Monday, October 7, 2013

Won't a US default be way worse than 2008?

It has often been said that in the event of a US default, the
economy would be as bad as in 2008. I don't really understand that much about economics and finance, but from what little I do know, it seems to me that a US default would actually be far, far worse than what we saw in 2008.

In 2008, falling housing prices revealed that the world financial system had configured itself into something of a house of cards: huge institutions had placed leveraged bets on the idea that housing prices would not fall, and other huge institutions had in turn placed leveraged bets on the idea that those other institutions wouldn't lose money on their investments. When the prices did fall, the institutions found that that the "assets" side of their ledgers dropped lower than the "liabilities" side, and all simultaneously began to sell off their assets to reduce their liabilities. But since everyone was selling at the same time, it flooded the market and prices of those assets dropped further--which made everyone's balance sheets look even worse.

The dynamics of a classic financial panic had set in--but the thing that eventually ended it, and prevented the Great Recession from becoming a second Great Depression, was the US federal government--or more accurately, the world's faith in the US federal government to be solvent and responsible. The panic had caused investors to want to move their money to a "safe" investment--and the safest one they could find was US dollars, or US debt. When the US government eventually bailed out the financial system it did so with borrowed dollars that were extraordinarily cheap to borrow--the interest rate was close to zero (in fact if you factored in inflation, the real interest rate was negative). The US being able to borrow large sums of money so cheaply and easily contributed to the confidence of the financial world that the system could be saved, and so in a self-fulfilling prophecy, the system was saved. The downward spiral of assets losing their value and being sold off was interrupted and though the world economy was in terrible recession, at least the financial system was once again sound.

If Congress does not raise the debt ceiling, the US will default on its debt obligations, which means that all those investors who have placed their money in US Treasuries will be stiffed when it comes time for the US to pay the interest on them. The real damage, however, isn't so much that the investors will miss out on a few payments--it's that such an event would shatter confidence in the US Treasury as a safe investment. Everyone will suddenly want to get rid of their US debt, and--just like in 2008--the mass, simultaneous selling off of US debt will cause the value of US debt to plummet, suddenly throwing everyone's balance sheets into the red. Just like in 2008, the revelation that something widely held to be safe and valuable is, in fact, not safe and not valuable, will trigger a panic and a downward spiral of sell-offs and insolvency.

Only this time, if it's the US federal government itself that has triggered the crisis, who then will play the role of the savior and rescue the financial system? When a panic occurs, the only way to stop it is to get a player big enough to interrupt the positive-feedback loop of sell-offs and insolvency. The player needs to be in a position to amass an overwhelming amount of money to do this. By consensus, the financial system had with its loans anointed the US to play this role. But do we know who the backup will be if the US fails? Will it be the EU? Will everyone sell out of their position in US debt and buy German debt instead? Or will there be no bottom to it, like the Great Depression?

The other thing is that it seems to me that however critical those mortgages ended up being to the financial system in 2008, US Treasuries are far more critical. They seem to be the cornerstone of the world financial system: governments back their currencies with US dollars and debt, financial institutions stay solvent with them. I don't understand what would happen if those assets suddenly plummet in value. I'm morbidly curious to find out, but, honestly, I really don't want to live in that world.

I hope the Republicans come to their senses soon...

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