8 Aug 2011

North Atlantic debt crisis ‘giant game of Jenga’

I arrive in Manhattan with the price of gold shooting to new records above $1,700 per ounce, over £1,000 sterling. The common perception is that stock markets will take the S&P downgrade of US debt in its stride.

Asian markets are notably down, but there’s no crash as of yet. In Hong Kong there is genuine concern that the dollar is facing structural weakness. The G7 finance ministers and the IMF have put out well-meaning but low fibre statements after various teleconferences tonight.

The statement of the European Central Bank last night, seemed to suggest a large intervention in Italian and Spanish markets is likely this morning. The ECB will justify doing this now, having chosen not to do so barely four days ago, on the basis of Silvio Berlusconi’s promise to balance his budget in 2013 rather than 2014.

Market pundits will call it a “bazooka”, designed to put existential fear and doubt into the minds of the traders betting against Italy and Spain. It may put a floor under today’s market moves.

But do not be fooled. This will be short term sugar rush, rather than necessary medicine. I have referred to this as a giant game of “whack-a-mole”. So you sort Greece out, and the markets move to Italy. Persuade or force the ECB to buy up Italian debt, and then the mole pops up in Germany. No, not the fear of German default, but fears around a massive political backlash to the backdoor bailout of Italy long-feared since the abandnment of the beloved Deutsche Mark.

Here in the US, the popular wisdom has been to entirely write-off the downgrade, based on the notion that it probably won’t cause another crash today. But that misses the point. The US Treasury bill is a unit of megacurrency, that has suddenly been rated as riskier than we thought. If Freddie and Fannie are also downgraded today, expect long term mortgage costs to rise across America. Also how about the trillions of dollars of derivative contracts for which Treasuries are used as collateral. And what about the supposedly uber-safe “money market funds” which are also supposed to be risk free. When in 2008 post Lehman, some of these funds “broke the buck”,  i.e suddenly lost capital value, for the first time in history, it caused huge panic in the markets. It’s plausible again.

More than that, it is difficult to stress how toxic is US politics right now. President Obama’s allies were trying to get one message across over the weekend: this was the “Tea Party downgrade”. The Tea Party meanwhile want the Treasury Secretary to resign. So reserve your judgement for now.

The big worry is if the unintended consequences of the sovereign worries expressed here in New York and the bazooka to help Italy starts to point investors to another EU nation. A nation as yet not downgraded by S&P despite having debt levels similar to the US, yet taking on heavy burdens from bailing out other European nations. Its AAA status being essential to the eurozone bailout. That nation is France.

Follow Faisal Islam on Twitter: @faisalislam