What the financial system has in common with a sewer

October 15, 2013
This is the Libor-OIS spread during the 2007-2008 financial crisis. It was the canary in the coal mine of economic disaster. Source: Federal Reserve Bank of St. Louis
This is the Libor-OIS spread during the 2007-2008 financial crisis. It was the canary in the coal mine of economic disaster. (Federal Reserve Bank of St. Louis)

Think of this as a rule for life: When you see articles in mainstream newspapers about the detailed inner workings of the financial system -- clearing and settlement systems, triparty repo markets and other money market esoterica -- something horrible has probably gone wrong in the economy. And that is why so many economy-watchers are fretting so much about the debt-ceiling negotiations in Washington this week.

Most of the time few pay much attention to the details of the electrical grid or sewer system, and in normal times only the real specialists keep their eyes on these arcane markets through which trillions of dollars flow and which are fundamental to the workings of modern finance.

People care a lot more about the physical plumbing when the sewage overflows -- when something stinks. Similarly, the financial plumbing matters a lot only when something smells horribly wrong.

For example, to understand where the economy was going in the financial crisis of 2008, you had to pay attention to the Libor-OIS spread (rates that the premium banks were charging to lend each other short-term cash relative to the overnight indexed swap rate, which spiked that fall when the solvency of the banking system was in question). It was by watching that rate and similar indicators as they gyrated wildly that September that one could best guess how high unemployment would rise that winter and in the spring of 2009.

That experience is partly why many analysts and executives are sweating the strange movements in money markets over the last week, as the United States draws closer and closer to breaching its legal debt ceiling.

Here's what Jamie Dimon, the chief executive of America's largest bank, JPMorgan Chase, said when asked about what would happen if Congress doesn't raise the debt ceiling: "You don't want to know," he said at a meeting of the Institute of International Finance over the weekend. "It would ripple through the world economy in a way that you couldn't possibly understand . . .  the money markets are the most fickle markets in the world; they're like a rabbit."

U.S. Treasury securities are the bedrock of the global financial system. They are used as ultra-secure collateral for trillions of dollars' worth of transactions, and are used by banks, pension funds and all sorts of investors as a safe place to park cash. When the world was at its financially scariest point in 2008, short-term Treasury bills were considered the safest of safe assets -- to the degree that investors actually bought them at a negative interest rate (they were paying, say, $1,002 in exchange for a bill that would pay them $1,000 30 days later).

The truth is, we don’t really know what would happen to the broader financial system if the United States seriously threatened to make its payments late or started failing to meet its obligations. It might not even follow the usual logic of debt defaults. Usually when a creditor looks like it might not make bond payments on time, its borrowing costs skyrocket, whether that creditor is Argentina or Enron. But because Treasuries are viewed as a safe haven, financial chaos could actually cause their yields to fall, which is what happened after Standard & Poor’s downgraded America’s credit rating in August 2011.


But though we don’t know exactly what a U.S. default would look like, we do know that chaos in the financial plumbing tends to have a very bad effect on the economy. That’s why the strange movements in Treasury bill markets over the last week -- major investors shedding bills that will be maturing in the coming weeks out of fear they would not be repaid on time — are so worrisome. The interest rates on Treasury bills maturing on Thursday have hovered within a few hundredths of a percent above zero throughout the last six months. That is, until the start of October. The chart above shows their extraordinary volatility in the last five trading sessions.

The prices built into markets right now still suggest that the odds of an actual default on U.S. government obligations are quite low. What makes the debt ceiling standoff scary is not that we know exactly what would happen if we head into next week without an agreement.  What makes it scary is that we know how bad things can get when these inner workings of the money markets go awry.

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Sarah Kliff | October 15, 2013