The debate in Washington, DC about raising the debt limit has the potential to change the way the world looks at risk. While there are all kinds of risk, one bedrock of an assumption has been that US government T-Bills are a risk free investment. You will always get your money back, even if as a last resort the government has to print it to give it to you. The US government will never default on its debt, is the belief and promise.
Most importantly, US T-Bills and other US government debt are backed by the full faith and credit of the United States of America. That was the guarantees of guarantees. Corporations may fail. Banks may fail. Cities and States might go bankrupt. But you could always, always depend on the US government to make good on its commitments.
I still expect that to be true. However, I look disapprovingly on those who wish to carelessly and thoughtlessly use the full faith and credit of the US as a bargaining chip in a political game of chicken.
I need to believe in the full faith and credit of the US. I want to believe in it. Without that belief, the whole world of risk changes for me. There is no longer a rock upon which to build. The foundation for all other risk becomes vulnerable. Throw out any investment or risk model that includes the concept of a risk-free investment, which would be probably all of them.
Back in 2001, when the US Treasury decided to stop issuing 30-year Treasury Bonds, I was critical of the decision. What the Treasury had done was make the long end of the curve riskier. There was no longer the fresh available supply of debt from the US with the full faith and credit of the US. The anchor upon which to connect long term debt was cast away and the market was adrift on its own. It was not a good thing for other issuers of long term debt, or those buyers of long term debt hoping to lock in guaranteed yield.
One way many products trade is versus a relationship to an actively traded and liquid market in a similar product. US government debt is the underlying product for the basis of many interest rate products issued by every other US player. What is the price of this security versus something that is risk free, or at least enjoys the full faith and credit of the United States? That is the question we ask when we look at and quote the market.
I understand and respect the lawmakers’ desire to cut spending in order to stave off future debt problems that would undermine the ability of the US to fulfill the full faith and credit promise it has made. However, I draw the line at using that same promise as a bargaining chip in a political game with a very uncertain outcome.
It was not that long ago that the biggest problem we had was a lack of confidence in our financial system. Despite the passage of Dodd-Frank and similar efforts around the globe, the financial structure we have today is not much changed from what we had before the financial crisis. We still have a long way to go build and test a new regulatory structure. We should not test the financial structure we have in place by pulling out the cornerstone of risk upon which so much is built.
It was only a little more than a year ago that we had a flash crash. While all kinds of theories abound for the cause focusing on market structure and technology, the behavioral aspect should not be downplayed. We have had market panics before and we will have market panics in the future no matter how we trade or how the market is structured. One only needs to read the book “Extraordinary Popular Delusions and the Madness of Crowds” by Charles Mackay to realize market panics have been with us a long time.
Those US lawmakers who want to play a political game risking the promise of the full faith and credit guarantee of the US are delusional and don’t know the power of risk they are playing with. If there is one thing that is too big to fail, it is that promise.