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MAYBE everything will turn out all right. One shouldn't forget that possibility. As each day passes, however, frustration grows. Leaders in America and Europe are dallying with failure on an epic scale. They are constrained by dysfunctional institutions, it's true. In Europe, the architecture of the currency union is far too underdeveloped to weather a crisis of the current magnitude. In America, the creaking machinery of the legislature is ill suited to settlement of big questions on a short time frame amid divided government. But it's no longer sufficient to blame inadequate policy responses on institutions alone. America and Europe are flailing because their leaders are failing. They seem to be too small for the tasks at hand, too petty, and too myopic. 

The challenges facing Europe and America are big, but they're not mysterious. In Europe, the issues are sovereign debt, vulnerable banks, and a poorly designed currency area. It's not tricky to see what must be done. Peripheral debts should be addressed through austerity, sure. But unsustainable debt loads need to be written down. Banks should be recapitalised to prevent trouble in financial markets. Emergency funds should be bolstered to fight sovereign and banking contagion. And substantial fiscal integration must take place, including fiscal transfers to support peripheral economies while they get their budgets in order. The central bank should also stop fighting the phantom of accelerating inflation.

European leaders know what they need to do. They have been slow to do it for two reasons. First, the magnitude of the commitment necessary to save the union is uncertain, and they don't want to pay a penny more than is necessary. And second, the distribution of the costs of the commitment is uncertain, and no individual entity wants to pay a penny more than is necessary. The concerns are understandable, but this thrift is fundamentally wrong in the context of the current crisis. Euro-zone unemployment stands at 9.9%; among young workers, the rate is more than twice that level. The euro-zone economy appears to be heading back into recession. Industrial activity is already shrinking in Greece, Ireland, Italy, Portugal, and Spain. And despite Europe's most ambitious intervention to date, yields on peripheral debt are rising, and rising fastest in Spain and Italy. A real sovereign-debt crisis in Italy would pose a serious threat to the euro zone itself, to financial markets, and to the European economy. Now is the time for those who can to pay whatever it takes to save the situation. But among the euro zone's top leadership there is a stunning complacency.

In America, the situation is more ridiculous still. The economy is vulnerable. New data continue to reveal just how weak growth was in the second quarter. The economy may scarcely have expanded at a 1% annual pace. Unsurprisingly, job growth was too slow to keep up with a growing labour force, and the unemployment rate began rising again. Conditions were expected to improve in the third quarter, however. Industrial activity seemed to be rebounding, and there have been hints that labour markets might also be revving back up; initial jobless claims fell back below the 400,000 level last week for the first time since April. Markets were nearing their recovery highs.

Washington seems practically excited to stamp out optimism. Congress has spent the first month of the third quarter dangling the prospect of a full blown fiscal crisis over the heads of American firms and households. Markets are retreating, and businesses are building up cash reserves as insurance against the worst. After two years of pitifully slow recovery, while tens of millions of workers are un- or underemployed and wages flat, the government is doing its absolute best to kill the latest growth rebound in its crib. It is shocking.

Again, it's not like the correct policy path is incredibly complicated. Here, I'll sum it up in three quick steps:

1. Don't cause a major crisis.
2. Do spend more and tax less for the next year or so.
3. Do spend less and tax more after that.

See? That's really easy! If you wanted to move up to more complicated ideas, you could talk about using the opportunity of record low borrowing costs to make needed, long-overdue investments in critical American infrastructure. Instead, Congress seems determined to convince the world that America shouldn't be allowed to borrow at all, except at highly punitive rates. It might also be a good idea to confirm appointees to the Federal Reserve board who know a thing or two about how labour markets work. Instead, Congress is blocking nominees for sport, citing debasement of the currency while 10-year inflation expectations are under 2%. And while the very same legislators muse publicly about how an American debt default might not be so bad after all.

It's inexcusable. And it is a direct result of a leadership in Washington that is too small-minded to see the danger it's courting by recklessly pursuing a foolish ideological agenda.

