Wednesday, July 27, 2011

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 . . .