citigroup report warned that investors needing to hedge against Greek economic woes would likely sell or short government bonds if they are prevented from taking positions in the CDS market.

Few would quibble with sensible regulation of the CDS market. The recent political storm is just a sideshow, however.

Like most conspiracy theories, it’s a fanciful concoction designed to obscure a more basic reality: that Greek finances, like those of many other European states, are in a miserable state.