Tag Archives: Money

Should hedge funds be allowed to short a country’s debt?

A few weeks ago, I wrote about how credit rating agencies had cut their outlook for Italy, and how this was being blamed for Italy’s borrowing costs going up. Well, Italy’s borrowing costs continue to rise, and this time it’s being blamed on the hedge funds. Whenever I see an article like this make the rounds on social media, I invariably see some of the same comments come up: “hedge funds shouldn’t be allowed to bet against a country like that, they’re making money on other people’s suffering.”

First, I think the moral arguments are misguided. When two companies compete with each other and one drives the other out of business, the successful company could be said to be making money on the other’s suffering. But our capitalist system accepts this as the price we have to pay for an efficient economy, and so I don’t see the big difference between that and countries. Should people not have been allowed to short Lehman Brother’s because its collapse would likely harm the American economy? Surely not, so why should Italian government debt be protected in this way?

Secondly, it’s important to realize that the process of shorting is a mutually beneficial arrangement for both the entity doing the shorting and the one lending them the bond. In order for a bond to be sold short, it must be borrowed, then sold, then repurchased and handed back to fulfill the borrow. The borrowing of the bond generates interest, which must also be repaid by the entity doing the short selling. So bond-holders have an incentive to lend out their bonds to short-sellers because this lets them generate interest and therefore income on their bond. If they were not allowed to generate this income, then the bond would be worth less to them and they would not be as willing to purchase it. This would reduce the demand for a nation’s debt and thus would increase borrowing costs, which is something we’re trying to avoid by outlawing short selling.

Third, how would such a short-selling ban be implemented, and what would that affect? The processes that go into a short sale: the borrowing, selling, and purchasing of a bond, are all legal on their own. You would have to write a new, more complicated set of laws therefor to outlaw short selling but not also outlaw these individual practices which seem good and legal. So once you add this new complicated regulation to the market, how many entities will decide that it’s no longer worth it to invest in Italian debt (which has these complicated regulations attached to it) and will instead just invest in German debt (which doesn’t have these complicated regulations). And even if you could ban short-selling EU-wide, then many organizations would just pull their money out of EU bonds and park it into American, British, or Japanese bonds. People think that countries have all the power in the bond market, that they can set the rules because financial institutions need to buy bonds to make a profit. But countries’ bonds are competing with each other, there’s always another bond market people can invest in, and if you want to save Italian borrowing, then scaring money out of the Italian bond market doesn’t seem like the right way to do it.

Finally, short selling is a necessary part of price discovery. Without short selling, markets would not so easily discover the true price of bonds, and so would operate far less efficiently. Again, let’s say you banned short selling throughout the EU. Empirical evidence has shown that banning short selling only increases trading costs and lowers liquidity. That means that if you banned short selling, there would be less money in the market to buy bonds anyway, which again is counter-productive to Italy’s current predicament. In terms of Price Discovery, the failure of price discovery would mean that all prices would tend to converge together, as there is no strong discovery mechanism to discern them. That means the price of Italian debt and German debt would likely converge because investors would not be able to discern their true prices. This would be good for Italy, in fact it is exactly what some people want to accomplish by banning short selling, it might make it easier for Italy to finance it’s debts.

…but it would be bad for Germany. Germany currently enjoys a distinct position as having perhaps the most highly regarded debt in the Eurozone. That makes its borrowing costs very cheap and makes it easy for Germany to finance its obligations. Now, if the EU wanted they could always ask Germany to help out Italy, in fact years ago there was a call for Common European Bonds aka Eurobonds. This proposal would mean that member states could take out bonds which were to be paid back by all members of the EU together, making it easier for states like Italy to get cheap loans (because they were leaning on the German economy) while making it more expensive for Germany to get loans (because they were propping up the Italian economy). It is important to note that this Eurobonds proposal was soundly rejected by the EU and by the Northern EU member states in particular. Absolutely no one was willing to make Germany’s borrowing more expensive for the benefit of Italy.

