Insurring against Political Risk (reprise)

By Dave Anderson:

   A reprise of one of my more more relevant posts from January 2009:

Felix Salmon is confused as to why US government debt insurance in the form of collatoral debt swaps (CDS) is priced as high as it is:

if we take a quick and very dirty look at 5-year CDS, and say they're being priced at 60bp, then that means total premiums over five years are 300bp, or $30,000 to protect $1 million of debt. If you assume a 50% recovery rate, then you're basically paying $30,000 to receive $500,000 in the event of default -- which implies a default probability of 6% over five years.
It's hard to see what would trigger such a payout, though. Dean Baker says that "a default event... could include the government temporarily exceeding its debt limit"; I don't think that's true. In order for the CDS to be triggered, I think there would have to be not only an actual payment default, but that default would have to continue for longer than the grace period....
Maybe this is just a form of black swan insurance: buying US government CDS is a way of making money when everything else plunges in value.

The black swan insurance idea is a reasponable explanation. However I would like to offer another potential explanation. It may be insurance against political risk.

Let's go back to 1995 when Gingrich shut down the US government. He was working with a larger majority of anti-government politicians who thought that the American people did not like Medicare, or Social Security or the National Park Service or most functions of government. So he tried to engage in a game of chicken with Clinton to play to his ideological base and had his ass handed to him politically. The public supported Clinton and vulnerable GOP representatives applied backroom pressure for Gingrich to stop.

Now let's fast forward to today. The Republican caucus in Congress has far fewer vulnerable incumbents in it. Most of the vulnerable incumbents in the House and Senate have already been beaten in either 2006 or 2008. The survivors are ideologically more homogenous and further from the median voter position than they have in the past. The current set of Republican incumbents' greatest political threat is usually a primary challenge from the right AND not a general election challenge from a centrist or liberal. The Republican party base is more anti-government today than it was in 1995. So there is a slight but real possibility of internal caucus politics that empowers the hardliners such as Coburn and Infohe to try to shut down the government and default on the US debt.

I don't think this chance is that high, but it exists.

The chance is higher now than it was in January 2009 that internal caucus pressures in the Republican Party will prefer forcing a default than cutting any deal that includes a dollar in additional non-regressive tax revenue.  The fiscal risk in the United States is not fiscal carrying capacity as the US has plenty of space to maneuver against historical standards.  It is political risk of nihilists.