Strike Three!

The naturally optomistic bias of the human mind is such that when someone speaks of convergence, the assumption is always that the process will involve bringing the inferior to the level of the superior, improve the condition of the less fortunate so that it more closely approaches that of their betters.  Why should that be?

Consider, for a moment, the issue of political risk in investing.  In orgies of reflexive self-congratulation, rich investors residing in rich countries have for decades assured themselves that investments in poorer, more primitive places carried with them a political risk and required a discount that was unnecessary in countries that were more economically advanced, more politically stable and (generally) whiter.  Proponents of investment in economically poorer, politically more tumultuous and (frequently) off-color countries enthusiastically argued that progress towards elected governments, free markets and rule of law reduced these risks (and the required discount), as those lesser breeds made steady progress towards the Olympian heights of the developed world's commercial splendor.

But perhaps the convergence is trending in the other direction.  Without regard for whether conditionas are improving in the emerging market countries or other parts of the world, perhaps the developed world is experiencing a deteriorating set of political conditions such that there is now political risk associated with investments in the United States or the Eurozone similar to that traditionally associated with Brazil or India.

Consider this summer and last summer.

Strike One!  The treatment of BP during the oil spill in the Gulf of Mexico over the summer of 2010.  Four companies were deeply involved in that situation.  BP owned a 60% interest inthe lease and was the lease operator.  An American company owned the other 40% of the lease and at one point started baying with the hounds.  Another American company was the drilling contractor.  A third American company manufacturer the blowout preventer that failed to prevent the blowout.

Of those four companies, which one bore the brunt of the assault?  The foreign one, of course.  A classic exercise in Banana Republic allocation of political blame.  Although that wasn't the limit of the political risk.  Anyone with an economic interest in oil and gas drilling and production in the Gulf of Mexico found that interest buffeted for months.

Strike Two!  The PIGS in Euroland.  Who would have thought that the arrest on sexual assault charges of the front-runner in next year's French presidential race would almost disrupt the elaborate quadrille under way to hold the Euro together, save the Franco-German banking system and make the indolent South pay for its sins?  Fortunately Christine LaGarde can pronounce 'exorbitant seigneurage' (in English).

Strike Three!  The circus just ended in Washington D.C. over raising the federal debt ceiling.  Wilful sovereign default (which may not even be possible in the United States) is all about political risk.  There is not a financial metric on the planet that can address it.

No more need be said.

The End of the Risk Free Asset

However the debate of over the extension of the U.S. government's debt ceiling plays out, this episode marks the beginning of the end of the risk-free asset. What that will mean for financial models, economic policy, asset-liability management, investment strategy and so on is anybody's guess. But the mere circumstance that the federal government is entertaining the possibility of default as a result of political exigencies challenges forever the assumption that U.S. dollar denominated short-term U.S. Treasury obligations can serve as a risk-free benchmark.

Observers as a group have been so fixed on the recent commonplace circumstance of sovereign default--the inabilility of the borrower to service debt denominated in foreign currencies--that the rather more difficult context of a borrower electing to default despite its ability to meet its obligations or defaulting for other (overwhelming) reasons has been overlooked. In other words, everyone has been endlessly focused on the example of Argentina within the last decade rather than Ecuador. Or on Russia 1998 rather than Russia 1917.

The apparatus is in place for handicapping, assessing and evaluating sovereign defaults of the first type. One can argue that inflation is a form of default for sovereign credits capable of borrowing in their own currencies, and inflation is a topic that has been beaten to death. The machinery for dealing with those credits that have borrowed in dollars may be controversial, but the drill is commonly understood. It even translates into Euroland.

The second type of sovereign default, though, is a horse of a different color. In the paradigm Stephen Roach used to employ (pre-2008), the sources are exogenous rather than endogenous. More colorfully, if the politicians are unwilling to pay a government's debts, it matters little whether they came to power through a Tea Party, rolled in with an invader's tanks, or led a revolution that involved standing the ministers of the prior government against a wall and shooting them.

Obviously, no one knows what the result of this astonishing display of financial irresponsibility will be. I am not going to hazard a detailed guess. In the short term, probably not the end of the world. Probably not a non-event. Probably a recession, that may have been coming anyway. A Washington Recession of 2011 to go with the Wall Street Recession of 2008. Probably a great deal of short term confusion, disruption and hardship. If culpability for causing this situation clearly lies with the Republicans in the House, the responsibility for how the disruption is handled with clearly lie with the Democrats in the Administration.

Longer term, it is hard to say what it will do to interest rates. No one can predict the term structure, level, or credit spreads of interest rates in a world without a risk-free benchmark. I suppose the value of financial assets across the board should diminish dramatically, but whether that happens quickly or slowly is anyone's guess.

It will be bad for the dollar. It opens a window for the Germans to lead the Euro into a new role. But it's astonishing how little interest a country that started two world wars using its military machine to conquer Europe has so little interest in doing so using the economic and financial muscle. That calculus may be recomputed. Unless all the Germans are on vacation for August, in which case that can wait until autumn.

All the smart money has been betting on a collapse of the Euro because of its conceptual flaw--a common currency without a common political system. But given the performance of the American political system this summer, perhaps that's not the defect it seemed to be. A unitary political system without a common agreement to honor its full faith and credit financial obligations doesn't assure very much. Certainly not enough for U.S. Treasuries to serve as the 'risk-free' asset of the global financial system.

So, get ready for a brave new world . . .