End_full_faith_and_credit

The End of Full Faith and Credit

"Doomsday." "Lehman times ten." "A catastrophe." "A political basket-case." The ways of describing the potential outcome of the current U.S. government debt imbroglio continue to pile up, with the adjectives becoming increasingly descriptive as the clock clicks down to D-Day on August 2. There is no such thing as an orderly default on sovereign debt -- when someone screams "fire," nobody walks to the exit, they run. With over $14 trillion of debt at stake, a U.S. debt default would be calamitous - not only would the U.S government be unable to pay its bills, the cost of borrowing for anything tied to U.S. interest rates would increase around the board. Even worse, the psychological impact of a loss of confidence in the U.S. financial system would have ripple effects around the world for years to come.

If you think about the current financial pillars of the global financial system, they start and end with the United States. For nearly 100 years, the U.S. has been the bedrock of the global financial system, with a rock-solid triple-A credit rating. Even when the U.S. went off the gold standard, the word of the U.S. government was as good as gold. U.S. Treasury bills were the ultimate risk-free assets. The U.S. was the ultimate "safe haven" anytime disaster struck around the world. Take any Finance 101 class, and you'll gain a quick appreciation for why short-term U.S. Treasury bills have become the ultimate building blocks of any asset-pricing model around the world. That's why it's so troubling to see that investors are finally starting to price in the risk of a debt default into their calculations. The risk-free asset is no longer risk-free.

Perhaps more troubling, the major ratings agencies have hinted that a U.S. debt downgrade could be forthcoming, even if the squabbling political parties manage to raise the debt ceiling in time. In a world where investors constantly monitor the trade-off between risk and reward, a debt downgrade is no laughing matter. It is not the equivalent of bringing home a bad report card for the first time (look, mom, I got my first B!) and having people laugh off the matter as an unfortunate turn of events. A ratings downgrade is real. A ratings downgrade has consequences. Investors like to get paid back on time. When they don't, they start to rattle the cages.

Russia financial crisis What's been so, well, bizarre, is how people have largely ignored an impending U.S. government debt default across America. We've assumed from the start that our elected representatives in Washington would figure this kind of thing out without our input. Yet, if you've ever lived in a country like Russia that has experienced default, you'd know how surreal the consequences surrounding default can be. It all happens in slow motion, and people promise a solution up until the final hours. One moment, you're enjoying a great shot of Moskovkskaya Vodka, the next moment, the ruble-dollar exchange rate has fallen out of bed, there's a run on your local bank branch, and your next-door neighbor has started stockpiling capital goods in a madcap attempt to preserve his or her ruble-denominated savings. Things happen quickly.

Manias panics crashes Read any history of the global financial markets, and you'll be struck by how quickly public perceptions can change overnight. One moment your tulip is worth countless numbers of Dutch guilders, the next moment, it's worth exactly zero. Read Kindleberger's Manias, Panics, and Crashes or MacKay's Extraordinary Popular Delusions and the Madness of Crowds. These are literally textbook examples of how a loss of public confidence can lead to unexpected financial consequences.

Rest assured, the end of full faith and credit is about more than just a slight adjustment, a slight ratcheting down, in the way that the world sees us. It is about a fundamental re-thinking of the very pillars of the global economic system. Now is the time to strike a deal in Washington, now is the time to throw away the trappings of bi-partisanship. For now, our kindly debt collectors in China, Japan and the oil-exporting states have stayed on the sidelines, showing their displeasure from afar. At what point, though, do they stop buying our debt? At what point do they start showing up with demands for a "coercive restructuring" of U.S. government debt? The end of full faith and credit is about the loss of our collective financial innocence, the day that we roll over in bed and discover that our sovereign debt bedmates are no longer the United Kingdom or Canada, but instead, Spain or the Czech Republic.

comments powered by Disqus
×