Crisis shows risk can’t be abolished

Allister Heath
IT is going to be a hot summer – and I’m not even talking about the weather. After a brief and irrational lull after last week’s pseudo-deal in the Eurozone, the global sovereign debt crisis is accelerating again, with the row over extending America’s debt ceiling becoming ever more farcical. Gold hit close to $1,630, a new record – the gold bugs are laughing – and the US authorities admitted that they won’t be able to pay all of their bills by next Tuesday. The cost of insuring against a US default hit a record high yesterday, with the rise focused in the one-year credit default swap market.

These are destabilising times for the global financial system, which rests on one central assumption: US government debt is safe and will always be repaid in full and on time. The US economy is the biggest in the world and it was always thought that the Federal Reserve could simply produce more greenbacks if necessary. That is why the dollar is the world’s reserve currency of choice, why so many commodities are denominated in greenbacks and why institutions that wish to be safe and boring typically hold lots of US government bonds. A supposedly self-evidently sensible economic architecture now feels terrifyingly shaky.

The yield on US Treasuries is deemed to be the global risk-free rate of interest; all other rates are derived from it. With a bit if luck, any default over the next few days won’t last for more than a few hours – but the current fiasco ought to remind investors and the markets that the slightly simplistic assumptions of yore – such as those surrounding US debt – need to be ditched. The very idea that any debt can be risk-free is dubious; perhaps the rating agencies should stop awarding their highest-quality grade altogether. After all, the events of the past few years have shown quite clearly that circumstances can change very quickly and that apparently rock-solid IOUs can turn to junk almost in an instant. It is pure hubris to believe that risk can be abolished entirely. It cannot – as ought to be clear from the fact that governments, the erstwhile safety net of last resort, are themselves facing insolvency and have become the new systemic threat.

The only good development to come from the US was that Barack Obama has said that he won’t try to bypass Congress by citing the 14th Amendment to the US constitution, which states that the “validity” of government debt “shall not be questioned.” This has been interpreted by some, including Bill Clinton, as a means for Obama to simply ignore the debt ceiling and take the matter to the Supreme Court. But such an outcome would trigger a massive constitutional clash at the worst possible time and would undoubtedly cause extreme panic in the markets. Let us hope Obama doesn’t change his mind.

Closer to home, yesterday was Cyprus’s turn to be engulfed in the crisis, with a downgrade by Moody’s; the government is likely to resign today. The country’s financial system owns vast amounts of Greek bonds and has been destabilised by an explosion at the country’s main power plant. The question is: which European Union country will be next to hit the rocks? Given how over-borrowing by governments is now the number one danger to global prosperity, it beggars belief that anybody in Britain still thinks the UK government can afford to relax and borrow even more. It is time to deleverage – or all bets are off.
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