So with that said, banning short selling would only accomplish what has already been deemed unacceptable. It would cause liquidity problems in the Italian borrowing market, and it could only help Italian borrowing if it also hurt German borrowing due to obfuscating price discovery across the EU. So why even do it? If Italy truly truly needs help financing its debt, the idea Eurobonds would accomplish exact what is desired without harming the bond market.

Did credit rating agencies make Italy’s borrowing costs go up all on their own?

Yesterday I discussed how credit rating agencies work and why they are a healthy part of a mature bonds market. To recap: credit rating agencies like Moody’s, Fitch, and S&P rate the creditworthiness of nations based on economic and political indicators, and publish those ratings to investors. Investors in turn pay for these in-depth credit ratings to decide exactly what bonds they should invest in and how much. Investors are willing to invest in lower credit-worthy bonds, but will only do so if they can get a higher interest rate due to the higher risk involved. That’s why it is big news when a ratings agency cuts their rating of a country’s bonds, such as Italy. This should directly translate into the market seeing Italy as a riskier investment and thus demanding higher interest rate to buy Italian bonds, forcing the Italian government to spend more and more money servicing its debt and deficit.

That’s the simple part but it doesn’t always work like that. Here for instance is the “spread” between Italian bonds and German bonds, it can be seen as how much more Italy has to spend to service its debt than Germany does. Germany’s bonds did not have any cut in outlook so they should be fairly stable, while Italy’s outlook was cut so it should have even more expensive bonds, right? Well not in this case, Italy’s outlook was cut on August 5th and since then Italy’s borrowing costs have gone down relative to Germany’s. Now I don’t want to ascribe too much to any one thing, analysts have a tendency to over-analyze market moves, but there is a sort of pattern that is often called “buy the rumor, sell the news.” In this case, investors expected Italy’s credit outlook to be cut, so they expected Italy’s bonds to get more expensive. They thus invested in such a way that the price of Italian borrowing went up prior to the actual cut, and then went down after it happened. Regardless, even with this messy pattern it’s hard to say that Moody’s alone was responsible for any increase in Italian borrowing cost, there’s clearly more to it than that.

And that’s an important caveat to the bond markets, Information from Moody’s and other ratings agencies are of course used by investors to inform their decisions, but they aren’t the only thing used. Indeed, Moody’s can sometimes seem reactive rather than proactive, it cuts a country’s credit rating after the country’s borrowing cost has already gone way up due to other economic or political news. Moody’s and the credit agencies are I think a big easy target for financially illiterate commentators because they’re easy to blame. The big bad American ratings agencies cut our credit score and made it more expensive for us to borrow. But these agencies are just one cog in the much larger bond market, and the individual actions of thousands of investors big and small is what causes the change in borrowing costs. If no one trusted Moody’s they wouldn’t have any effect on the bond market, and if they weren’t seen as trustworthy raters of bonds then no one would trust them. But Moody’s doesn’t have the kind of power and authority that its detractors ascribe to it, and Italy’s borrowing costs are expensive for many, many reasons that would not be fixed by Moody’s giving them an Aaa credit rating.

Do credit ratings agencies have too much power?

Recently, the credit ratings agency Moody’s reduced its outlook for Italy from “stable” to “negative”.  For those of you who don’t remember, ratings agencies were some of the key “villains” of the Eurozone crisis of the 2010s.  A ratings agency is simply a company who does research into the creditworthiness of people, organizations, or governments and then sells this information to lenders and investors.  Moody’s is one of the “Big 3” ratings agencies and so its ratings carry a lot of weight, whenever it cut its rating of Italy, Spain, or Greece, lenders would take notice and would consider those countries to be less creditworthy.  This in turn made it harder for those countries to borrow money to cover their expenses, just as an individual with a low credit rating has a harder time getting loans and has to pay higher interest on what loans they can get.  And for countries that were already saddled by high debt, this could be catastrophic.

Whenever Moody’s or another ratings agency cuts its ratings for European debt, the cries arise from various places that these ratings agencies are bad actors who must be reigned in.  People say that they are untrustworthy, they are profit-seeking, and worst of all they are American.  Because of all these things, they should not have this much power over the borrowing costs of European countries.  I think that while there are multiple criticisms to be made of ratings agencies (and I will try to address them later), at least some of this criticism comes from a place of ignorance and I’d like to address this.  

