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The Game of Thrones Returns

With the downgrade of US debt and the spread of the European financial crisis to Italy, an important line has been crossed.  The global economic crisis began as a crisis of markets; it has now moved to a crisis of sovereigns.

Two years ago we asked if individual firms like Lehman Brothers could manage their debts.  Now we ask if the European Union can survive and if the United States can manage its finances without printing so much money that the world chokes on the dollar.

The crisis in markets is the mother of the crisis of states.  The bailouts and stimulus programs that governments used to address the market crisis led directly to our current problems.  States (and multilateral institutions like the EU and the ECB) took on so many obligations that investors began to lose faith in the ability of governments to honor them — and drew attention to the dire long term problems of modern welfare states on both sides of the ocean.

In the short term, a dramatic acceleration in the process of liquidating blue social model policies on both sides of the Atlantic is required.  Italy is speeding up its plans to balance its budget and moving aggressively to deregulate its labor and professional markets.  (As always in Italy, we shall see.)  The United States has made feeble and halting steps in the direction of trimming its eye-popping deficits.  More will be needed.

But in the long term, we face the return of real risk.  Since World War Two, we have lived in a bubble.  Governments were always available to backstop the economy.  In a way that was never true before 1945 and may never be true again, governments were the sovereign lords of the economy.  States were big enough, their taxing power was high enough, and national economies were closed enough that in the last analysis governments could be the lenders of last resort and could draw a line under financial panic.

No more.  Financial markets have become so large and so volatile, and the global economy (especially though not only) at the level of finance has become so integrated, that not even continental powers like the US and the EU can control or even guarantee them anymore.

This changes everything.  For two generations markets have mostly thought of risk in terms of tame risk: the risk that an asset might lose some of its value, the risk that a particular counterparty might not fulfill its side of a transaction.  But now we are back to the world of real risk or wild risk: the risk that a currency might disappear, the risk that a major government (as opposed to the occasional banana republic) might default on its debts, the risk that a financial crisis could erupt and that no government, no central bank could limit its scope or temper its impact.

Interesting times.

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  • Kris

    In short: markets/economies have become big enough to fail.

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