Tuesday, July 26, 2011

Bigger May Be Different

. Tuesday, July 26, 2011

Social scientists are trained to conceptualize the world in terms of linear relationships between normally distributed variables. This paradigm underlies current discussion about the consequences of a US government default. Although the US has never defaulted, we can draw inferences about the likely consequence of a US default based on the consequences of sovereign defaults in other countries. Small defaults have small consequences, median defaults have median consequences. Larger defaults have larger consequences. Because the US would be an extremely large sovereign default, the consequences of its default would be extremely large too.

Although the inference that bigger is bigger might be correct, I want to posit a non-linear alternative: bigger is different. One sees evidence that bigger was different in 2008. As the US financial system teetered on the edge in 2008, foreign capital flowed in and the dollar strengthened. As one prominent student of global capital markets has noted, this is exactly the opposite of what happens every where else. “In most emerging-market countries…bursting of domestic financial bubbles was accompanied by capital flight, which only exacerbated these countries’ financial crises by generating exchange rate depreciation and higher interest rates. But foreign funding of the United States—both public and private—continued during the crisis, even as the United States lowered interest rates dramatically. Indeed, the dollar even strengthened as the crisis became more severe after mid-2008.”* In 2008, bigger wasn’t bigger--more capital flight, sharper currency depreciation, larger interest rate increase. In 2008, bigger was the opposite.

One sees suggestive indications that bigger might be different now too.

  • "David Joy, chief market strategist at Ameriprise Financial, believes that US Treasury debt could even rally…"
  • "Others say it is likely that big investors in Treasury bonds—particularly central banks—would still show up to buy Treasury securities even in a crisis. With Europe already struggling, the US Treasury might still have no rival as a place to invest money.”
  • Deborah Cunningham of Federated Investors in Pittsburgh put plans in place to deal with a default several weeks ago. “The firm will convene a teleconference with the boards of affected funds…and she is considering arguing for holding onto the federal debt. “We have to justify to the board why we would want to continue to hold them, which might be because they are a high-quality, minimum-risk security…The question I think investors are going to have to face is, Where do they go? Do they go to foreign banks? U.S. commercial paper? U.S. agencies? Is there a safer haven than Treasury securities?"
Admittedly, a few quotes are not evidence. But these quotes hint at a causal mechanism that makes bigger different--mutually reinforcing individual (psychological) and social (network) characteristics. Individual participants seem to believe that US Treasuries remain safe in spite of a default or downgrade. These beliefs are reinforced by a global financial system that offers no better alternatives to US Treasuries (in large part because there has been no need for an alternative). Neither proposition applies to Greece (or to Spain, or to Portugal). No one believes that Greek debt is safe, even with an EU bailout. The global financial system provides plenty of alternatives that are far safer Greek debt. The psychology is different, the market structure is different. Bigger may be different.

I don’t know if bigger is different. Nor, if bigger is different, do I believe that it conveys immunity; different means that US sovereign default need not trigger an apocalypse—it does not imply that it cannot trigger one. What I am suggesting is that market participants might react differently to developments in the United States than they do to similar developments in other countries. Different reactions may generate fundamentally different outcomes. Bigger may be different.

*Eric Helleiner. 2011. "Understanding the 2007-2008 Global Financial Crisis: Lessons for International Political Economy."Annual Review of Political Science 14(1): 81.


Emmanuel said...

I guess there's only one way to find out ;-) IPE needs to be more macho IMHO. Economists are not known for having cojones, so our niche market ought to be manly social science commentary.

As for the dollar strengthening in 2008, I lay it down to margin calls back home and precautionary measures leading FIs and other MNCs to bring home dollars. It's not because they wanted to--who the heck enjoys nugatory yields and perpetual devaluation--but because they had to.

So temporarily the dollar strengthened, yes, but the structural trends still point to enormous deficits that are a drag on growth and fiscal sustainability.

The Boehner and Reid plans maintain the fiction that higher taxes are not needed and that efficiency gains--I don't know where from--is what matters. The end result when a deal eventually gets done are negligible medium- to long-term deficit reduction and a continuance of present (dollar negative) trends.

So same old, same old regardless of whatever credit rating agencies say.

Bigger May Be Different




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