Let me first give a very brief explainer of how a ratings agency like Moody’s works in the context of government bonds.  A bond is basically a loan to a government, when you buy a bond you hand the government some money in exchange for their promise to pay you back over time.  So in a bond market you have the bond sellers such as Italy, and the bond buyers such as the banks and money funds.  Like any loan a bond has an inherent risk, a country that is more likely to not pay back its debts is seen as a riskier investment and must pay higher interest rates in order to sell its bonds on the market.  A government might confidently believe that there is zero risk in their bonds and thus they should only give the absolute minimum of interest rates, but if the market disagrees then no one will buy that government’s bonds and they won’t be able to raise money this way.  But how do the bond-buyers know which governments are less or more likely to pay back their debts?  Ratings agencies like Moody’s look at both the political and economic situations of the governments and come up with a rating, that rating says how risky the bond is and thus how likely it is to be paid back.  That in turn informs the market actors, who will demand higher interest rates for riskier bonds then for less risky bonds.

First of all, ratings agencies aren’t evil entities who make borrowing expensive for the lols, they are simply an element of the division of labor of modern finance.  Financial organizations, be they banks or pension funds or what have you, want to invest in stable, high quality bonds.  But if every bank and fund needed an entire team of analysts to assess exactly which bonds were high quality and which were not, there would be a lot of wasted labor as competing banks paid different people to find the same information.  Instead, banks outsource a lot of this investigation to the ratings agencies like Moody’s, then buy the information provided by Moody’s and use it to understand which bonds they want to invest in.  That in turn is a money saver and so the expenses of the bank or fund are a lot lower than they otherwise could be.  This division of labor is a godsend to modern finance, and to remove it for no reason would not be wise.  Moody’s provides a genuine service, it researches the economies and outlooks of almost every major government and investible corporation, and it has built a reputation of trustworthiness over its long history.

Second of all, ratings agencies have a lot of power in part because the market gives it to them.  Market actors such as banks and funds trust Moody’s and the rest of the Big 3 because of their long history of accurate ratings, or at least being more accurate than their competitors.  Those market actors use the information Moody’s provides to inform their investments, but Moody’s isn’t forcing anyone to raise the price of Italian borrowing, the market actors demand higher costs for Italian bonds in part because they trust Moody’s ratings and Moody’s says Italy’s outlook is not as good as it once was.  If you create a new organization, it wouldn’t necessarily change anything because a new, unproven organization would not be trusted.  The market would still trust Moody’s ratings more and thus Moody’s ratings would inform the price of bonds, this new organization wouldn’t.  You can’t really force every market actor to not use information from Moody’s.  I mean you can try, governments can always write laws, but enforcement of this kind of information ban would be a nightmare and would probably only cause bond-buying entities to flee from the EU bond market altogether because they wouldn’t want to fall afoul of new laws but also don’t want to buy a bond that they don’t know if it’s trustworthy or not.

Thirdly, trying to replace Moody’s is not an easy task and I’m not sure most of the detractors are up to it.  As I said, they only have power because the market gives it to them, so let’s say you put together a “European Moody’s” let’s call it Euddie’s (pronounced YOO-dees), then what?  Euddies won’t have the long track record of Moody’s, it won’t have the trust of the market, and so no one will buy their ratings or use their ratings to inform decision makings.  Instead they’ll just keep using Moody’s ratings and there will be no change to the borrowing price for European countries.  Furthermore, who will run Euddies?  If it’s a private company like Moody’s then you run into the exact same criticisms that people have for Moody’s ie it’s profit focused and shouldn’t have this much power over governments.  The only difference would be the nationalist complaint that Moody’s is American and Euddies wouldn’t be.  On the other hand if Euddies is an EU-level government entity, then who outside the EU would trust them?  EVERY government in the world says it is perfectly creditworthy up until the moment it defaults, so why would investment organizations trust an entity that is controlled by the very governments it is supposed to be rating?  In all likelihood without stringent ring-fencing between Euddies and the governing bodies of the EU, it would be seen as just another government agency like the ECB, without the trust that Moody’s has.  Finally, I don’t think Euddies will solve the problems that Moody’s detractors think it would, nations like Italy are still heavily indebted with poor economic outlooks, any reasonable credit agency will not give them AAA credit rating no matter where the agency is based or who runs it.  There is every reason to believe for instance that Moody’s ratings are as much reactive as proactive, oftentimes borrowing for a country will get more expensive before Moody’s even cuts their outlook.  So I don’t think that a Euddie’s organization giving preferential treatment to European government bonds would really change their borrowing costs when Japanese, American, Chinese, and all non-EU investors will continue to believe that those governments are not as creditworthy as they claim to be.

