The debt ceiling negotiations broke down last weekend. Despite predictions of looming financial catastrophe, the stock market fell less than 1% on Monday. Andrew Ross Sorkin in today’s New York Times writes:
Wall Street’s blasé response presents a serious challenge for the administration. The government has been ringing the alarm bells of an impending catastrophe to add urgency to its efforts to get Republicans to hash out a compromise.
While the sky indeed may fall if the sides cannot compromise, the fact that the market has been calm has served only to deepen the resistance to a deal. People who perhaps should be worried don’t seem to be, and worse, appear to have stopped listening to the warnings.
Uh oh. We do not want Washington basing its decisions on the behavior of the stock market.
The problem is that if investors are trying to figure out how the government will behave, and the government is looking to investors to learn how it should behave, then the market’s reactions may reveal nothing about the costs of default. To understand the issue, suppose two things: first, that Congress and the administration will reach agreement if and only if the stock market falls substantially prior to Aug 2; second, that the stock market will crash if the debt ceiling is breached. What happens? It’s not clear.
If investors believe that there will be a default, the stock market will fall, and Congress and the White House will then reach agreement. The stock market’s belief, however, will have been irrational: the fall of the stock market will induce an outcome where it should not have fallen.
On the other hand, if investors believe that there will not be a default, the stock market will not fall, Congress and the White House will not reach an agreement, and the stock market will fall. Again, the belief will have been irrational: the stock market will not have fallen when it should have.
So what happens? Clearly if the negotiators in D.C. are paying attention to the stock market, then investors must make a delicate calculation that requires thinking about, at a minimum: the objective costs and benefits of a default; the beliefs of other investors about the likelihood of a default; the private information of government officials (how disruptive to operations would a default be?); and the extent to which the negotiators are really paying attention to the stock market. Yikes! We can only guess what the market price is telling us.
It is of course possible that reaching the debt ceiling will be no big deal. Perhaps the government can muddle through without much damage and eventually there will be some agreement. But you cannot be sure that this is what the market believes. If Republican leaders are taking solace from the market’s apparent complacency, they may be on thin ice. Worse, we all may be on thin ice.
If you want to know more, this issue has been discussed in the academic literature. See in particular papers by Bond, Goldstein and Prescott (2010, Review of Financial Studies) and Bond and Goldstein (2011, working paper).