Anatomy of a debt crisis

It’s amazing how complacent politicians and investors are about debt national problems. The main reason is they misunderstand the relationship between debt, risk, and interest rates.

It is an open secret that the global economy is tipping towards recession. On the basis that interest rates and bond yields are controlled by central banks, this allows investors to assume that if the recession does materialise, the authorities will simply cut interest rates to guarantee a soft landing. The can will be kicked down the road, as it always has been, preventing past recessions from being anything other than shallow.

The exception was the so-called great financial crisis of 2008/09, when there was a momentary deep recession. But just to prove the efficacy of central bank policy, the Fed did what it always does — cut the Fed Funds Rate aggressively from 5% to ¼%. But the other thing it did was write open cheques to the banks, underwriting and guaranteeing the entire US banking system.

While the cut in rates undoubtedly helped, it was the open cheque policy which mattered more. Bankers had stared into the abyss and heaved a sigh of relief, not calling in their loans. They had, in fact, been remarkably reckless — caught up in a collective groupthink over residential property loan syndications. They had stopped pricing risk as they should have done. And having been caught out put the relationship between risk and its proper pricing on the back burner.

The situation today is very different.