In conclusion, Moody’s and other credit rating agencies are not bad actors in the market, they are performing a legitimate service for other financial institutions and cannot be simply removed or replaced without serious consequences.  Tomorrow I will try to touch on the differences in borrowing costs between Italy and Germany, and how Moody’s ratings have fit into that.

Capitalism 2: A game that makes you appreciate loans

I’ve played a lot of video games in my time, and let me tell you Capitalism 2 is a doozy.  You can get it on the Steam store for about 10 dollars and that’s about what it’s worth because it’s decades old and the UI is painful.  Still, I’ve played a lot of it and it does help you appreciate some nifty real-world concepts.

For those of you who have never played it (ie everyone), Capitalism 2 is a game in which you take control of a large corporation with nothing more than a few million dollars and a dream of riches.  You then use that money to try to turn a profit by manufacturing and selling one or more of the games 50 or so unique goods.  There’s food items, furniture, electronics, cars, and they all have their own production chains and sales strategies for you to manage.  Food items are all about quality and price so you just need to invest a lot into your farms and try to outcompete your competitors.  Designer clothes are all about branding, so you need to spend millions of dollars on advertising to gain market share.  While electronics require investment into R&D before you can even begin to try making them.  It’s kind of fun to throw down with a few AI companies and compete to turn $1 million into $1 billion, but if the game has taught me one thing it’s that loans are overpowered.

A loan, both in game and in real life, is a way to get money now in exchange for money later.  While the total amount you’d have to pay back is greater than the face value of the money you get loaned to you, you can do a lot of things with money now to make that be a net gain.  You can invest it, start a company, build a factory (if you’re a corporation), and all those things can net you a bigger gain than the interest and principle you will need to pay back.  The difficulty is of course that the real world is a world of uncertainty, you don’t know for sure if your investments will pan out or your factory will work, you’re taking a risk and that risk includes a downside.

In Capitalism 2 however there is near perfect information so most of the risk doesn’t exist.  You know instantly what the price of every good on the market is and how they will change in the future.  You know exactly who your competitors are and usually you know what they’re building.  With perfect information there is almost zero risk, and with zero risk there is never a reason not to max out your available loans to build new factories to make new profits.  The AIs in this game by the way don’t seem to be programmed to ever take loans, they wait until they have the cash in hand before ever buying something, so this is a technique only available to the player.  But as I said pretty much any investment is a certain success, so loans are just free capital for the player.  And that’s why they’re so OP in Capitalism 2.

Why do people still try to defend cryptocurrency as being “early” technology? This isn’t growing pains, it’s a scam

Bitcoin was launched in January of 2009, making it roughly 13.5 years old by now.  In that time, it has gone from scam to scam to scam and yet time and again the True Believers make excuses for both it and the entire cryptocurrency ecosystem.  “The tech is still early,” “it’s like the early days of the internet” “any day now mass market use will take off” and it NEVER EVER DOES.  Let’s get some context going:

Google was incorporated in 1998, and by 2008 it had 20 billion dollars in revenue.  Not valuation mind you, yearly revenue

Amazon was launched in 1994, and by 2005 they were offering Amazon Prime, which promised unlimited 2-day shipping on over a million in-stock items for a modest yearly fee

Microsoft was founded in 1975 and by 1985 they launched the Windows 1 which sold over half a million units.

