Washblog

As this prescient Financial Times piece suggests, There are two ways to handle large-scale government default. The first way is for governments to come together and work together financially in a much closer fashion, expanding the total amount of credit available through sounder management and increased borrowing. The second way is to invite financial panic and engage "competitive" and "retaliatory" default. There isn't a third way and rational people don't really even want to think about the second way.

...governments would soon discover that simply saying No was not going to work either [Editor's Note: Even Republicans?]. Back in the real world, governments would have to take into account the risk of contagion. For example, a sovereign default by a small country could wreak havoc on the markets for credit default swaps and might even destroy financial institutions in other eurozone countries.

A default could also trigger a panic rise in bond yields elsewhere, which could turn the threat of contagion into a self-fulfilling prophecy.

In other words, if you hated the Lehman Brothers default, you'll absolutely loath Greece, Portugal, Spain, California, Illinois, New York, etc., etc. etc..

This is because all modern finance rests on a foundation of the bonds of safe, powerful - and now democratic - governments. That's why - from the Rothschilds in the late 1700's to UBS, Deutsche Bank, Goldman Sachs and PIMCO today - the barons  and mavens of the bond market have collected so much power. It's not gold or oil or Chinese manufacturing that underpins our system, it's government bonds.

This is because the bonds of those governments are the core capital of all banks. Diminish the value of that core capital and things get very ugly, very, very quickly. So, every major government can be thought of as a bank. Washington is kind of like a small, well-run credit union. Greece is more like WaMu.

Banks are different from other businesses. You can run a bankrupt car dealership or manufacturing business while the creditors fight it out in court. You can't run a bankrupt bank because when a bank goes bankrupt it ceases to have any meaning. All the money just goes away. When the money goes away in one bank, it goes away for the entire system, which is, of course, why they call it "systemic risk".

Obviously a systemic risk has to be met with a systemic solution. What has to happen is that government debt has to be "monetized" on a massive scale. This means that governments buy old debt with new money they print. This creates a very large tax on wealthy debtholders - which is both good and completely just - while simultaneously preserving the relative value of bank capital.

[Governments] would agree a package of credits to stabilise the defaulter.

The recipient would, in turn, have to accept an austerity programme, perhaps even the temporary loss of fiscal sovereignty, to ensure that the loan was repaid and to reduce moral hazard. In other words, the [governments] would bail out one of their own, but it would not be fun for anyone, especially not for the defaulter.

To that I would add an important additional concept: investment. To the extent that government takes on the role of banker, government must also demand that its investments generate value. This is not so hard as Wall Street makes it out to be. Revenue-positive investment is fairly straightforward if governments cooperate instead of competing.

From Juneau to San Francisco there is a region with many common concerns, common resources, and financial systems that could be much more closely integrated. Obviously this would take place through the federal government(s) but the concept really has to come from governors. Governor Gregoire should be leading a conversation about regional recovery and security.

In addition to this financial tsunami, such a group could and should be talking about natural tsunamis and earthquakes and I-5 and rail and fishing and oil spills and environment and a whole host of other issues now rather than trying desperately to play catch-up when a crisis occurs.

Washingtonians are famous for their enmity towards California, but if you don't think that a California default crisis would have a hugely negative "contagion" effect on Washington, you're just not thinking clearly. Our economy is intrinsically linked to the California economy. As we saw with WaMu, financial disaster (mostly) in California has an enormous effect on the state of Washington.

To bring it back to Greece, in 2008, I reminded people that the world is actually desperate for high-quality, dollar-denominated bonds. That is still true, especially now and a well-managed state like Washington can benefit enormously from that fact, if it has just a little foresight.  - And hindsight! Governor Gregoire and all of us need to remember what it was like in 2008 when the financial dominoes started falling. And borrow and invest now to stop that process before it starts.

The level of cooperation and trust in a society creates the limit of credit available. From Athens to Sacramento, the looming government defaults mean we are very close to that limit. If the defaults happen, the amount of credit available will plummet well below what our modern society needs. So, we have to get together and expand credit. It's the only rational thing to do. If Washington, D.C. is too scared and mired in its own nonsense, governments like the state of Washington have to take the initiative and get the process started.