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You don't need a fictional alternative universe, you need the real world.

Consider this from the position of a creditor bank in a creditor country where long-term funding costs are 4%.

Debtor country bonds are now selling in the secondary market (and being issued in the primary market) at 10%.

You can fund yourself at 4% and buy the bonds at 10% in the secondary market, pocketing a 6% margin. However, there is a risk of default. If there's a default by the debtor country, you not only don't make 6% but lose your 4%, and the principal.

To avert a default, the creditor government lends money to the debtor country at 7% to pay interest. The creditor country makes 3% margin, and the debtor country can pay its interest. The market is kept in jitters about default risk so the bonds still sell at 10% in the secondary market and the creditor bank can continue to make its 6% margin from buying in the secondary market.

If you allowed the debtor country to buy the bonds in the secondary market 1) the creditor bank loses the ability to buy the bonds at firesale prices to make the nice 6% margin since the debtor country always has an incentive to outbid the creditor bank in the secondary market; 2) if the creditor bank sells the bonds in the secondary market they instanty realise a large loss.

So the game here is:

  1. the creditor country makes seigniorage income;
  2. the creditor bank avoids losses through default or through realised losses in a sale;
So far, so good. The possible scam made possible by forbidding the debtor country from repurchasing their bonds is

  1. the market in debtor country bonds remains illiquid and the bonds cheap for the creditor bank to buy,
  2. the creditor country cannot be outbid by the debtor country for bonds held by third parties;

It is important that the market be kept nervous about the possibility of a default, otherwise the bonds would become expensive again.

Economics is politics by other means
by Carrie (migeru at eurotrib dot com) on Wed Apr 6th, 2011 at 08:42:21 AM EST
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