Each of these modern tech giants started small, but had reached mass market appeal in less than a decade.  What does Bitcoin have?  Where is the mass market adoption of Bitcoin as a unit of currency?  Where are the merchants and vendors who take Bitcoin instead of Visa or Mastercard?  Time and again minor partnerships area announced where some sucker claims to accept Bitcoin, Bitcoiners exclaim that this is the beginning of mass adoption, and then Bitcoin is quietly removed from the available payment methods or ends up being the smallest method used by a large amount.  Bitcoin doesn’t compete with PayPal, or Apple Pay or any credit card or payment processor because it sucks and always has sucked.  And mass adoption isn’t right around the corner, we aren’t in the early days of Bitcoin we’re over a decade in and it is still useful for nothing more than scams and ponzi schemes.  Every now and then new stories pop up that *this* time it will be different, *this* will definitely be the start of mass adoption.  And of course every time it’s wrong.  I could go through every year from 2010 to today and find someone claiming that this would be the start of mass adoption too.  It’s always been nothing more than scams and hype.

Do dividends solve inflation?  Yes in theory, who knows in practice.

Congress just passed the CHIPS act giving billions of dollars to Intel, who turned around and cut their fab investments to hand money to investors as dividends.  One of the benefits of CHIPS was supposed to be reducing inflation by increasing the supply of microchips from companies building more fabs.  That obviously won’t be the case if companies follow Intel’s lead in handing the subsidies to their investors as a dividend.  But it made me think of how neoliberal economics believes that inflation is supposed to be self-correcting.

When demand for a particular product outstrips supply, prices will of course rise.  But what are the consequences of a rise in price?  First it means the consumers of the product will have higher costs, but that will incentivize consumers to use less of the product (reducing their demand and thus costs).  If those consumers are companies, then this can act as a market force driving efficiency, companies that can produce the same number or quality of output products while using less of the pricier input products will have an advantage over those who are more hamstrung.  In some ways we are seeing this with car companies offering cars that don’t have the full range of interior knick knacks due to the chip shortage.  If they can still produce a car while using less computer chips, then they will have an advantage over companies that cannot.  This means that the more efficient companies should remain competitive while the less efficient ones get removed from the market, thereby decreasing demand for the chips overall thanks to these efficiency gains.

For producers of the product however, when prices rise the company makes more money.  Now not all that money will be reinvested in the company, a lot of it will be handed back to the shareholders in the form of dividends.  But to neoliberals that isn’t a problem, that’s the solution.  When the company hands big dividends to its shareholders, the price of the company’s stock will rise greatly.  Everyone and their mother will realize that holding that company’s stock will net you a passive dividend income, and will rush to buy up the shares, driving share price up.  As I noted before companies like having a high share price because it gives them a source of money that they control.  They can use that share price to compensate employees and invest in large capital projects, both of which can theoretically lead to higher production either through higher quality/more motivated employees or through more factories or whatever.  And not only that, the return on investment for dividends should cause more money to flow into new companies as well that want to enter the market, because no one can resist those sweet sweet profits.  This higher production means supply increases and the cost of the good goes back down, thus massive dividends from profitable products are supposed to act as a reward mechanism that entices more investors to invest in that sector of the economy.

This paradigm, by the way, is why some neoliberal economists will oppose market interventions to alleviate shortages.  Price controls or rationing of good are supposed to mess up both the demand and supply side of the equation.  If price is controlled then the supplying company can’t make a higher profit, meaning they can’t expand supply and new companies won’t enter the market.  Likewise price controls mean that there isn’t as much gain from being an efficient demand-side company.  Rationing works much the same way as price controls, artificially keeping the price low by constraining demand.

So according to this theory of economics, supply-induced inflation should always be self-correcting.  The high price of chips should have pushed demand-side companies to buy less of them, and supply-side companies to sell more of them, both of which push the price down.  The question is whether any of this works in the real world, and the bigger question is whether the CHIPS act will sufficiently spur investment in fabs considering the money has basically no strings attached.  We’ll have to wait and see if every company decides to act like Intel.