Right now, Angela Merkel doesn't look like the leader Europe needs to spare it a wrenching crisis. Jean-Claude Trichet looks like the wrong man in the wrong place at the wrong time. Barack Obama looks like a man who picked a fight he couldn't finish. John Boehner looks to be too worried for his political future to cow a caucus apparently hungry for catastrophe.

One wants to shout at them: stop screwing around! Lives and livelihoods are on the line! Nothing good will come of a return to recession, to saying nothing of a new financial meltdown. And yet, the trifling continues. Sometimes history gives us individuals equal to troubling circumstances. Sometimes it doesn't, and the world suffers. Maybe everything will turn out all right. Shame on the leaders of Europe and America for working so diligently to ensure that it doesn't.

THIS week's interesting economics research:

• The colonial origins of the divergence in the Americas (Robert Allen, Tommy Murphy and Eric Schneider)

• Last-place aversion (Ilyana Kuziemko, Ryan Buell, Taly Reich, Michael Norton)

• The impact of issuer size on pricing of mortgage-backed securities (Jie He, Jun Qian, and Philip Strahan)

• The external impact of China's exchange rate policy (Barry Eichengreen and Hui Tong)

• Lessons from the Eeropean Financial Stability Framework Exercise (José Viñals, Antonio Borges, and Sean Hagan)

• The collapse of the Railway Mania (Andrew Odlyzko)

TYLER COWEN quotes Politico:

It’s not the default that strikes the most fear in the White House and Congress these days. It’s the downgrade.

…what really haunts the administration is the very real prospect, stoked two weeks ago by Standard & Poor’s, that Barack Obama could go down in history as the president who presided over his country’s loss of its gold-plated, triple-A bond rating. Financial analysts say such a move would hit Americans with more than $100 billion a year in higher borrowing costs, but it’s not just that. It would be a psychic blow to a nation that already looks over its shoulder at rising economic powers like China and wonders, what’s gone wrong? And it would give the president’s Republican rivals a ready-made line of attack that he’s dragging the country in the wrong direction.

As psychic blows go, this might be a significant one. Personally, psychic blows don't bother me much. America would obviously prefer not to spend $100 billion more a year on borrowing costs than it does now, but it's worth remembering that that amounts to less than 1% of GDP.

The government should shoulder reasonable costs to avoid a downgrade, but I think it's easy to overstate what reasonable costs are likely to be. How serious is a downgrade, really? Markets have given us some sense this week. Over the past few days, it has become clear that a downgrade to America's debt rating is likely. Intrade contracts on the likelihood of a downgrade by the end of the year have surged from about 40 to over 60 and rising. Wall Street is no doubt building expectations of a downgrade into prices. And the result? Well, shares are off a little and borrowing costs are up a very little. A downgrade might be messy and could generate some economic ripples, but it's not the kind of thing that's likely to tank the economy. The White House and Congress should fear a default more than a downgrade. And they should certainly be more worried about the impact of an overzealous fiscal contraction than about S&P's judgment.

CATHERINE RAMPELL tells the troubling story of the long-term unemployed in America, who often find that even their job applications are unwelcome:

A recent review of job vacancy postings on popular sites like Monster.com, CareerBuilder and Craigslist revealed hundreds that said employers would consider (or at least “strongly prefer”) only people currently employed or just recently laid off.

The practice is common enough that New Jersey recently passed a law outlawing job ads that bar unemployed workers from applying. New York and Michigan are considering the idea, and similar legislation has been introduced in Congress. The National Employment Law Project, a nonprofit organization that studies the labor market and helps the unemployed apply for benefits, has been reviewing the issue, and last week issued a report that has nudged more politicians to condemn these ads.

Given that the average duration of unemployment today is nine months — a record high — limiting a search to the “recently employed,” much less the currently employed, disqualifies millions.

