Markets aren’t sweating the fiscal cliff

December 31, 2012

The financial markets are proving to be surprisingly indifferent to the last-ditch negotiations underway Monday to avert an austerity crisis.

The stock market was up 0.2 percent at 11:00 a.m. as measured by the Standard & Poor’s 500 index. A key measure of expected market volatility known as the Vix index was actually down slightly Monday morning, falling 2.4 percent after a steep rise on Friday.


No worries on Wall Street. (Scott Eells/BLOOMBERG)

So what’s going on here? First, global investors clearly aren’t viewing this as an end-of-the-world doomsday scenario that they did in 2008 when the House rejected the bank bailout bill in 2008 on its first pass (that day, the stock market fell 8 percent). That will likely change if it starts to look like the nation is not only going over the fiscal cliff, but poised to stay there. It could also change if the brinksmanship shifts from the relatively manageable risk of an austerity-induced recession toward the more existential one of a debt ceiling showdown and possibility of a U.S. government default.

But the stability on Wall Street reflects two bigger trends.

First, investors are becoming more savvy about how Washington works. After repeatedly watching Congress and the White House face off and make a deal at the last possible minute (see, for example, talks to avert a government shutdown in April 2011 and increasing the debt ceiling in August 2011). So the fact that it is now New Year’s Eve and the outlines of an ultimate deal are still murky isn’t fazing traders. It may not be a great way to run a government, but it would in some ways have been more surprising if these talks hadn’t gone to the very last minute. If a deal had been made before Christmas, both sides would have felt that they left something on the table by not holding out for longer. Ironically, the very fact that markets aren’t swinging wildly has likely meant less sense of urgency on Capitol Hill. (And, frankly, I expected that there would be some much more harry days on the markets than we have actually seen if we reached New Year’s Eve without a deal).

The second reason for the stable markets is that the deal that seems to be taking shape—and things remained fluid Monday morning—seemed to avoid some of the major pitfalls that investors had feared. If the reported “mini-deal” indeed takes shape and passes the House and Senate, it will not begin an aggressive move toward austerity. It will raise taxes on households making more than perhaps $450,000 (the exact number is still being negotiated), which shouldn’t have much short-term impact on growth. The two percentage point payroll tax holiday is almost certainly being allowed to expire, which will cut the typical American worker’s after-tax pay by about $1,000 this year—but that was generally expected and its economic punch already priced into market expectations of what 2013 will look like.

In short, if the deal taking shape now is enacted, it should not cause any austerity-driven recession. Indeed, the deal appears to be one that would not cut the deficit relative to current policy; if one believes that we need deficit reduction to instill confidence among businesses, this deal is a bust.

But, and there’s a big but here, it does set the stage for an even more dangerous set of deal making in a couple of months. That’s when the Treasury runs out of tricks to avoid raising the debt ceiling, and, if early reports are accurate, the “sequester” of automatic spending cuts will take place.

In other words, we get to do this all over again in a couple of months. Let’s hope that the financial markets are as sanguine then as they are now.

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Dylan Matthews | December 31, 2012