Friday, 11 October 2013

The (political) failure of safe assets

US T-Bills, today:

(source: U.S. Department of the Treasury)

No, you aren't imagining it. The yield curve has inverted. The yield on 1-month treasuries is higher than the yield on 1-year treasuries. It seems markets think the USA might default on its short-term debt.

This is all because of the standoff between President Obama and Congress regarding funding Obama's "health care for the poor" (the legislation for which Congress has already passed). I'm not going to discuss the wrongs and rights of the situation here. Suffice it to say that both sides think they are right: both sides are refusing to negotiate about the health care, though they do seem to be prepared to discuss other fiscal expenditure matters: and both, it seems, are prepared to allow the USA to default on its debt rather than back down from their entrenched positions.

If the USA were Argentina this perhaps wouldn't matter too much. Argentina has a history of debt default, it is currently going through an interesting series of cases in the international courts regarding whether or not it is obliged to pay debts it defaulted on a decade ago, and it is probably going to default again even if it doesn't win the case. Most people watch this saga with some amusement, but not with any great concern. Argentina defaulting on its debt might cause some stress to the world economy, but it doesn't threaten to bring down the global financial system.

But the US is not Argentina. It is the largest economy in the world, its currency is the world reserve currency and its debt is the world's most widely traded safe asset. Short-term debt (T-bills) are prime collateral in the global secured lending markets, and the yield on the 3-month UST is regarded as the closest proxy to the risk-free rate for pricing calculations. For the US even to contemplate defaulting on its debt is destabilising: if it actually did default, the result could be catastrophe. Hence the inverted UST yield curve.

And hence, also, the anger from countries around the world at the US Government's behaviour. The BBC reports that China and Japan, the USA's two largest foreign creditors, have both expressed concern at the prospect of the US not honouring its commitments to them. Countries from Canada to Zimbabwe have warned about the consequences for their economies of  US default. And people are beginning to call into question the nature of a system of government that could potentially cause a catastrophic debt default purely through intransigence. Not being able to meet commitments because of financial mismanagement is bad enough. But failing to do so because of political gridlock is frankly appalling. The USA needs to get its act together. Playing brinkmanship with the world economy to achieve domestic political objectives is unacceptable.

However.....the USA could argue that it did not ask the world to become dependent on its debt as the primary safe asset in world markets, and therefore the consequences if it defaults are not its problem. Some in the USA do indeed argue this, and they perhaps have a point. Government debt - any government debt - does not exist purely to lubricate international markets, as the BIS seems to think. Nor does it exist to provide safe assets for risk-averse international investors. The purpose of Government debt is firstly, to fund government expenditure until sufficient tax revenue can be obtained to meet spending commitments, and secondly, to enable the citizens of the country to save. At its most basic, government debt has no international purpose.

But it is not that simple. The fact is that international markets need safe assets, and at present the only country that can produce them in the quantity required is the USA. When the USA was downgraded, FT Alphaville considered alternatives to US Treasuries as a safe asset, and concluded that there weren't many. Markets concurred: the downgrade passed almost unnoticed and AA became the new safe asset standard. Nothing has changed since. There are no more safe liquid assets from other sources in the market than there were when the USA was downgraded. So if the USA does default on its debt, markets will be in the extraordinary position of having to regard as "safe" securities that are technically defaulted, because there really isn't anything else.

There have of course been questions recently about the future of the US dollar as global reserve currency. Various suggestions have been made regarding its eventual replacement: the Chinese yuan, the IMF's SDR, the Euro, a completely new international currency, or even a multipolar world in which there is no single reserve currency. At present there is no clear front runner. But at least it is being discussed. The future of the world's primary safe asset is not being discussed at all.

Yet the present situation is that the global financial system is critically dependent on the quantity and quality of US debt issuance. US domestic political shenanigans therefore threaten global financial stability. But US domestic politicians behave as if it has nothing to do with them. Hence the angry comment from the Times of India (quoted by the BBC) that the USA is "holding the world to ransom". Unfortunately there is no solution to the present conundrum other than for the USA's politicians to resolve their differences. But we urgently need to consider what alternatives there could be to US Treasuries as a primary source of global safe assets in the future.