A little background: the recent recession looked somewhat different from most previous recessions in that the rate of exit from unemployment fell dramatically. In the early 1980s, by contrast, lots of workers lost jobs, but most of them returned to the labour force relatively quickly. So while the unemployment rate in the early 1980s peaked above the top unemployment rate of this latest downturn, the average duration of unemployment in the early 1980s was about half of the current level. The result is an unprecedented crisis of long-term unemployment.

The employer behaviour described by Ms Rampell is probably rational. Firms likely see long-term unemployment as a useful signal of worker quality, and given the huge volume of applications attracted by any advertised opening, this filter makes their job easier without eliminating too many high-quality candidates from consideration. (Though Ms Rampell questions this here.)

What's fascinating to me are the labour-market dynamics revealed by her piece. Consider:

“I feel like I am being shunned by our entire society,” said Kelly Wiedemer, 45, an information technology operations analyst who said a recruiter had told her that despite her skill set she would be a “hard sell” because she had been out of work for more than six months.

I'm going to draw an analogy here that is in no way intended to degrade Ms Wiedemer; it's simply meant to be illustrative. Suppose you're trying to sell a product and you're informed that the product is a "hard sell". Suppose further that the product you're selling is perishable; the longer it sits on the shelf, the less attractive it is to potential buyers. What do you do? You might try an advertising campaign to lure in buyers. If there are lots of other people selling similar, perishable goods, however, then they'll be doing the same thing, and your message will be drowned out. You might try to repackage the good. But that's not cheap, and having shelled out for the good in the first place you might not have the money or the time to spend on repackaging. So what do you do?

You mark down the price, obviously. You slash the price by 20% or 50% or 70% if need be, because it's not doing you any good at all to have that product sitting on the shelf going bad. So the question is: why isn't Ms Wiedemer cutting her asking price?

Continue reading "Long-term unemployment is a sticky situation"»

BRITAIN'S economy faces serious economic headwinds, and the strain is showing. British economic activity grew by just 0.2% from the first quarter to the second, thanks largely to a big decline in output in production industries. Kash, at the Street Light, draws the obvious conclusion:

It's not mysterious: when you raise taxes and cut government spending, growth slows. And when you do that during a very fragile and weak recovery, you can push your economy back into recession, or at best, choke off growth almonst completely. That's exactly why, as has been extensively written about both here and elsewhere, austerity during a time of economic weakness is not a good way to beat a budget deficit, and will be largely self-defeating.

Given the debt panic sweeping the European continent, Britain's decision to pursue a preemptive fiscal consolidation looks prudent (though the low level of yields on British debt indicate that austerity has been more aggressive than it needs to be, perhaps putting the economy at unnecessary risk). What should stand out, however, is the significant difference in Britain's experience relative to the euro zone's. 

The British austerity programme kicked in in earnest in 2011 and ramped up considerably in the second quarter. Despite this, the British economy grew substantially faster in the first quarter than the economies of the struggling euro-zone periphery. The slowdown in the second quarter is disconcerting, but it's also somewhat overstated. The Office for National Statistics estimates that one-off factors, including the Japanese disaster and the royal wedding, reduced growth by half a percentage point. But for those drags on growth, expansion might well have accelerated from the first to the second quarter. We don't yet know how the euro-zone periphery performed in the second quarter, but indicators suggest that contraction is a real possibility. Purchasing managers' indexes show British expansion in June but shrinking activity in Greece, Spain, Ireland, and Italy. 

The biggest difference in the outcomes would seem to be Britain's monetary independence. The European Central Bank responded to a mild increase in inflation with interest rate increases, despite ample indication that a shrinking euro-zone economy would soon gut price increases. In Britain, by contrast, the Bank of England has allowed inflation to stay above the normal target level. Its Monetary Policy Committee appears to recognise the importance of stabilising growth in nominal spending and in accommodating austerity.

History is clear: big fiscal consolidations are almost impossible in the absence of monetary-policy and exchange-rate-policy freedom. Britain's austerity clearly won't be painless. But the record will almost certainly show that fiscal sustainability was achieved faster, at less cost, and with fewer crisis moments in Britain than around Europe's periphery.

