As the probability of a US default goes from zero to non-zero, what the hell is a safe place to put my retirement money for the next couple of weeks. Currently, I’m doing the appropriate thing of having a Target 20XX fund hold my entire 401(K) as I know that I suck as a money manager and that I’m prone to the same biases that cause active investors to traditionally lag the market. However, I also know that those target funds are extremely passive in their management and are not optimized to deal with bizarre events like a political party willing to cause default just for the hell of it. So where do I go if I’m willing to forgo upside but want to preserve principal?
Money markets or short term US bond funds are the traditional flights to safety. But those would be the epicenter of a default crisis as either the US government would not be paying interest or principal on some debts and obligations OR there would be an asterik on any short term US debt issued at the end of October that was backed by the platinum coin option.
Krugman had an interesting model last week on the dynamics of a debt crisis for a country that has an independent central bank, open currency flows and debt denominated in its own currency.
As Romer points out in his notes, this can be reinterpreted as an open-economy model if we let capital flows be influenced by the exchange rate (most international econ types tend to think in terms of stocks rather than flows, but it doesn’t really matter here), so that a lower interest rate leads to currency depreciation. In this case the IS curve includes the effect of a weaker currency in promoting net exports.
Now suppose that investors turn on your country for some reason. This can be represented as a decline in capital inflows at any given interest rate, so that the currency depreciates. If you have a lot of foreign-currency-denominated debt, this could actually shift IS left through balance-sheet effects, as we learned in the Asian crisis. But that’s not the case for Britain; clearly, IS shifts right. If LM doesn’t shift, the interest rate will rise, but only because the loss of investor confidence is actually, through depreciation, having an expansionary effect.
He was talking about the UK in the model, but if we assume the Fed acts as lender of last resort, a political crisis that leads to foreign currency outflows from the US would behave similiarly. Higher local inflation and a weaker dollar to aid in exports and help local providers of trade competitive goods.
Umm…