A System Adrift and Imperiled

Lex Rieffel

“None of the mature democracies in the world have come close to a sovereign default in the Bretton Woods era.” —From Restructuring Sovereign Debt: The Case for Ad Hoc Machinery (Brookings Institution Press, 2003)

What was true then is not true now, and the world is worse off because of it.

In the primer on sovereign debt restructuring that I wrote eight years ago, I gave three reasons for why mature democracies had become immune to default: they had deep domestic capital markets (allowing them to sell bonds denominated in their own currency to foreigners); they had political systems that facilitate smooth transitions from one government to another; and they had an abiding nation-wide commitment to macroeconomic stability.

The first two reasons remain valid, but two elements of the essential commitment to macroeconomic stability have been lost since the Global Financial Crisis in 2007-08: monetary discipline and fiscal discipline. Monetary discipline assures households and businesses that their savings and investments will not be wiped out by inflation. Fiscal discipline avoids a debt build-up that will become burdensome to future generations. The mature democracies in Europe, the United States, and Japan have largely succeeded in suppressing inflation, but they have allowed their public sector debt to balloon to unsustainable levels.

Clearly, they knew better. When the European Union started down the path toward monetary union in 1992, the member countries committed to keeping their annual budget deficits below 3 percent of GDP and their stock of public sector debt below 60 percent of GDP. If the mature democracies had respected these limits, they would not be in the fiscal pickle they are today.

There is no simple explanation for why the mature democracies went off the fiscal rails. In some countries, aging populations could be the main cause. In others, extreme polarization of political opinion seems to have eroded the necessary social consensus. Perhaps the war on terrorism threw the whole global economy off-kilter. Or maybe the core problem was an international monetary system that allowed emerging market countries to maintain undervalued currencies. This undervaluation, combined with sharply lower barriers to international trade and investment, may have led to shrinking employment in the manufacturing sectors of the mature democracies, which could not be offset fast enough by new jobs in the service sectors.

Regardless of the causes, it looks as though it will take years — if not a generation — for the mature democracies to achieve and sustain the budget surpluses required to bring public sector debt back to comfortable levels.

Still, this dismal outlook might not be the worst consequence of the debt crises in the U.S. and Europe. A greater concern could be that the world is just a small step away from not having a “risk-free” financial asset, leaving global markets adrift like a sailboat in the ocean that lost its keel.

Arguably, the health of the international financial system depends on the quality of its single most important product, the U.S. Treasury bond. While understanding that all financial assets have some risk, for decades market participants have viewed U.S. Treasury bonds as being “risk free” because no other financial asset appeared less likely to experience a default. All other bonds are issued in primary markets and traded in secondary markets at a premium (the “spread”) to U.S. Treasury bonds, which reflects the market’s perception of their greater risk of default.

If markets instead believe that the risk of default on U.S. bonds will rise and fall with the political and economic winds of the day—as it does with corporate bonds or emerging market bonds—then the impact will be debilitating for households and businesses around the world. In particular, both domestic and international investment will be depressed and as a result trade will languish and fewer jobs will be created. The loss of global GDP could be in hundreds of billions of dollars every year until fiscal discipline is restored in the mature economies.

Can rising powers like China and India provide an alternative risk-free asset? No they cannot. They may score well on their commitment to macroeconomic stability, but it is likely to take more than one generation for them to have deep capital markets and smooth political successions comparable to what the mature democracies have today.

It is impossible to put a value on preserving the role of U.S. Treasury bonds as the world’s benchmark risk-free asset — or their close rival Euro bonds. If the political leaders in the United States and Europe cannot do a better job of restoring confidence in their sovereign debt, then our children and grandchildren will suffer the consequences.