SORRY to be so stuck on news in Europe and America; these days it's difficult to focus on much else. Earlier today, I mentioned that yields on Spanish and Italian debt were up sharply to start the week. That increase is partially a product of ongoing consideration of last week's deal and it's implications for the future of the euro zone. It was also influenced by a Moody's downgrade of Greek debt. The ratings agency expressed concern that a Greek default would hit financial institutions in other peripheral countries, and it fretted that, "The support package sets a precedent for future restructurings should the finances of another euro area sovereign become as problematic as those of Greece". In other words, having put together the machinery of a sovereign-debt restructuring, the euro zone is likely to use it more than once. That doesn't mean that the euro zone made a mistake in putting these mechanisms together; it was simply acknowledging the inevitable. But having acknowledged one obvious case of insolvency, it does become harder to delay acknowledgement of other obvious cases.

That's especially true when pressure is being applied from several directions. The Financial Times reports today that a number of European banks with significant exposures to Greece are showing reluctance to sign up for one of the voluntary restructuring options in last week's deal. It's early going yet, but there is growing concern that the estimated 90% take-up of the restructuring offerings was a tad optimistic.

European banks have plenty to worry about, as things stand. European default risk is one worry, but banks are also feeling an impact from the impasse in America. The FT:

US money market funds have sharply cut their exposure to banks in the eurozone over the past few weeks and reduced the availability of credit, even in stronger countries such as France.

While the agreement of a second bail-out deal for Greece might ease nerves, the funds are also stockpiling cash in case US politicians fail to raise the federal debt ceiling, prompting withdrawals from investors.

One French financier said: “Up to mid-June, getting three, six or nine-month money was not that difficult.

“But now, getting one-week or one-month money is about all we can manage”.

At the moment, this is undermining euro-zone economic activity and putting additional pressure on stress banks. Should a debt-ceiling impasse lead to real financial market difficulties and a flight to safety, peripheral banks and sovereigns will come under a great deal of pressure. A lot of people will yank their money away from anything that looks vulnerable, and there are a lot of European institutions looking vulnerable right now.

America will probably avoid the catastrophe of an outright default. But it could experience an economic setback serious enough to trigger collapse in Europe. If you think those two dominoes can fall without knocking over any others, you're more optimistic than I am.

FOR a few wonderful days, we were all able to pretend that Europe's troubles might not be so unmanageable after all. No more. Monday brought a market reckoning, all right, but it came on the European side of the Atlantic. European equities and the euro are giving back some of their recent gains today, but the real story is sovereign-debt yields. Borrowing costs are up around the periphery, but Spanish and Italian yields are soaring. Yields on Spanish 10-year debt are back above 6%, signalling that Spain remains a strong candidate for an eventual bail-out. It's telling that one of the boldest policy moves the euro zone has made in this crisis calmed markets for all of two trading days.

Why such a short respite? The main reason is that the euro-zone periphery is being squeezed from two sides. On the one hand, borrowing costs are high and rising. On the other, growth is faltering. The euro zone's struggling members are back in or close to (or, in Greece's case, never left) recession, and the euro zone as a whole may soon follow suit. With the cost of debt rising and economies contracting, debt burdens are growing ever less manageable. Markets are understandably reacting by demanding a higher risk premium, which increases borrowing costs, prompting new austerity measures, which reduce growth.

The only ways to break to the cycle are through large reductions in debt levels or through greater fiscal transfers that cushion economies against the impact of austerity. Last week's deal was hailed for its boldness, but in terms of actual reductions in debt burdens, only Greece's obligations were involved, and those look likely to be cut too little to put the Greek economy back on a sustainable footing. Euro-zone leaders also made vague promises of a Greek Marshall Plan, but what's actually needed (if the euro zone is to be preserved) is a much greater level of fiscal burden-sharing. 

