While thinking about the CDS model in general and the Greek situation in particular, I realized that I left out a key variable from my previous analysis: Net Debt Interest Payments.
This variable should be very useful, as it implicitly measures net debt as well as the part of the deficit that isn’t changed by fiscal policy. It also measures interest rates in the previous time period, so the information content contains last year’s CDS prices as well. While using data on which countries were considered at risk last year’s will give us a good idea of which countries are at risk this year, it only helps so much because it doesn’t explain why the country was in trouble in the first place.
However, this is a good example of Soros’s theory of economic reflexivity. Countries that the markets see as having problems have to pay higher interest payments, making their fundamentals deteriorate further, which in turn drives interest rates even higher. It will be interesting to see how Greece breaks out of this vicious cycle.