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Location: Ottawa, Ontario, Canada

Tuesday, August 02, 2011

Raising the US Debt Ceiling - Don’t Start Cheering Yet

The impasse over raising the US debt ceiling has been resolved. The US will continue to pay its creditors -- even though it now has to borrow more to do it. The public, the media, politicians, the markets and many economists are all now breathing a sigh of relief. The crisis is passed and they can get back to business as usual, which is the business of buying and spending to grow the economy.

On the other hand, I believe the US has already unknowingly suffered a profound blow from this recent crisis. Much like a computer virus that you might pick up and only later find it wreaking havoc on your system, in terms of the US and global financial systems what was once unthinkable is now thinkable and the future consequences of this shift will be severe.

Even a year ago, the thought that the US might default on its ever growing debt was never taken seriously. The idea that the US could fall prey to the same instabilities as Ireland, Greece or Italy was just silly. The US had the biggest, strongest, safest economy in the world. That’s why investors have continued to park their money in US denominated assets. US treasury bills have been considered the safest investment on the planet. Their return was essentially guaranteed.

No more. The specter of the US federal government defaulting on its debts was painted loud and bold for everyone to see. For the first time in over two hundred years, investors can envision uncertainty associated with lending to the US government. This new risk will soon see itself as a higher risk premium not only for US government debt but for the global financial system as a whole. Both have been anchored in the belief that the major economies of the world, but particularly the US, would never default on their debts and so there has been a greater willingness to lend to them than might otherwise be determined by economic fundamentals.

It’s an awful lot like the difference between a wealthy man who goes into to a bank to borrow a hundred million dollars and receives the best rate with little or no inspection of his books despite being many hundreds of millions in debt and a small businessman who tries to borrow $10,000 while being debt free and having a thriving business. The small businessman is given a gruelling audit and then told to come back when he can show more money on his books and, if he’s lucky, he’ll get a loan at prime plus ten. What lies at the bottom of this obvious discrimination is the perception that the wealthy man has made a lot of good decisions in the past to become wealthy and so he is a good bet to pay off a large amount of debt in the future. The small businessman has yet to prove himself and so the perception of his risk is a great deal higher – even though he may want to borrow only a small amount of money. In this way the lending of money, especially in large amounts, often comes down to the lender’s subjective assessment of the borrower’s potential to repay.

In the case of the recent US political circus, the world’s lenders have just had a ring side seat to the possibility that the risk free US government may not be so risk free. As a result, expect them to pay a lot more attention to financial fundamentals. For instance, the US federal debt to GDP ratio is now almost 1:1. By comparison Canada’s debt to GDP ratio is about 0.4:1 and Greece’s is 1.4:1. By this measure the US situation is closer to Greece than to Canada.

As the notion that the US could default (and that some of its leaders would be willing to allow it to default) begins to worm its way into the calculations of investors worldwide, investing will now become a whole lot more uncertain and risky. For if the US can default then any country can default, let alone any company. Lenders will subsequently want a higher premium to protect themselves against the vagaries of this potential default. And when this is coupled with the general tightness of capital that has resulted from the recent government spending binges to avert recession, it may well push us into the next phase of what is likely to be a long and drawn out recession.