The conventional wisdom is that a much larger fiscal commitment to the euro zone is unthinkable within the core economies, Germany in particular. I don't know if that's true or not; Matt Yglesias argues here that there's more of an appetite for closer union in German than is often asserted, particularly when the alternative is an escalating series of crises. What is clear is that until the euro zone demonstrates its awareness of the stresses imposed by currency union and its preparedness to build the machinery to offset them, markets will continue to question the union and push it toward dissolution.

AFTER musing on the new euro-zone plan for an evening, two principal thoughts stand out. First, the deal clearly makes for good firefighting. Yields on peripheral debt are cratering this morning, and it isn't too difficult to understand why. A few days ago, I wrote:

Either the Europeans are willing to fight to keep their union or they aren't. If they aren't, they'll lose it; it's as simple as that.

In recent weeks, markets came to doubt seriously that the Europeans were willing to fight. The seeming lack of urgency and imagination made a near-term break-up of the euro zone look plausible, even likely, and that was increasingly reflected in bond yields. The new plan does not solve all of the euro-zone's problems, but it does send a strong signal that Europe is not done fighting. And it increases the likelihood that further troubles in the future will be met with further assistance from core euro-zone governments. That alone is enough to take the wind out of the sails of traders betting against the future of the euro zone.

That's the good news. The bad news is that while the euro zone has come up with a bold new array of firefighting tools, they haven't begun to address the fire-prone nature of the currency area itself. Right now, the focus is on keeping banks and governments afloat while committing member nations, over the medium-term, to the old Maastricht rules for fiscal propriety. What's missing is a mechanism to address the weaknesses in the economic structure of the euro zone.

Even after this plan, peripheral countries—and Greece especially—face wrenching periods of fiscal austerity. They face this prospect within the confines of a euro zone that makes devaluation impossible and that lacks a meaningful mechanism for internal fiscal transfers. At the same time, the growth outlook for the currency area continues to worsen; fiscal and monetary policy are both growing tighter, and a return to recession looks likely.

Talk of a new Marshall Plan is all well and good, but a meaningful effort to support the Greek economy (to say nothing of the Irish, Portuguese, Spanish, and Italian economies) will take a meaningful fiscal committment from core economies, and that's not a prospect German voters are likely to look kindly upon. Without that, however, the periphery faces years of grinding contraction and painful reductions in real wages. History suggests it's very difficult to sustain austerity in these conditions. Without a lot more help the tensions will remain, flare-ups will be inevitable, and everyone involved will have their patience tested.

This plan has averted a near-term disaster. But the biggest risk to the euro zone is that its leaders will begin thinking that they've solved the problem. As growth figures worsen in coming months, markets will once again become antsy. Euro-zone officials had better be preparing for a way to convince them anew that they want this thing to work.

AFTER months of dithering, through which market confidence in a struggling periphery steadily eroded, eventually dragging the economies of Spain and Italy into the gyre, the euro zone has at last prepared its response. While it may not prove sufficient to the task, it is more than many hoped for or expected to get. An emergency Brussels summit has concluded with agreement on a new rescue package for Greece, worth an estimated €109 billion, and a new set of weapons in the battle to limit contagion.

As expected, private creditors of the Greek government will take a hit, contributing €37 billion of the package's total. Bondholders will be given four restructuring options to choose from, a menu that includes a selection of durations and coupon payments. The hit to private lenders will most likely lead to a "selective default" rating from ratings agencies, but the European Central Bank has acquiesced to this outcome. ECB President Jean-Claude Trichet suggested that European governments would likely guarantee Greek bonds in the event of a default rating.

The bail-out programmes for Greece, Ireland, and Portugal would all be amended as a result of the agreement. The interest rates on emergency loans would fall to 3.5% (a drop of 1 to 2 percentage points) and repayment schedules will be lengthened considerably. There was also agreement on a Greek bond buyback programme worth €12.6 billion.

Lastly, expected changes to the European Financial Stability Facility were included in the deal; the EFSF will not receive an increase in funding, but it will be allowed to lend to countries without a bail-out, and it will have the ability to recapitalise struggling banks. It may also get permission to purchase the debt of troubled countries on secondary markets in "exceptional circumstances".