Why do companies give out dividends in the first place?

I took a class on economics in high school, and as part of that class we had a classroom discussion on the stock market.  In that discussion, one of the most confusing parts for me was dividends.  It seemed crazy that companies will just give you free money if you buy their stocks, what do the companies get in return?  Other folks my age were more cynical, they thought that dividends were just how rich people paid themselves to avoid taxes.  Well dividends aren’t free money, and they aren’t *entirely* a tax dodge, they actually play an important part in the stock market.

As stated in a previous post, dividends are one way that a stock has value to an investor.  Even if a stock doesn’t currently give out dividends, there can be an expectation that they will in the future, and as stated the expected value of all future dividends (divided by uncertainty, multiplied by money now>money later) is part of what gives a stock value.  So if companies want their stock price to be high (and thus the value of their company to be high), they will often give a dividend to prop up the stock price.  But why would they care about a high stock price?  The important thing about stocks is that they are a source of money that the company controls.  The company can do a lot of things with stock: it can pay employees in stock, it can raise money by selling stock, it can purchase other companies with its own stock. Money is power, if a company has a whole lot of value because they have a giant stock price, then all sorts of methods to raise money and acquire assets become available.

So dividends aren’t a scam and stocks aren’t a ponzi scheme.  Companies pay dividends in order to have a higher stock price, which they want in order to finance their company’s expansion should the need arise.  These dividends are part of what give stocks value, and they are one of the reasons that no matter what Bitcoiners tell you, stocks are not ponzi schemes.

Why would investors invest in non-voting shares?

I said yesterday that stock has value in part because the investor is owning something real, a tiny part of a larger company.  With that ownership usually comes the right to vote on the direction of the company, but not always.  Some companies like Google, New York Times, and WWE have a dual-share system whereby only certain shares are “voting” shares and all others have no right to vote on the direction of the company.  Or in Google’s case, many shares are voting shares but thanks to “super-voting” shares two people (Larry Page and Sergey Brin) hold 51% of voting rights and can never be outvoted by investors. Why would an investor buy shares knowing they don’t come with any rights?

Well first of all there is still some small amount of rights that come with a share, your ownership must be compensated if the company gets bought.  And of course the share may still come with a dividend or an expectation of a dividend.  But without the ability to change the company by voting, the shareholders have no input on the dividend or the direction of the company in general.  I think that for large shareholders, they still have an expectation that they can move the direction of the company even without voting rights.  BlackRock and Vanguard Group, for example, are some of the largest holders of Google stock, and if they were to exit the company in a hurry it could crash the price.  Now these companies don’t want their Google investment to fail, they want Google to succeed so they succeed with it, but if they believe that the company is hopeless they can always exit in a hurry.  And because they are major investors (and their exit would crash the stock price), they have the ability to talk with Google higher ups on the regular.  This gives them an interpersonal line of communication to voice their grievances and request changes, even if they have no legal recourse to change Google’s behavior.  Google in turn doesn’t want to upset major investors, and so may acquiesce to some things in exchange for investor assurances.

These sorts of interpersonal dynamics go on all the time in the world of finance behind closed doors.  We can read countless examples of them from the 20th century since people retired and wrote tell-all books, but I doubt we’ll get any about Google until those books are written in the future.  But interpersonal relationships between investors and management can be as or more important than the legal framework that regulates them.  Large investors have some amount of power and access with a company, even if using their power by selling the stock would hurt the investor as much as the company.  Meanwhile management wants as high a stock price as possible and so can make an effort to placate the investors.  In this way, at least some investors will still feel that they have input into the direction of the company, even if they can’t change its direction by voting.

