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posted: 10/20/2013 6:11 AM

Washington can't seem to make markets nervous

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  • An employee puts front pages in the displays in front of the Newseum in Washington, D.C., on Thursday. On Wednesday night the Congress sent President Obama a bill to avoid government default on its obligations.

      An employee puts front pages in the displays in front of the Newseum in Washington, D.C., on Thursday. On Wednesday night the Congress sent President Obama a bill to avoid government default on its obligations.
    Bloomberg News

 
By Ezra Klein
The Washington Post

The markets shuddered slightly as the debt ceiling neared. The yield on short-term Treasurys rose tenfold. Fidelity Investments sold off its short-term government debt.

But the shudder was slight -- and on Oct. 11 there was a relief rally in equities on the news that House Republicans might agree to suspend the debt ceiling for six weeks in order to spend more time with their shutdown.

The markets' faith in the United States is long-standing and not easily dislodged. The dollar has been the world's reserve currency for decades, with the foreigners who hoard our cash providing essentially interest-free loans to the U.S. Treasury. The global appetite for Treasury bills produces similar gains, with purchasers -- including foreign governments buying in bulk -- lending the U.S. government money at minimal, even effectively negative, rates. The result is a huge economic advantage for the United States.

All this comes from a deep confidence that the U.S. political system will make sound decisions -- a confidence, at this point, that few of the system's participants share and one that's hard to square with the evidence of the past few years. The simple fact is that Congress is getting worse at avoiding the traps it sets for itself.

In February 2011, the U.S. government almost shut down. In August 2011, it narrowly avoided breaching the debt ceiling, a precursor to financial crisis. In January, it tumbled over the "fiscal cliff" (if only for a couple of hours). In March, Republicans decided to "suspend" the debt ceiling for three months but enabled the indiscriminate budget cuts known as sequestration, which both parties had derided as unthinkable, to go into effect. This month, the federal government shut down while simultaneously veering toward a potentially cataclysmic, yet wholly voluntary, new crisis over the debt ceiling.

And those debt-ceiling increases are becoming more tenuous. The 2011 agreement lifted the ceiling until 2013. The first 2013 agreement suspended the ceiling for only three months. It's likely that the next agreement will hold for a matter of weeks.

Capitol Hill staffs freely admit that they don't know how the debt limit will be routinely raised going forward. Dispensing with his predecessor's practice of radiating confidence amid chaos, Treasury Secretary Jack Lew has said that he's "nervous" and "anxious" that the nation will breach the debt ceiling. President Obama was more blunt: "I think this time is different," he told CNBC, adding that markets "should be concerned."

Why are markets not yet in a panic?

"Markets are quite relaxed about all this, and for an unfortunate reason," wrote Mohamed El-Erian, chief executive of Pacific Investment Management Co. "They have been conditioned to expect headline-grabbing political posturing, extreme rhetoric and seemingly endless drama from Capitol Hill."

The brinkmanship is simply considered part of the grand show that is American politics. Like an episode of "CSI: Miami," it's tense in the middle, but it all works out in the end.

"The markets have been conditioned to believe it always gets solved at 11:59," said Rep. Jim Himes, D-Conn.

But that's the nature of financial crises: Everything seems fine until -- quite suddenly -- it doesn't. In the months before Greece revealed the true extent of its budget deficit, Greek bonds were trading at almost the same yield as German bonds. In the months before the subprime crisis cracked the global economy open, mortgage-backed securities remained a hot item on Wall Street. Every financial crisis is dismissed in real time, only to be deemed inevitable in retrospect.

Is the American political system the latest bubble? Is the markets' faith inflated by bad historical analogies and a willful disregard of current facts?

The model many in the markets follow is best summed up by an old line, often attributed to Winston Churchill: "You can always trust America to do the right thing after it has exhausted all other options." If that's right, then the markets are right to tune out the political bickering until 11:59 p.m. on the night before crisis strikes. Everything that happens before then is just noise. It's America exhausting all the other options.

But the U.S. political system hasn't always been doing the right thing lately. That model doesn't explain the failures of sequestration or the shutdown. And even market participants have noticed the chinks in it.

Capital ideas

Standard & Poor's downgraded the United States in 2011 on the grounds that "the effectiveness, stability and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges." That assessment looks pretty accurate today, reinforced by the procession of finance titans shuttling to Washington to emphasize the dangers of continuing dysfunction.

Indeed, many business leaders realize something is seriously awry. "It's a terrible way to go about this," Jamie Dimon, chief executive of JPMorgan Chase, said of Washington's game of debt-ceiling chicken.

A scary possibility is that the market price on the U.S. political system doesn't reflect what market participants are coming to believe about it -- that a once capable and reliable system is now dysfunctional and unpredictable. That raises the possibility that a pivotal event could move markets dramatically because traders are prepared to believe, and to begin trading on, a much more pessimistic assessment of America's political system. If everyone were moved to act on that belief simultaneously -- by a debt-ceiling crisis, for example -- the results could be earthshaking.

Gary Gorton, an economist who specializes in financial crises, put it crisply: "Financial markets can be wrong, and they can be wrong in a big way, because they don't understand the situation and it only becomes clear ex-post."

It's easy to imagine how a politically induced financial crisis would seem inevitable in retrospect. Signs of distress abound. Look at the highly respected measure of congressional polarization developed by political scientists Keith Poole and Howard Rosenthal. According to their analysis, the two major U.S. parties are more polarized than at any point in history. A Gallup poll found that public confidence in Congress is at an all-time low. The Republican Party is less popular than at any time on record. Congressional records show that the two most recent Congresses produced less legislation than any since Congress began keeping records in the 1940s.

