How Do We Measure the Uncertainty of Government Finance?

Greece is in trouble, and there’s been a bit of a run on Portugal.

Both of these reflect the doubts of private investors internationally about the national public management in these countries.

Governments are financed with bonds, which are owned by private investors. When those investors get nervous, they sell those bonds, driving down the price, and driving their interest rate up.

There are two ways to measure this risk. The direct way is to look for prices for “bond insurance”. A lot of this data is proprietary (i.e., hard to come by at SUU). The indirect way is to look at interest rate spreads between similar bonds issued by two different countries.

The New York Times piece entitled “Fraying at the Edges” showed a plot of those spreads.

Greece is so bad (the top one) that it’s label is off the chart.

The Times doesn’t make it easy to steal their chart to put in this post. For perspective, the peak to the left of the chart is from last summer. So, Greece hasn’t been in good shape the whole time, but it’s gotten a lot worse over the last 3-4 months. Portugal’s problems are much more recent. The dashed horizontal lines indicate spreads of 1% over German bonds — so you get about 1.5% more by investing in Ireland and Portugal. Greece’s spread is around 4% right now.

One example of the direct method is to find an article that looks at the price of credit default swaps (CDS’s). Here’s one about Greece from Business Week.

A credit default swap is a derivative you buy that pays you the full value of a bond if the government defaults on it. If the government doesn’t default, you get nothing. Currently, to insure a Greek bond for 5 years, you need to shell out about 3% of its face value.