Brad Delong on our current state
… I would have laughed at you. I would have said that while there were possible futures in which each of those things happened, they were disjoint futures.
Tyler Cowens adds
One way to solve that conundrum is to think about what expected real rate of return fits into both facts.
I think that’s the wrong way to think about it. One of the things that makes high finance so clear is that it sweeps away some of the bad intuition that we form being a part of the retail market.
For example, going about their daily lives people think that sometimes they buy things, perhaps sometimes they sell things, though mostly they get to buy things because they have a job.
From an economics standpoint this is of course all rubbish. There is no buy. There is no sell. There is only trade. I give you and you give me.
Because no one can take delivery of $500 Million in cold hard cash this fact becomes obvious in finance. If you are selling one thing you are buying another and hence the prices of all things are interlinked. They are in the retail world as well but because they are mediated by ever changing cash balances the link is not as direct.
So now we think about all the worlds in which S&P could downgrade the United States on August 5, 2011. How many of those worlds contain a viable alternative to Treasuries? In how many of those worlds is there an asset that you could sell out of Treasuries and into for safety reasons.
Lets even suppose that Europe was fine and Japan was fine. Does it make sense to sell Treasuries to buy German and Japanese bonds? In what world does the US default but Japan does not? In what world does the US default and Germany is not swept up into an unpredictable firestorm?
If you are selling Treasuries on credit risk, what are you buying? You have to trade for something. This has always been the problem.
This is why a downgrade of the United States is a downgrade of humanity itself. Its also why alternative to the dollar and Treasuries need to be found.