Sunday 6 October 2013

The Doomsday device

Everyone loves a good tale of Armageddon, and obligingly, the US is currently creating one before our very eyes. I was planning to write a blog post about the US government shutdown, but my knowledge of the chaos in Congress is not really good enough to do it justice. If you want an excellent, straightforward explanation, try Hank Green.

Instead I thought I would discuss the possible consequences of Congress’ inability to agree a budget, because there’s potentially a much bigger problem looming later this month, when the US is once again due to hit its debt ceiling. If agreement is not reached by then there is a good chance America will default on its debt, and that could spell disaster for the lot of us.

The Economist noted briefly this week that a default would be pretty catastrophic for global financial markets but didn’t go into much more depth, so I’m going to take their reasoning and run with it a bit further.

The problem (or rather, one of the problems) with the US defaulting is that US government debt is widely regarded as about the safest return-giving asset it is possible to hold. For this reason it is commonly used as collateral in transactions between banks called tri-party repos.

A repo (short for “repurchase agreement”) is a deal done between two counterparties, where one lends the other money at a certain interest rate, and the other gives securities (such as US government bonds) as collateral. If the borrower defaults, the lender keeps the securities. The “tri” part comes from a clearing bank, which acts as go-between for a small fee.

Keep your friends close... Obama shakes hands with the (Republican)
Speaker of the House, John Boehner
Because US debt is seen as super-safe, it is accepted as collateral for a vast number of tri-party repos. Repos take place the whole time, usually at very short maturities (overnight) allowing banks to deal with short-term unexpected funding shortages.

During the financial crisis, lenders stopped lending because they were scared of losing their money, and the market instantly seized up. Banks that should have been safe suddenly found themselves unable to borrow, and the global economy entered a tailspin.

So, if financial markets later this month realise US government debt is not as safe as they thought, they will either stop accepting it for repos, or demand a hell of a lot more of it as collateral for the same amount of lending. Either way, the market loses one of its largest and most liquid assets, and a 2008 financial crisis-style seize-up is likely to happen. This would very likely cause another financial crisis.

There are other problems too. As part of global reforms aimed at making banks safer, banks are expected to hold more capital based on the riskiness of their assets. Those holding lots of US government debt (i.e. everyone) would suddenly find their balance sheets encumbered with vast quantities of risky securities; they would find themselves having to cope with risks they thought were non-existent, just at the moment a financial crisis kicks off.

Combine that with the mess that most governments’ finances are in, and the recent “Great Recession” will look like a minor blip.

The good news is that even the Republicans are likely to realise this is a problem – after all, they did back down the last time the US nearly hit its debt ceiling. That might have the added benefit of stopping all this silliness about a government shutdown, but it is more likely to kick the problem six months or a year down the road.

The main problem is that US politics is broken. Unfortunately the rest of us can only watch while Democrats and Republicans wrestle with one another terrifyingly close to the big red button that sets off the Doomsday device.

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