Now, with this voting vs non-voting shares, I do think this is neo-feudalism and must be stopped.  The WWE shares, for instance, stipulate that only the descendants of Vince McMahon can ever hold the super-voting shares in the company, any shares sold by them get converted into lower-voting or non-shares.  This allows people to inherit what are basically titles of nobility that no one else could ever have.  Only the descendants of ennobled investors can ever steer the direction of the company, even if they own far fewer shares the the other investors.  Capitalism is supposed to be plutocratic and this sort of hereditary nobility will do more to harm competition than any possible good it could do.  It’s no accident that the poorest countries during the industrial revolution of the 19th century were those that held on tightest to nobility and titles, money can’t compete with inherited rights.

A free market absolutist might claim that you can just start your own business and replace Google or WWE but we all know that’s not how the world works.  Large companies can have an outsized influence to maintain their market share even if there is some modicum of competition so that they don’t count as “monopolies.”  In the end, ennobled families will hold unwarranted power over cornerstones of the world economy, and those cornerstones will be hard to replace due to their sheer size and ability to buy or outlast the competition.  In the end, we’re all worse off.

The president of El Salvador is playing a dangerous game

El Salvador became internet famous about a year ago first when President Bukele declared that they would be the world’s first country with Bitcoin as a legal tender and second when their president began having his government buy Bitcoin as a “sovereign wealth fund.”  But flirtations with the Bitcoin ponzi are not even El Salvador’s biggest problem.  El Salvador owes billions of dollars in sovereign debt, and due to a large government deficit and little hope of improving economic conditions, the debt is currently at junk status.  The status of debt is basically how people express the risk of the debt not being paid back in full, and for El Salvador that risk is very high.  The money markets that have lent money to El Salvador believe it to be somewhat likely that El Salvador will default on its debt, leaving them with either nothing or less than the full amount that they lent, and because of that the debt is considered to be junk status.

What is a default?  A default is basically where a country declares it won’t pay back its debt.  It may be a partial default (we won’t pay back specific bonds) or a “haircut” (we’ll pay back only a certain percentage of what we owe) or a total default (we won’t pay back anything).  But a default leaves the lenders with less than the face value of the debt they lent to the country, and it in turn makes other lenders way less likely to lend money to that country.  Think about it, if you lend a buddy 100$ and he never pays you back, will you lend him another 100$ next time?

Now even junk debt isn’t worthless.  It may be *likely* that El Salvador defaults but it is not *certain*.  So if you hold an IOU from El Salvador, you can still try to make money off of it.  Let’s say you own El Salvador government debt worth 100$.  You think it unlikely that you’ll get back the full 100$ but someone else will buy the debt from you for 20$.  You’re taking a loss by selling the debt instead of waiting for El Salvador to pay up, but the 20$ they will give you is more than the 0$ you think El Salvador will give you, so you go ahead and sell it.  This sort of debt market happens all the time as institutions sell and buy debt based on their expectations of how likely the debt is to be paid back.  As economic conditions improve, the likelihood of being paid back increases and the price of the debt can rise, while worsening economic conditions would make it fall.

The problem is that President Bukele saw this debt market, and he hatched a scheme.  The debt markets think that El Salvador is unlikely to pay back its debt, and so 100$ of debt can be bought for 20$.  Well, thought the president, what if El Salvador just buys back the debt itself?  Now we can wipe away 100$ of debt for just 20$, genius!  Except not really, the debt is trading cheaply on the expectation that it won’t be paid back in full.  Buying it at this discount is an admittance that El Salvador won’t pay it back in full, they won’t pay back 100$ for 100$ worth of debt, they’ll pay back 20$.  In some ways that is a de facto default, and in the future when El Salvador wants to take out a loan (and remember they need loans to cover their deficit), banks will be very leery of giving a loan to a country that basically entered a partial default.  Secondly, President Bukele announced this scheme on twitter, and with this public announcement the price of El Salvador’s debt went way way up.  Obviously a lot of people holding El Salvador’s debt expected to get nothing, so with the public announcement of a buyback they now expect to get something and will raise their prices accordingly.  If the president thought he could buy back all the debt on the cheap, he’s very likely to be mistaken.

