The PIIG’s Progress
Almost everyone seems to be debating the same issues. Spend less, tax more, or both?
Now perhaps Portugal has made some progress. Hoping to bring its budget deficit down to 4.6% of GDP in 2011, their VAT will ascend to 23%. But will they cut public sector pay 5%? They vote in several days. Last spring, Italy announced a civil servant wage freeze. Meanwhile Ireland, with the highest budget deficit in the EU (Luxembourg was the least indebted in the EU) announced that its spending cuts and refusal to pay into a pension reserve fund were achieving some success. Interestingly, Spain said it has made progress but, the areas it will not cut include pensions and unemployment benefits. Finally, Greece. Maybe some progress with spending cuts but tax revenue is a challenge.
What does all of this mean? Markets are not optimistic. The price of insurance, a credit default swap, on PIIG’s debt has risen.
The Economic Lesson
A credit default swap is like an insurance policy. Instead of diminishing the impact of a house fire or a jewelry loss, this kind of insurance lowers the risk of a financial investment. Yes, credit default swaps were central to AIG’s financial debacle because AIG sold much more “insurance” than they could possibly cover. Managed appropriately, as described in this econtalk discussion, credit default swaps perform a valid financial role.