Who Defaults First: Greece or the US?

When I saw the BBC headline I thought to myself: “get with it, the US is not going to default.  This is just a game of political chicken.”  For the past several months, whenever this topic has come up, I’ve been thinking that this is an example of great showmanship by the Republicans who are going to teach President Obama a very painful and expensive lesson in using leverage when you have it.  I even read this CNN article earlier today, which summed up my take on the whole thing rather nicely.  And then I started to consider the possibility of the US Congress and the White House failing to reach an agreement.

If you’re not familiar with the issue, here’s my version of what’s going on with the “debt ceiling.”  Every so often, the United States reaches the limit of how much its allowed to borrow and the US Congress has to then increase the limit in order to allow things to continue functioning as they have been.  Because the US runs at a deficit (my government spends more money than it collects in taxes), it needs to borrow more and more to keep the status-quo.  As the BBC article points out, unlike most countries, the US has a legal amount it’s allowed to borrow and this amount is not set by the President but rather by the Congress.  This year, the Republican controlled House of Representatives decided to use the threat of this financial nuclear weapon going off to get something it wants – drastic reduction in the amount the US spends.  As the earlier referenced CNN piece pointed out – shame on the President for not forcing the issue when he had the upper hand last year.  Now the Republicans are going to use their upper hand to get what they want.  It seems to me that it’s all just a game of chicken.  We all know that the Republicans would never allow the US to default on its debts.  Right?  Right?  But isn’t that what chicken is all about: we all know that no one in their right mind would drive a car head-on into another speeding car.  Right?  Mutually Assured Destruction in the financial age.

What would happen if the US actually did default on existing debt or was unable to pay its legal obligations?  Remember Lehman and “too big to fail”?  We saw what happened when just one major bank went under:  instantaneous freezing of world markets.  Liquidity disappeared overnight and took about a year to show signs of realistic return.  We got out of that mess partially because world governments – including the US government – banded together and brought some semblance of stability or at least good intentions to restore confidence in markets.  And it still took months before firms did business with one another.  A US default would make that look like a walk in the park: riots in Athens are one thing but riots across the US are quite another.  How does one even begin to hedge against such a possibility? As a financial hedge you can short US Treasuries.  But there really is no hedge for the larger issue of liquidity and the ability of the US government to function.  How do you hedge against riots?

The US Congress seems all too willing to play with fire in front of world cameras.  Besides making us look like we don’t deserve our place on the financial world stage, it shows how much of a dangerous game the US government is willing to play with the stability of the world’s financial markets.  And that’s not a sign of a mature and respect-worthy nation.  So far, markets haven’t taken the threat seriously: gold prices are down a bit over the past 30 days.  As a natural hedge against the US Dollar, gold is quite high by historical standards.  But if the US doesn’t resolve the issue soon, look for it to go even higher.  For the next few weeks, I’ll be looking at gold as a proxy for the probability of default by the US government.  Writing that last sentence has an “other world” feeling too it.  Talk about a fat tail…

3 Responses to Who Defaults First: Greece or the US?

  1. Paul says:

    Hi Damian – thank you for the reply. I dont want to keep beating this to death but gold telling us what the markets are thinking in terms of the possibilty of a US default is off base. Today 8/2 US raises debt ceiling gold is up plus $20 at another new high.

    What gold is telling us here is that the US economy and the world economies are slowing and more stimulus and QE is coming.

    Gold is telling us more inflation and monteary debasement is around the corner.

    Has any of your clients used Gold as a proxy for inflation or some sort of currency? That may be interesting

  2. Paul says:

    Hi Damian – I enjoyed your article and I agree with you that a US default is extremely unlikely. USA has the printing press. The default is more likely in Greece or another EU country because there printing press was taken away from them by joining the EU.

    I do however disagree with you that gold is a natural hedge against the dollar. Gold does have some correlation to the USD but that isnt the whole story why gold has rallied to a new high. Gold priced in all currencies is at all time highs. Its not just a USD story. Gold is at all time highs in all currencies is saying that the monteary system is broken (paper currencies are losing value). Gold has been up for 10 straight years now heading to year eleven.

    I do beleive that gold has a place your risk system but just not sure how it should be used. I think it is more then just a proxy for US default.

    • Paul – thanks for the comment. Yes, the gold story is not just the USD story – it’s the story of all currencies every since we, collectively, got off the gold standard. I didn’t mean to imply that gold should be used as a proxy within IA’s risk system – I meant that over the next few weeks while the clock ticks down to August 2 that gold’s price will give a good indication of what the markets are thinking in terms of the possibility of a US default. Last week we saw two such moves: when it looked like the WH and Congress had reached a deal, gold spiked down. And when the deal broke apart, gold spiked up. Of course, the equity markets did the same thing, reminding us that everybody is watching the US right now.

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