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A self-inflicted financial crisis - Outside View by Asad Dossani

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A self-inflicted financial crisis
Aug 1, 2011

During the week, markets sold off globally and continue to remain on edge as the risk of a US default increases by the day. As many analysts have pointed out, the consequences of a US default could be catastrophic for the global financial system. On the other hand, it may not be another Lehman Brothers, but a lot of uncertainly has been unnecessarily created.

The US congress must raise the debt ceiling by 2nd August, or the country risks defaulting on its debt, as it will not be allowed to issue new debt to cover its obligations. The two main political parties, Democrats and Republicans, have been battling it out in negotiations and have been unable to reach an agreement. Crucial to this failure has been the ultra conservative section of the Republican party (know as the Tea Party), who are unwilling to raise the debt ceiling under any circumstances.

It is still possible and probable that they will come to a last minute agreement and prevent a default. However, even if this occurs, it is unlikely to be satisfactory. The deal will certainly be too small to make a significant positive impact on the US fiscal position, and will likely lead to further political wrangling in future negotiations.

This whole episode is deeply embarrassing for the US, even if they end up striking a last minute deal. The political system is built on the idea of checks and balances, whereby compromise is often needed to pass legislation. In the debt ceiling debate, this has spectacularly failed. Congress' inability to come to a deal has really highlighted the dysfunction in the American political system.

If the US ends up defaulting, it would be like a football team deliberately scoringan own goal in the world cup final. Except that the consequences would be more than a few angry fans. It would be the first time that a country has created a financial crisis for itself and the rest of the world for no real reason.

While countries like Greece and Ireland are doing everything they can to avoid default, the US is close to willingly defaulting, even though plenty of investors are happy to lend the US money at very low interest rates. Another issue is the credit rating. Once again, the country is happy to let their rating fall and allow damage to their economy.

If we think back to 2008 when Lehman Brothers defaulted and collapsed, the impact was enormous. Markets went into free-fall, and soon afterwards, most countries experiences a recession or a slowdown. Lehman Brothers was important to the financial system, but not nearly as important as the US government. If the US defaults, the consequences could potentially be much worse.

Plenty of politicians point the blame at one another for failing to reach an agreement. They all talk about how important raising the debt ceiling is; yet they have so far failed to do it. The simple fact is that most people don't care who says what, or whole fault it is, people just want this issue sorted out. The old adage holds true: actions speak louder than words (especially when it comes to politicians, who talk a lot but do very little).

Disclosure: I do not hold the currency/commodity that is analyzed in this column.

Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!


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