I don’t know who advises the president of El Salvador, but it seems like he does financial policy without much understanding of the effects.  By the way, this entire article is written using dollar denomination because El Salvador’s debt is denominated in dollars and dollars are an official currency (alongside Bitcoin). It’s probably one of the reasons El Salvador doesn’t have many economic levers to pull, they don’t control their own money supply.

I don’t think people understand stocks or what gives stocks value, and I think that’s why some people fall headlong into Bitcoin

Let me get one thing clear: Bitcoin is a ponzi scheme and Bitcoin “exchanges” are rugpulls waiting to happen.  There is no value in Bitcoin as an asset; anything it can do, everything else can do better.  But it’s clear that Bitcoin has a hold on people and I’ve seen many try to defend Bitcoin by comparing it to stocks.  Once you accept that Bitcoin is terrible and has no use cases, the only thing left is to claim that everything else in the world is even worse.  I’ve seen the argument made that the stock market is a legalized ponzi scheme taking money from individuals and giving it to corporations, but that argument clearly comes from a place of ignorance. Stocks are a legitimate investment vehicle, unlike Bitcoin, and I’d like to explain why.

First, why does a stock have value at all?  Two big reasons cited are ownership and dividends.  When you own a stock, you have real *ownership* of a small percentage of the company with all the property rights that come with that.  In a very real sense the stockholders can plutocratically vote (plutocracy in this case means 1 share = 1 vote) on the direction of the company. The stockholders have a sort of representative plutocracy in which they vote for the Board of Directors, who then act as the stockholders’ representatives guiding the direction of the company through their chosen CEO.  In 2021 for example, ExxonMobil stockholders led by a group called “Engine No 1” fought to make ExxonMobil commit to new environmental standards and a sustainable energy future.  There have also been cases in which stockholders such as private equity will put up a proposal to replace the board of directors and management staff with someone else in order to turn around the company and bring it back into profitability.  All these things are possible only if you can get the stockholders to agree, and this is the value that owning a share of stock has.

Another reason shares of stock have value is dividends, and here ownership comes into play as well.  If a plutocratic majority of the stockholders want it, they can demand that the company give them more and more of the company’s money in the form of dividends.  The value of the stock therefore is the value of all future dividends, divided by the uncertainty the company will stay in business, multiplied by the fact that money now is better than money later.  Say I hold a corporate stock that gives a yearly 1$ in dividend. I think the dividend is stable, so I expect to receive 1$ per year every year.  So the price of the stock is infinity because I expect to receive infinity dollars?  Well no because there is market uncertainty, I could be wrong about the company for instance, and it goes bankrupt next year. Or the market could change in ways I can’t predict and the company goes bankrupt, there’s no certainty about how long this company will stay in business.  Also, money now is always worth more than money later (even if inflation is zero, I’ll talk about that some time), so the dollars I expect to get 10 or 20 years from now are worth less than and less then the dollar I will get this year.  And so despite seeming infinite, the stock value can converge to a finite amount because there’s no guarantee I get all those future dividends. And of course different people can value a stock more or less based on their own personal appetite for risk.

So the value of a stock is based on real value.  A company has value just as much as say a factory does.  People want to buy the things that come out of it, so owning it gives you something that makes money and therefore has value.  Likewise a company gives money back to its stockholders in the form of dividends.  Now there are many reasons a company would want to give dividends, and likewise reasons stockholders would be OK with not having dividends, but going back to shares being ownership, remember that the shareholders can always demand the company give them dividends if there is a plutocratic majority in favor of it.  So dividends are demanded by the stockholders, given by the company, and the value of all future dividends plus the value of owning a part of the company itself is what gives a stock value for a stockholder.

Bitcoin does not have this value.  There is no dividend, there is no underlying thing of value that you “own” when you own a Bitcoin.  All Bitcoin has is the greater fool theory, the idea that somehow you’ll find someone to buy your Bitcoin for more than what you bought it for.  Greater fool theory isn’t unique to Bitcoin, and at least some percentage of stock market daytraders are only buying in order to sell to a greater fool, but as I said stocks have more than greater fool theory underpinning their value.  Bitcoin only has greater fools, and that’s what makes it a ponzi scheme.