The possibility of a default is a black swan

It has been now 15 days since the US congress failed to agree on a budget. The political brinkmanship has gone on relentlessly though the ball has now gone to the senate and an agreement seems to loom in the horizon. Somewhat unexpectedly, markets remain rather optimistic about the whole thing and have shown a reaction which is way under the expected panic, with the DAX even reaching new records today.

A range of analysts have rightly said that it would probably an anti-climax since expected returns for US debt on the long run are expected to return to 100 cents per dollar, even if there’s a default for a short time. All of them agree that the chicken games being played by American politics are downright stupid bordering on suicidal. Though I am not an economic analysts and my understanding of financial markets is limited at best, I’d recommend caution when expressing the belief that it might not be as terrible as we’d expect.

Much as the Lehman Brothers default back at the beginning of the subprime crisis, I don’t think we can assess all variables at play here. Back then it all started with a real state bubble which had been made worse by bad probabilistic analysis (under the assumption that defaults on mortgages are independent events from each other, much as a throw of the die). What unleashed afterwards rather unexpected, especially when looking at Europe, where the fringe Economies of the monetary union spiraled one after another, requiring bail out money for several rather large economies.

Even after the full extent of the crisis had become more apparent, a few months into 2009 everybody expected the awful crisis to last a few years, not to spiral into a mess that might begin actual recovery by 2014, if the US politicians manage to sort the mess they’ve created. It is as true now as it was back then, we certainly don’t know what would happen if the US defaults even for a short time.

Probably the minute the announcement is made nothing will happen, but much like on technological development, it might be that we overestimate short term changes and underestimate long term ones.

Let us consider one particular scenario as a thought exercise. A US default would certainly make things harsher for the recovery in Europe. This in turn might result in European politicians taking a slightly bolder course and going for the measures which are and have been necessary for a while (like a real fiscal and banking union with an independent central bank, as opposed to the half-cooked monetary union we have). 

The drive to make Europe and European fringe economies more competitive would get a new push, and the lost drive for reform would again be urgent. Even now the EU is getting together with business in England and other countries for some serious red-tape reduction. Under the current situation mostly nothing much would happen. Under the lens of a financial debacle unleashed by the US default, political will might change and the red-tape cutting become a real efficient measure.

Let the huge European economy gather momentum, and its drive in world economics would be huge. Also the Euro would be more reliable as a currency than the dollar. Is the possibility of countries to go for the Euro as a reserve currency instead of the US Dollar really that remote? Even as I write it, it seems extremely unlikely, but how unlikely is it? If the political system in the US fails to improve after a default, and the extreme polarization driven by tea party supporters is not reversed, then the dollar might seem not as safe as previously thought.

Then one of the factors which have kept the imminent default of US debt from being the cataclysm we all expected would be off the table. Then again, a more competitive Europe would drive world demand, especially after the developing economies slow down. A shift from the US to the EU seems rather simple; both cherish the same western values and stand for democracy, the rule of law, and pluralism. Europe, is not, however, the US. Democratic values are different, and the perception of markets and companies is different. 

People in Europe mostly trust their governments, and distrust companies. They also believe in a far more extensive welfare state, and surrender a considerably larger amount of freedom to the government. Europe already has a hefty influence, demonstrated by Christine Lagarde as a head of the IMF even at a time when candidates from third world countries might have had a better insight into what a crisis entails and how it is solved, by having managed a country out of one.

The depth and duration of the ensuing recession notwithstanding the shift of powers would have effects that we cannot really foresee. I have painted a rather rosy picture not wanting any alarmism, and have thus disregarded China’s political influence, or Asia’s in general (depending on how China and India face their particular challenges). I have also not mentioned how Russia could use this to once again ascertain its own place in the world, as it did by cajoling western powers to agree to its own proposal to rid Syria of chemical weapons, without even the threat of military action looming at any time.

My point is not that the world would be extremely different immediately, my point is that we’re extremely bad at forecasting what the world would be like should a particular previously unthinkable disaster happen. Just as a tsunami in Japan has led to a 40% increase in energy costs in Germany, the possible consequences of a default, however short it might be, cannot really be assessed.