Given such telltales, a prominent display of political dysfunction can't easily be dismissed as a one-off. Instead, it could be the trigger that leads global markets to construct a whole new narrative about the United States -- one that prices in the likelihood that an increasingly polarized, gridlocked Washington won't always get it right and may increasingly get things wrong.

The case for pessimism can be overstated, of course. "The last thing you want to do if you want to preserve credibility is to appear to be an optimist on the American political system," said Thomas Gallagher, a principal at Scowcroft Group. "But so far the outcomes have been okay. We've been averting disaster."

Perhaps foreigners who don't follow every twist of congressional negotiations have an analytical advantage over Beltway denizens, who are surrounded by so much noise that they've lost track of the signal. "The process is ugly, and people in Washington are very focused on process," Gallagher said.

Process, however, matters. These past few years have normalized debt-ceiling brinkmanship. So let's assume that we have one or two debt-ceiling showdowns annually for the next decade. The chance that any particular conflict leads to a breach is quite low -- let's say a mere 5 percent. Yet despite the low probability of a debt-ceiling breach in any given showdown, repetition makes the odds extraordinarily good that we will, ultimately, breach the debt ceiling at some point over the next decade.

In that case, the nation will, solely because of political dysfunction, default on some of its debt. Perhaps we will pay off bondholders and only default on commitments to the elderly. Perhaps the default will last only a few days, or a week. No matter how it unfolds, the safest and most predictable investment in the world -- U.S. government debt -- will have proved itself unpredictable.

And if we miss a payment -- even by accident, even just because our on-the-fly recoding of the government's automatic payments systems failed -- the United States will have done something unthinkable. So unthinkable, in fact, that absolute faith in U.S. credit is embedded in the very way we borrow.

"There are very material differences between the United States and virtually every other country that borrows," said Lee Buchheit, a specialist in sovereign-debt restructuring. "We borrow only in our own currency. We've had, for many years, the arrogance of issuing on the assumption that a default would be unthinkable."

"When most sovereigns borrow from the international markets," Buchheit continued, "the investors benefit from a range of contractual protections such as events of default (that permit acceleration of unmatured principal if something goes wrong), a promise by the debtor not to pledge its assets to secure another lender, waivers of sovereign immunity and so forth. These provisions are absent in U.S. Treasury bonds. What you get -- indeed, all you get -- is a promise to pay a certain amount of money on a certain date. The unspoken premise of U.S. government borrowing is that no investor will ever need contractual provisions that improve a creditor's legal position in case of a default in payment. Why? Because there never could be, there never would be, a payment default on a U.S. government debt."

But spectacular crises aren't the only way a political system can fail. A Congress that cannot routinely legislate to address problems (such as aging infrastructure) and take opportunities (such as immigration reform) will, over time, meaningfully harm the country's growth prospects. And it will do so in a way that's hard to notice, and thus hard to fix: People don't much miss the three-tenths of a percentage point worth of growth they didn't have that quarter. But compounded over time, it's a disaster. Crises can happen slowly, too.

Only choice?

As chief economist at the International Monetary Fund, Simon Johnson saw more than a few countries disappoint global markets and pay dearly for it. He's more sanguine about the United States. "The key thing is the relative comparison," he said. "If they don't like the U.S., where will they take their reserve access and rainy-day holdings? We're so big we have this extra element, which is, where else will you put your stuff?"

This is the "cleanest shirt in the dirty-laundry bag" theory: As bad as U.S. political problems are, Europe's are worse. Investing in the euro area because you're worried about political dysfunction in the United States is like buying an eight-track because you're concerned your CD player is going out of style. China, too, is troubled, and its financial markets aren't sufficiently liquid or transparent to support a market flight from U.S. Treasurys.

The paradox is that defaulting on our debt could lead to a panic so severe that, in a desperate bid for safety, markets will buy even more of our debt. "We are the only country in the world where a fiscal mess, rather than increasing spreads, pushes yields lower," El-Erian said. "If there was another round of debt-ceiling fight with no agreement, we might have lower 10-year Treasury yields, rather than higher." Unfortunately, we might also have a stock market crash and an economy headed into a deep recession.

The markets' complacency is contributing to rising political risk. Just as an overabundance of confidence in Greek debt permitted Greece's problems to fester, becoming far larger than would otherwise have been possible, the markets' enduring confidence in the U.S. political system has allowed dysfunction to metastasize.

"Without market discipline," said Nouriel Roubini, chairman of Roubini Global Economics, "there's no pressure to do anything because you can continue to finance yourself cheaply."

Yet absent such discipline, politicians have begun to convince themselves that the catastrophes they court aren't catastrophes at all. Rep. Ted Yoho, R-Fla., said that piercing the debt ceiling "would bring stability to the world markets." Sen. Orrin G. Hatch, R-Utah, the top Republican on the powerful Finance Committee, said that, in the event of default, "the administration could work on who gets paid and who doesn't in a way that would pull us through." What makes him so confident? "I don't think the markets have been spooked so far."

Hatch is right. Markets haven't been spooked so far. But given the deepening entrenchment of such views in one of the country's two major political parties, the wait may not be long.

On the brink, increasingly more often:

1. February 2011

Federal government almost shuts down.

2. August 2011

U.S. narrowly avoids breaching debt ceiling, agreement lifts ceiling until 2013.

3. January 2013

Congress briefly goes over the "fiscal cliff."

4. March 2013

Debt ceiling suspended for three months, and sequestration cuts are allowed to go into effect.

5. October 2013

Federal government shuts down, with next agreement on debt ceiling to hold on for a matter of weeks.

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