Arnold Kling  

A Fragile Financial Order

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Tyler Cowen writes


Of the world's share of AAA sovereign debt, we issue 59 percent of it. (Next is Germany with ten percent and then France with nine percent of the total.) You can read this a few ways:

1. Wow, we really abuse that AAA privilege.

2. Losing the AAA rating would spell disaster for repo markets and the like.

3. The world trusts us enormously, isn't that wonderful?

4. All of the above.


I would say "read the whole thing," but you just did. Sorry Tyler, but it was too pithy to excerpt. I will toss in

5. The international financial order is based on people treating the U.S. as AAA from a credit standpoint. This has essentially nothing to do with the credit rating agencies. It may not have much to do with how the debt ceiling theatrics unfold. But at some point, investors may become convinced that the U.S. just does not have the will to fix its budget. If that happens, then the international financial order will collapse, and something else will have to pick up the pieces. I see the Kipper- und Wipperzeit as the relevant precedent.



COMMENTS (11 to date)
Dan Carroll writes:

Generally, I liken it to the Japanese debt levels - Japan is able to carry a very high debt load because the holders of Japanese debt have no alternative. In the case of the US, it is a combination of sovereigns who are linked to the US via a trade promotion strategy that necessarily results in large holdings of UST's, and a domestic financial system that uses UST in lieu of cash (not a stretch, given that UST and cash both pay no interest). If China unwinds their position, they break their exchange rate and their export sector sinks. Incidentally, that would reverse the trade balance and, indirectly, the US budget deficit.

The debt ceiling has no economic meaning - it is a legal technicality. Holders still get will paid with interest, but the concern is over whether it will trigger selling over technical reasons.

I wouldn't give too much credit to the rating agencies - their influence is, again, legal and technical, not economic. The US financial situation is apparent to all but the brain dead.

Clay writes:

Just wondering... Doesn't the AAA rating just mean that investing in the US is relatively safe - not absolutely safe? What if all the relative ratings are more or less correct, but the average rate to borrow money is too low? Wouldn't that manifest by too many countries accumulating too much debt? Isn't that pretty much the situation we are looking at?

So you know, just because we have a self defeating legislature doesn't mean that many of the fundamentals aren't relatively strong...

Jeremy, Alabama writes:

I don't think the Chinese or Saudi's need Moody's to tell them what risk premium to demand from the US.

AAA rating is needed only so that it is "investment grade", a regulation required by our government for certain institutional investors. Presumably, they can amend this to say "AAA, and US debt" and finesse the whole thing.

foseti writes:

5 is totally correct.

Most regulations and policies/procedures have USG debt in a separate category from AAA rated securities.

All you Mason guys that love markets seem to be ignoring the fact that as it's looked more and more likely that there won't be a deal on the debt ceiling, yields on treasuries have . . . done nothing.

tom writes:

Arnold, why are you messing with Tyler? He's working so hard to show that he is on Team Klein/Yglesias (Klegel?) by repeatedly stressing how dangerous these negotiations are and how much the GOP is putting the US at risk. And you seems to want to undermine him.

Of course, I still have no idea whether Tyler is really on Team Klegel or just trying to remain in a position to influence them as they become The Leaders of American Thought. Do you wonder about that too?

drobviousso writes:

Totally agree with Tom. Cowan is a good economist, but as a political commentator... he makes a good economist. Heck, even as a prophet of technology... he makes a good economist.

Also - Team Klegel? That's one for the books (I just don't know which book).

Joe Cushing writes:

It's already been downgraded by Egan-Jones. They have a reputation for getting it right too.

Randy writes:

There is going to be a default. The only question is who will be defaulted on.

Option a; Default on people who hold entitlements (pay them less than originally promised).

Option b; Default on people who pay for the entitlements (i.e., raise their taxes - which has the effect of leaving them with less than originally promised).

Option c; Some combination of a and b.

I prefer option a because I do not believe that anyone has a right to politically bind what others have created. I recognize though that I live in a world dominated by political behavior, so I expect option c, heavily weighted towards option b.

tom writes:

This morning, Tyler compared the debt deadline issues to the.... Norway killings! (as in, we won't get a second chance if we mess this up)


I can only top that with a 9/11 or Nazi reference.

Godwin's Law forbids going National Socialist, so, shorter Cowen: "If Republicans fail to do what Obama now wants on the debt ceiling, it will be just as if airport security cops had pushed the 9/11 hijackers onto their flights despite knowing their intentions."

PrometheeFeu writes:

I think it's pretty clear that a default on t-notes would be catastrophic in the short term. Even if you think government needs to be smaller, I'm sure you can see that this would be a huge break with the expectation of no-default on US debt. In other words, we would see a huge recalculation as everyone suddenly has to take into account the fact that the US can default on its obligations. Furthermore, money market funds must sell securities that are not rated AAA. Again, money market funds are expected to never break the buck which they would certainly do if they had to fire-sell US government debt. Finally, every measure of risk we have in the financial industry is based on 0-default by US debt. All those models would break. This would be the equivalent of simultaneously making a big hole at the bottom of the ship while throwing the compass into the water.

I think it is pretty clear that right now the markets expect a debt-ceiling deal to happen or at the very least for the treasury department to not default on its debt somehow. I think the feeling in the markets is that there is nothing they can do to protect themselves from US government default. Hold cash? Inflation would burn it. Hold other securities? Your counter-parties also have huge exposure to US debt. Plan B is to hope you can stake a good place in the forest before everyone else tries to go setup their own little camp. No securities you can buy for that.

Ryan Vann writes:

"All you Mason guys that love markets seem to be ignoring the fact that as it's looked more and more likely that there won't be a deal on the debt ceiling, yields on treasuries have . . . done nothing."

This is all a wonderful call option opportunity, and nothing else.

"Of course, I still have no idea whether Tyler is really on Team Klegel or just trying to remain in a position to influence them as they become The Leaders of American Thought. Do you wonder about that too?"

Ha. I didn't until you planted the thought in my head, and now I'll just assume it true because I like the theory.


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