Arnold Kling  

Financial Crisis, Phase Two

In Defense of Extreme Melioris... From Poverty to Prosperity<...

Carmen Reinhart talks to the WSJ.

historically, following a wave of financial crises especially in financial centers, you get a wave of defaults. You go from financial crises to sovereign debt crises. I think we're in for a period where that kind of scenario is very likely. I don't think a repeat of the fall of 2008 is at stake here, where it looks like the world is going to end. But I do think there is still, for reasons that are beyond me, quite a bit of complacency out there. Eastern Europe is another source of concern, and Europe has limited resources. You can rescue one. You can maybe rescue two. But you can't rescue all of them. The Baltics are very vulnerable. Romania is vulnerable. Hungary is vulnerable. Problems in these countries feed back to their lenders. Austrian bank exposure to Eastern Europe is great. The Italian exposure to Eastern Europe is great. The Swedish exposure is non-trivial.

It's probably not a good idea to position myself to the pessimistic side of Reinhart, but I am tempted to do that. I think that at this point, a wave of sovereign debt crises would make the 2008 Lehman-Freddie-Fannie-AIG collapses seem like a walk in the park.

Psychologically, there is no worse time to hit someone with a new problem than just after they think their troubles are over. The markets have been thinking that we've put the financial crisis behind us. I do not think that investors and taxpayers have the stamina to go through another round of collapses and bailouts.

The key indicator to watch will be the interest rate on Treasuries and the value of the dollar. So far, the rumblings in Europe seem to be causing people to once again flee to the good old U.S. of A. But I'm not sure how long people are going to feel comfortable with putting more of their eggs in the U.S. Treasury basket. My guess is that the expiration date on our "safe haven" status is no longer measured in years, but in months. Or it could be weeks.

Have a nice day.

Comments and Sharing

COMMENTS (9 to date)
N. writes:

So, let's say I want to hedge against a US sovereign debt crisis.

What are my options?

Mark writes:

So what becomes the safe haven?

mark writes:

In these (hopefully short) periods when panic abroad drives investors to US Treasuries, shouldn't Treasury take advantage of it by lengthening the maturies of what it issues?

Stephen W. Stanton writes:

I agree 100%.

The USA has benefited from the relatively worse positions of the other major economic powers. EU/UK fiscal, monetary, and financial sector problems are certainly no better. Japan's malaise shows no sign of improving. China's problems are just beginning to show up as the tiniest blips on the radar. The Middle East is dealing with massive losses from mis-allocation of sovereign wealth plus overly optimistic oil price forecasts in 2009.

In this global environment, investing in the US was the default option. The deteriorating fiscal picture and gloomy labor conditions are beginning to seriously challenge that assumption of relative safety.

There are lots of people like me, "going Galt, hoarding cash, etc. In the worst scenario, we are just at the front of the stampede away from the US as it goes through a much rougher patch. In the best scenario, we represent "dry powder" that will come back when conditions improve... Helping growth stats a lot at some indeterminate point in the future.

Prashant writes:

So far, the rumblings in Europe seem to be causing people to once again flee to the good old U.S. of A. But I'm not sure how long people are going to feel comfortable with putting more of their eggs in the U.S. Treasury basket.

To echo Mark's question, where are investors going to put their eggs then -- if the Euro is ruled out?

a) the yen
b) gold
c) renminbi
d) something else

Joe Calhoun writes:

Interesting to see that while there was a bit of a rush to the dollar this week, there was a rush out of gold. It seems to me that if people were really worried about sovereign defaults, gold would have been the default safe haven (pun intended). 5 year TIPS spreads are the same now as in mid December so it doesn't appear that there was a deflation (or growth) scare like in the fall of 2008. Maybe this was just an excuse to take profits on some very profitable trades of the last year. Short dollars, long anything with more risk has worked pretty well until a couple of weeks ago.

Yancey Ward writes:


I would argue that lengthening the duration isn't going to be possible. People in a panic want close cash equivalents, not longer term bonds.

Larry Phillips writes:

To my mind the two greatest threats to the international economy are the risk of sovereign default (and the collateral damage it would cause banks and other countries), and the likelihood that a great deal of China's economic growth is, in reality, a real estate bubble. (Protectionism is a major threat to long-term prosperity.) But what's truly frightening is the lack of tools in the USG's arsenal to offset these potential events, should either -- or God help us!-- both occur; real interest rates are effectively zero already and additional debt (beyond the unsustainable level we've already built into the baseline) is a non-starter.

jmb27 writes:

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