Peso Problems, Ruble Problems, Euro Problems and all Bhat

The Ruble is collapsing. This will do dramatic damage to the Russian economy, because many Russian firms have dollar denominated debts. This is a familiar story. Something similar happened in East Asian countries in 1997 and Russia in 1998. There is no good policy response, because defense of the Ruble based on extremely high interest rates (last I heard 17%) will also cause extreme distress.

I think that it is in Russia’s interests to impose capital controls, which will amount to allowing and forcing Russian firms to default but leave foreign creditors with no legal recourse. Imposing capital controls worked rather well for Malaysia in 1997 and Russia in 1998.

In this post, my interest is in why creditors lent dollars given the fact that Russian debtors would default if the Ruble depreciated. As used by economists, the phrase “peso problem” doesn’t just refer to the Peso. It is the argument that sample averages in available data can be very misleading indicators of expected values if there are rare large events. The example was devaluation of the Mexican Peso. This was back in olden days, when Mexican borrowers borrowed in Pesos and the Peso was pegged to the dollar. Peso interest rates were, nonetheless, higher producing what appeared to be a riskless profit opportunity. Then the Peso devalued. Milton Friedman is given credit for arguing, before the devaluation, that the apparent riskless profit opportunity was no such thing.

The bottom line is that rare extreme events can make it seem that riskless profits have been earned. I use “the bottom line” literally to refer to the profit or loss stated in a profit and loss statement.

It has been argued that people who manage other people’s money, have excellent reason to seek out (or if necessary create) peso problems. Until the extreme event occurs, there are high returns and low measured variance of returns (that is low sample variance in the sample of stuff that has already happened). Such a pattern is highly rewarded. If disaster comes later, it is too late to claw back bonuses. Bankers allegedly sometimes say “IBGYBG” that is “I’ll be gone, you’ll be gone.”

Dollar denominated loans to firms with revenues denominated in another currency are a way to recreate the Peso problem without pegged exchange rates. The knowledge that there is a risk of widespread default implies high interest rates on such loans. The fact that widespread default hasn’t occured implies high performance compared to ex post measured risk. Big bonuses.

Another example is a larger than optimal currency area, that is, the Euro block. The introduction of the Euro caused a huge increase in the flow of loans from Germany to Spain. The Peseta could not realign compared to the Deutschemark. But there could be widespread insolvency instead.

Default is often (typically ?) worse for creditors than devaluation. But fear of possible default in the distant future has not prevented massive foolish lending.
I think this could be the usual problem that people who manage other people’s money who are rewarded based on short run performance have strong incentives to push risk into the lower tail of the distribution. Rare huge disasters aren’t costly enough to them.