The end of "risk free"

By P.B. | LONDON

AT THE risk of celebrating too early, it looks like there will be a $2.4 trillion debt-ceiling deal, with initial spending cuts of around $900 billion. This addresses the immediate risk of a default—even if negotiations hit a last-minute hitch, there are short-term backupoptions—but doesn't meaningfully change the country's unsustainable fiscal trajectory.

The S&P has already warned that America faces a credit downgrade, and many observers now think that it is just a matter of time. The whole debt-ceiling farrago has demonstrated just how difficult it will be to achieve significant medium-term consolidation—incorporating both entitlement cuts and tax increases—given America's truly dysfunctional political system.

But, like my colleague, I doubt that a credit downgrade would be disastrous. Clearly, dropping to double-A would make it more expensive for America to service its debts. The S&P has estimated that a downgrade would lead to losses of $50-100 billion for Treasury holders and increased interest costs of $2.3-3.8 billion for each trillion in US government debt. It would also make bond yields more brittle; given America's relatively short-dated sovereign debts, this could leave the country particularly exposed to adverse shocks and panics.

The knock-on effects would also increase costs for municipal bonds and agency securities tied to America's sovereign rating. Private and quasi-private "too big to fail" companies (major banks, Fannie Mae/Freddie Mac) could be hit by higher operating costs as a lower credit rating would raise questions about the viability of their federal backstops. And, more systematically, a downgrade would increase the default risk premium baked into various forms of financial analysis—typically pegged to the supposedly risk-free 10-year Treasury rate—increasing the cost of capital and causing headaches for corporate finance types everywhere.

On the other hand, a well-signaled ratings drop need not cause an economic crisis. The expected increase in sovereign-debt costs is manageable, and a downgrade would be unlikely to cause a flight from Treasuries; double-A bonds still carry zero risk weight under Basel I/II/III, and as long as America retains is AAA short-term rating, money-market funds will still be able to hold short-term bonds.

Moreover, many buyers have nowhere else to go. As Tyler Cowen pointed out, America currently issues 59% of the world's AAA sovereign debt. There's simply no alternative option that could absorb that demand. The second and third largest sellers (France and Germany) are tied up in the euro-implosion, and even taken together the rest of the world doesn't provide a sufficiently deep and liquid supply of AAA debt.

So, while a downgrade would give Treasury buyers another reason to diversify their holdings over time, regulatory requirements, lack of alternatives and operational inertia seem set to underpin demand for now. And investors would be forced recognise that they operate in a world of omnipresent credit risk, an unambiguously good thing for global economic stability. More vigilance makes the world a safer place; as the Financial Timesput it, "risky assets do not cause crises. It is those perceived as being safe that do."

Subjecting America's "risk-free" debt to more market discipline would also be a good for the country. Politicians naturally tend to make unsustainable spending commitments that burden unorganised future voters, and bond vigilantes provide a necessary counterbalancing force. As long as America is the world's risk-free bond market, however, its politicians are insulated from such pressure. America's would-be vigilantes have been tranquilised by a combination of the country's unique role in the world, regulatory incentives to buy AAA debt, lazy risk-free assumptions, and a dearth of attractive alternative investments.

With such bond market somnolence, there's nothing to stop America from accumulating enough rope to hang itself. There's a reason why fiscal consolidation rarely happens in the absence of external pressure; without a clear market signal, there's no way for politicians or voters to judge whether spending cuts are really necessary. It would seem like pointless masochism. (Bond vigilantes don't eliminate this epistemological uncertainty, but they certainly provide a useful indication.)

I'm not suggesting that America should actively seek to discard its AAA rating; no one can confidently predict the consequences of what was a borderline inconceivable scenario only six months ago. Perversely, yields could even fall after a downgrade. As the above-mentioned Citi report suggests, risk is relative; a downgrade could cause investors re-evaluate other securities and decide that they too are riskier than previously imagined. And the dynamics of portfolio weighting may increase demand if investors buy more American bonds to keep their overall portfolio risk constant (i.e., Treasuries are riskier than before but still less risky than alternative investments, and therefore investors buy more American bonds to bring down their average risk).

That may be an unlikely chain of events, but it's hard to know what to expect. The big picture, however, seems clear: a world where America becomes one of many "very low risk but not risk-free" options would be, on balance, more stable and resilient.