European leaders made sure to assemble sound-bite ready material in calling (somewhat amusingly) for a "European Marshall Plan". This particular plan would apply only to Greece, and, if realised, would entail:

[A] Task Force which will work with the Greek authorities to target the structural funds on competitiveness and growth, job creation and training. We will mobilise EU funds and institutions such as the EIB towards this goal and relaunch the Greek economy. Member States and the Commission will immediately mobilize all resources necessary in order to provide exceptional technical assistance to help Greece implement its reforms.

The new framework covers many of the bases economists suggested should be hit. It reduces Greece's obligations, rather than merely postponing them. It creates a mechanism to support troubled banks. The size of the commitment is likely not sufficient to deter financial panic in the event large European banks are threatened by the potential insolvency of, say, Spain, but it may be enough to limit bank runs within Greece. It gives the EFSF some of the tools necessary to rebuild the firewall between Spain and Italy. And it holds out the hope for a programme of fiscal transfers to Greece, to help its struggling economy endure the austerity necessary to keep it in the euro zone. For now, markets have given the plan a big vote of confidence. Equities and the euro are up; yields on peripheral debt are down.

But already, some are criticising the plan as too timid. The impressive commitment to keep Greece afloat has not yet been matched by a commitment to restructure the debts of Ireland and Portugal, which are also probably insolvent. The failure to boost the resources of the EFSF may reduce the plan's impact on confidence in European banks and in the determination to halt contagion. And the vague "Marshall Plan" portion of the programme is the only nod toward the dire growth outlook across the struggling European periphery. Indeed, the agreement reiterates the euro zone's commitment to rapid reductions by 2013. The combination of continent-wide austerity and a hawkish ECB posture will ensure that euro-zone growth is slow to negative for the next few years. That, in turn, will make life very difficult for the beleaguered periphery. This increases the odds that the stated goals will not be met, and that disappointing performances will precipitate more crises of confidence in markets.

The euro-zone's leaders have done better than many hoped they could, but that is not saying much. This plan may buy the currency area time. But its survival will only be guaranteed if that time is used to continue the process of fiscal integration and reform.

Read on: More on the emergency euro-zone summit from Schumpeter, Charlemagne, and Democracy in America.

(Photo credit: AFP)

INVESTMENT bankers do not often advocate bigger government, but UBS’ Stephane Deo has an interesting paper arguing that wholesale privatisation is not the answer to European sovereign-debt problems. The potential revenues are significant—between them euro-zone governments own financial assets worth €2.35 trillion (or 26% of euro zone GDP), while UBS estimates non-financial assets such as property are worth double that. But Mr Deo suggests three alternatives to privatisation. 

First, the likes of Greece may be able to return to the bond market earlier if they pledge revenue from state-owned assets as security against new bonds. Second, leasing state-owned property rather than selling it would provide consistent deficit-reducing revenue year after year, rather than a one-off debt reduction. Finally, rather than privatising state-owned enterprises, why not impose market discipline, while retaining ownership of the subsequent profits?

We too have argued that privatisation, in Greece in particular, should proceed more cautiously than currently planned. Proper regulation should be developed before state-owned utilities such as railways and electricity providers are sold off, to ensure sufficient competition to restrain price rises. But that is very different from avoiding privatisation altogether.

Mr Deo says his proposals would lead governments to manage assets efficiently without sacrificing ownership: the more property a government can make available for rent, the more revenue it will raise, the higher the value of government-owned shares, the more bonds can be guaranteed against them. However few governments have been able to pull off the trick of fully exploiting assets, even when financial incentives to do so exist. This wider argument about whether governments can be effective managers is inevitably subjective, but could Mr Deo’s alternatives more effectively raise short-term revenue?