So what alternatives might there be? Well, it is by no means obvious. China is large enough to take over from the US as primary provider of safe assets,but it has such a large trade surplus, and such huge reserves, that domestically it does not need to issue debt and it is likely to be unwilling to do so. Russia, also, is probably large enough, but its credit history is distinctly ropy (it defaulted in 1998) and it seems unlikely that the global markets would trust it enough to rely on its debt as a primary safe asset. Japan has enough debt but nowhere near enough GDP to support its use as a primary global safe asset partly or wholly replacing USTs: its debt/GDP ratio is already by far the largest in the world. Other countries with a good credit standing such as Germany, France and the UK are simply too small.

There is, of course, an obvious future contender - and that is Eurobonds. The combined might of the Euro area countries could easily support production of safe assets of a similar quantity and quality to USTs. They would need to be backed by the ECB, just as USTs are implicitly backed by the Fed. Many people have suggested Eurobonds as a solution to the Eurozone crisis, but to my knowledge no-one has suggested Eurobonds as a competitor to US Treasuries in the safe asset marketplace. But once again, the obstacles are political.  Hell would freeze over before Germany agreed to this. Which is something of a pity. The world really does need an alternative source of safe assets. Either that, or the US Government must accept that it really is the world's bank, and stop allowing domestic politicians to play fast and loose with the world economy.

Related reading:

When governments become banks - Coppola Comment
Government debt isn't what you think it is - Coppola Comment
Safe assets and Triffin's dilemma - Coppola Comment
Pari Passu Saga series - FT Alphaville
Global rebalancing and the Bancor - John Aziz, Pieria
International liquidity in a multipolar world - Eichengreen
Are the G20 and IMF in the process of creating a global currency? - Global Research

Oh, and we've played this scene before, of course:

The price of distressed Treasuries - FT Alphaville (2011)


  1. Interesting that the credit rating agencies haven't downgraded USTs to junk status....

  2. They're thinking about it. Here's Fitch on the subject:

  3. Interesting article. I didn't have a look at the yield ...

    Indeed. You are not alone with that opinion. If you listen to the communication - Increasing the debt ceiling is not about increasing debt. That's 'true' but I am not sure if lots of people know what that means exactly especially for them on a long term. Of course the 'money' has already been spent and the liability does exist.

    These are nuances in a discussion about trust. Since the U.S. are making money instead of producing goods, I am pretty sure Americans think they would do anyone else a big favor and make everyone happy buy giving them more and more dollars...
    (South Park - American Economy)

    These safe assets are required for the Collateral Chains. (Creating money based on an asset you only hold for a short period). Pretty sure that some hedge fonds are invested in Greece because they expect a bailout indeed.

  4. The world needs enough CURRENCY to do business, but I don’t see why it really needs safe assets in the form of bonds.

    Second, there is no need for the World to turn to China or Europe if it wants an alternative safe asset to US government bonds: what about the good old US dollar? The rate of interest obtainable on dollars would be a bit less than the currently miserable rate paid on bonds, but that wouldn’t be a huge problem, seems to me.

  5. People could hold deposits at the central banks. Wouldnt get any safer than that. The central bank depository and payment system could be made more accesible just like it is to depository institutions.

    1. William Hummell agrees with that. See:

      Richard Werner and Positive Money agree, except that they think private banks should act as agents for the central bank. At least that’s my take on this work of theirs:

    2. central banks can offer depository services alongside the commercial banks without needing the restrictions of full reserve banking.

    3. On second thoughts, such a system already exists: National Savings and Investments.

  6. Frances, hat's off to you.

    You are one of the very few analysts who has caught the negative US yield curve. Last time there was a negative curve was before the 2008 crash. 'Why' is not so important as that it did indeed occur.

  7. You are not alone with that opinion. If you listen to the communication - Increasing the debt ceiling is not about increasing debt. That's 'true' but I am not sure if lots of people know what that means exactly especially for them on a long term. Of course the 'money' has already been spent and the liability does exist...!!!