The sovereign debt crisis is moving up a gear this weekend. As the fundamentals of the eurozone crisis remain unaddressed, as opposed to superficial remedies for the symptoms, the failure to raise the US debt ceiling within the next 4 days, which looks increasingly likely, could seriously destabilise the global financial system since American treasury bonds form its backbone. Bank capital ratios could be hurt as AAA-debtholders were forced to accept their holdings were worth less than previously recognised, and Eurpoean banks hold as much as $300 bn of US bonds, while Japanese banks hold an even greater total of $360bn. Some European funds might be forced to change their financial structures because they are restricted to investing only in AAA-rated debt. And where US treasury bonds have been used as collateral by some complex derivative products, it may cause other AAA-rated collateral to rise in value. But how far will this damage the UK economy?
Leaders of the major US banks in a letter to Obama expect that failure to reach political agreement in Congress would destroy business confidence, cripple the economy and collapse financial markets. What is bitterly ironic about the current US debt ceiling of $14.3tn is that half of it was created by Bush and only a tenth by Obama, yet the Republicans in hock to their Tea Party faction have rejected Obama’s offer to cut spending by twice the amount his own policies created. Furthermore the debt ceiling has been raised 106 times in the last 70 years, and under the recent Bush presidency it was raised 7 times. The current threatened implosion therefore has a lot more to do with factional in-fighting within the Republican Party than with economics, however much it is true that raising the debt ceiling should be only as an absolute last resort and with medium-term conditions attached to lower it as rapidly as feasible.
Nevertheless the threat is real and can only raise interest rates on all borrowing, seriously undermining economic recovery which was already fragile or non-existent, as in the UK. Osborne’s boast that the yield on UK government bonds at 2.9% had just dipped below the US rate of 3.0% is small confort since the fundamental UK problem remains deficiency of demand. And the continuing flatness of the US economy, with house prices now falling for 4 years and 30 million Americans in negative equity and unemployment higher than any time since the 1930s and still gradually rising, can only harm UK export prospects when every other avenue of growth is now closed.
Hold on to your seats: this is going to be a roller-coaster ride for at least the next 2 years and maybe 5.