A Greek bond backed by revenues from the sale of mobile-phone spectrum, for example, might well be attractive to investors. But it is a non-starter. Greece’s existing creditors, from the IMF to other European governments and private banks, would effectively be subordinated, since scarce revenue would be pledged to pay off new creditors. Even if Greek bonds do not have a negative pledge clause legally preventing the government from creating super-senior creditors, doing so is unlikely to be politically feasible.

Continue reading "Selling oneself short"»

JUST 12 days until the deadline, and there is little sign of progress on the debt-ceiling front. Ezra Klein writes:

One common explanation for where we are in the talks is that we're waiting for the last minute. No deal struck before the last minute will be credible as the best deal Republicans could possibly get, because in this negotiation, time is leverage, and if the clock isn't one minute from midnight, that means there's leverage Republicans chose not to use. Until we hit that point, there's just not enough incentive for the House GOP to say "yes" to anything, not enough pressure to force them to say "yes" to anything, and there's an argument, popular among some conservatives, that it would in fact be a mistake to say "yes" to anything.

But what no one quite knows is what the House GOP will accept when the clock is one minute from midnight, or, in more pessimistic tellings, the Dow is 1,000 points below whatever it was at the day before. We're hearing talk that the "Big Deal" is being revived, but the bigger the deal, the tougher it is to pass quickly.

There appears to be some movement toward a strategy in which the grand bargain is the main target (the better to avoid a ratings downgrade) with a short-term increase in the limit a possibility if additional time is needed to secure a big deal. That's all lovely to think about, but there's still no sign of that elusive holy grail: a plan that's acceptable in both the House and the Senate.

Meanwhile, there are signs that we've crossed into the penumbra of actual impacts on the economy. Goldman Sachs released a note this week suggesting that a recent deterioration in American consumer confidence seems to be related to concern about the outcome of the debt-ceiling impasse. The New York Times notes that the market reaction is beginning:

Even though many on Wall Street believe that a default remains unlikely, the financial markets are starting to become agitated. Volatility in stocks has soared, and some investors say stock prices are falling because a United States default could severely raise companies’ costs of doing business.

In the Treasury market, investors are starting to sell, fearing that the government will not make good on some interest payments that will be due next month. And complex financial instruments that will pay out if the United States defaults have become twice as expensive to buy as they were at the start of the year.

A note in the new edition of The Economist goes into more detail on the calculations being made on Wall Street:

Some fear that a default could cause a 2008-style crunch in repo markets, with the raising of “haircuts” on Treasuries leading to margin calls. The reality would be more complicated. For one thing, it’s not clear that there is a viable alternative as the “risk-free” benchmark. One banker jokes that AAA-rated Johnson & Johnson is “not quite as liquid”. In a flight to safety triggered by a default, much of the money bailing out of risky assets could end up in Treasury debt. Increased demand for collateral to secure loans could even push up its price.

Then there is the impact of a ratings downgrade. Money-market funds, which hold $684 billion of government and agency securities, are allowed to hold government paper that has been downgraded a notch. Other investors, such as some insurers, can only hold top-rated securities but their investment boards are likely to approve requests to rewrite their covenants, especially if a lower rating looks temporary. “It would be a full-employment act for lawyers,” says Lou Crandall of Wrightson ICAP, a research firm...

Amid the chaos, it's far from clear that Treasury yields would rise. A flight to safety would hammer equities, however, and could impact vulnerable sovereigns. Any of them around these days?

Lastly, it's worth noting today's big market move—at Intrade. Contracts on conclusion of a debt deal by the end of July dropped sharply today on high volume, indicating that no deal is seen to be the most likely outcome. More worrisome still, contracts on completion of a deal by the end of August also sank. Let there be no doubt: the failure to reach a deal on the debt ceiling through the month of August would mean a return to recession. That this isn't entirely out of the question is a frightening thought.

TODAY'S recommended economics writing:

• Fake Apple Store in China (Kottke)

• Renting v. buying (Economics 21)

• Randomized field experiments were tried and rejected (Mark Thoma)

• What kind of economics will intelligent aliens have? (Marginal Revolution)