Sovereign Risk

Everyone in the United States ought to be paying close attention to the troubles in the credit markets of Greece. It may seem hard to believe that the debt problems of a midsize nation halfway around the world would be of great concern to Americans. Greece, after all, has a population of about 12 million people, which is roughly the same size as the greater Los Angeles metropolitan area. And yet it matters—a lot.

Greece has been teetering near default for weeks now. The government has come up with a plan to cut spending and raise its credit worthiness. The plan has gone over pretty well among European finance ministers, but it has angered people at home, where customs officials and tax inspectors started a two-day strike Thursday. A broader strike has been approved.

The strike has put the cost-cutting plan into doubt, which caused investors on Thursday to flee other weak sovereign issuers such as Spain and Portugal. If those countries come under pressure, the stronger economies of Europe, such as Germany and France, could bear the brunt of a bailout. The prospect of higher interest rates and a slow economy was enough to cause widepsread pressure on both credit and equity markets around the world.

U.S. stocks were hammered, with the Dow Jones falling 2.6 percent to 10,002, its worst decline since April. Mortgage rates moved above 5 percent this week for the first time in a month and a half. The price of oil fell 5 percent and the price of gold had its worst day since 2008.

The problems are reminiscent of the state of the markets in September 2008, after the fall of Lehman Brothers. That period was marked by extreme volatility and broad declines across virtually all asset classes. The dynamic was similar on Thursday. The only asset that gained was the U.S. Treasury bond, as investors flew to its relative safety.

It's not so much that Greece caused problems in the United States, but that all of these problems are part of the same system. If one part of the system is in distress, it's time to worry about all of the other components. It's quite possible that Greece will regain its financial balance by cutting back on spending. But if the cost-cutting plan doesn't work, and if Greece turns out to be the Lehman Brothers of sovereign debt, the effects will likely be felt around the world. And in that case, the giant, debt-laden, economically challenged U.S. could be AIG.

In a global market, there's no such thing as an isolated financial problem. Financial trouble spreads like the flu. That was true in the corporate market in 2008, when the failure of Lehman Brothers and the near-failure of AIG brought the global credit markets to the brink of total failure. The markets for debt issued by countries, known as sovereign debt, are vulnerable to systemic risk too.

The United States isn't immune either. Over the short run, investors may turn to U.S. credit in a flight to safety. But how safe is it? The country has big balance-sheet problems of its own. And cutting costs here may prove just as tricky as it is in Greece, even if the general U.S. population doesn't go out on strike.

What the United States has is the burden of a high level of public debt and an economy that is wrought by high unemployment, as well as the threat of a double-dip recession. It's experiencing some of the same problems that vex Greece. At Davos, there were several warning about the threat of a relapse into recession, from Nouriel Roubini and George Soros, both of whom predicted various aspects of the financial crisis.

Next time around, the financial crisis could hit at the sovereign level. And that is a scary idea. Who bails out a government?