There is currently sharp and appropriate focus on Europe’s ever-evolving and surprising sovereign debt crisis among market participants and global policymakers.  This crisis will undoubtedly dominate the discussions at the upcoming G20 Summit in Cannes, France over the next few days.  While the Euro zone’s troubles are certainly deserving of careful attention, I’d argue that the deliberations and potential outcomes of the Deficit Reduction Supercommittee are of equal importance.

The stakes are sky-high.  Failure to meaningfully address the nation’s fiscal circumstances entails a number of financial dangers that could significantly impact the productive vitality and job-creating capacity of the United States – the world’s largest economy.  Principal among these is the risk that global investors could become increasingly worried about America’s debt position and begin demanding higher risk premia to continue purchasing U.S. government debt.  At current elevated levels of debt, rising interest rates will compound an already challenging debt situation, adding further to the nation’s debt burden, increasing investor anxiety, and likely leading to even higher interest rates. 

Moreover, given that Treasury bills and bonds are the basis for borrowing structures in private credit markets, the impact of rising government debt rates on the cost of capital, economic growth, and job creation would be far-reaching and decidedly negative.

Given the likely impact of higher rates on U.S. economic prospects, another risk associated with inaction regarding our nation’s debt position is that investors may become increasingly reluctant to hold dollar-denominated assets.  As investors increasingly choose foreign investment opportunities, the relative value of the dollar would fall, undermining Americans’ purchasing power and standard of living.  A falling dollar also has dangerous implications for inflation.

Finally, given the likely impact of higher interest rates, slower growth, and a falling dollar on asset prices and market confidence, further deterioration in the nation’s debt position would likely be associated with greater financial market instability. 

Markets are rightly focused on Cannes and the G20 meeting and what the outcomes will mean for financial stability.  The Supercommittee warrants similar attention. 

By Rob Nichols