Arnold Kling  

Loss of Risk-Free Status

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Maury Harris and Drew T. Matus write,


Even a temporary default would eliminate the safe and liquid nature of the U.S. Treasury market, harming this country's ability to exercise its power, to the detriment of the U.S. and the global economy.

The main impact on markets would come from sharply reduced liquidity in the U.S. Treasury market, as financial firms' procedures and systems would be tested by the world's largest debt market being in default. Given the existing legal contracts, trading agreements, and trading systems with which firms operate, could U.S. Treasurys be held or purchased or used as collateral? The aftermath of the failure of Lehman Brothers should be a reminder that the financial system's "plumbing" matters. All the legal commitments and limitations in a complex financial system mean a shock from an event that is viewed as inconceivable - such as a U.S. Treasury default - can cause the system to stall. The impact of a U.S. Treasury default could make us nostalgic for the market conditions that existed immediately after the failure of Lehman Brothers.

Treasury debt is supposed to be risk-free. Every economics textbook says so.

If Treasury debt ceases to be risk-free, the interest rate is going to go up. Also, investors will start to search for other assets to hold for safety. The problem is to find an asset that is stable in price, highly liquid, and widely available. I don't see any asset that satisfies those criteria. If you think that the modern financial system (a) requires a high-volume safe asset in order to operate and (b) is a wonderful thing for the rest of the economy, then you have to view a default as Armageddon.

If you think that maybe our financial system is out of whack to begin with, and/or you think that the U.S. is bound to default eventually, then maybe we are better off having the default occur now. I would be willing to make that case. We have a financial sector that is built on the pretense that the U.S. is fiscally responsible, and we have a reality that says otherwise. The longer that everybody postpones the collision with reality, the more painful the collision will be, no?


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COMMENTS (11 to date)
Noah Yetter writes:

The problem is to find an asset that is stable in price, highly liquid, and widely available.

What's wrong with cash?

Jonathon Hunt writes:

@Noah

He said stable in price, which means something that has not lost ~98% of its value since 1913.

quadrupole writes:

Uhm... Seriously folks... interest on our bond debt is trivially payable out of cash-flow without raising the debt ceiling. The only way we default on tbills is if treasury chooses to default by prioritizing debt service below other spending.

It's not a matter of not having the money to pay, it's a matter of choosing not to.

PrometheeFeu writes:

I don't think the US is bound to default on its legal obligations at all. It will have to default on some of its political obligations (Medicare, Social Security, etc) but those would not eliminate the perceived security of Treasury notes.

Vacslav writes:

>. Every economics textbook says so.

Well, then every economics textbook is wrong.

There are no risk-free assets in the world. Treasuries are dollar-denominated, hence are not risk-free. Money managers believing otherwise are deluding themselves, their clients, or both.

rpl writes:
I don't think the US is bound to default on its legal obligations at all. It will have to default on some of its political obligations (Medicare, Social Security, etc) but those would not eliminate the perceived security of Treasury notes.
I wouldn't be so sure. There are two possibilities for avoiding default, namely raising the debt ceiling and defaulting on "political obligations." Of those two, which do you suppose is the easiest to get through, politically speaking? Obviously the former. You need only look at Greece to see how people react when you take away their benefits (or at Britain, which is facing widespread strikes later this month over reductions in pension benefits). It's a political non-starter. Therefore, if Congress can't manage to put together a deal to raise the debt ceiling, what hope is there that they will be able to prioritize debt service over social security payments? Answer: very little.

As for perception, even supposing we manage to avoid a default, surely the perception that it is likely to create is that the US is a basket case politically. That could well cause people to conclude that Treasuries aren't as safe as they had previously thought. People will be thinking about the next political dust-up, and the one after that. Keep it up long enough, and a default starts to look inevitable. After all, would you have confidence in a government that can smell the gas leak, but is too busy smearing poop on the walls to be bothered to stop for a moment to turn it off before the house explodes? I wouldn't, and I would be surprised if a lot of Treasury holders feel the same way.

My prediction: if the US has to default on any of its obligations, even if Treasuries aren't affected per se, expect to see Treasuries take a hit.

tom writes:

Arnold, what are you talking about as being perceived as riskless today: the TIPS bonds you hold, or all Treasuries?

I've never understood why investors would treat a government devaluing the currency any differently than a government that might not make a payment on the due date.

Sunset Shazz writes:

Stanley Druckenmiller agrees with you.

http://online.wsj.com/article/SB10001424052748703864204576317612323790964.html?mod=WSJ_Opinion_LEADTop

rpl writes:
I've never understood why investors would treat a government devaluing the currency any differently than a government that might not make a payment on the due date.
I've never understood why people with an argument to make can't just make their without feigning puzzlement at the other side of the argument. It defies credulity that anyone could be genuinely baffled that people regard inflation and default differently. In the one case you have an event that is expected and causes mild loss, and in the other you have an event that is unexpected and causes total loss. Gee, I wonder why people treat those differently. What ever could they be thinking?
tom writes:

RPL, with the US, the default we are talking about now would unquestionably be short-term and more about making people nervous than anything else, and the losses would be extremely unlikely to be 'total'. At the same time, inflation of 20% per year could virtually devalue a 5-year T-Note with a low rate of interest.

And you are definitely wrong about 'the other side of the argument'. I wasn't on a side, just asking a question. But thanks for helping out with your wisdom!

Mathieu B├ędard writes:
The aftermath of the failure of Lehman Brothers should be a reminder that the financial system's "plumbing" matters.

Was it really systemic risk or was it that investors were so sure that the gov would never let a SIFI go bankrupt that they needed time to reassess the situation?

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