Is America a bubble?

October 13, 2013

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

But the shudder was slight -- and, on Friday, 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.

Did somebody get an early look? (Photo by Spencer Platt/Getty Images)
Will they continue to trust us? (Photo by Spencer Platt/Getty Images)

The markets’ faith in the U.S. 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 2012, it tumbled over the fiscal cliff (if only for a couple of hours). In March 2013, Republicans decided to “suspend” the debt ceiling for three months but enabled the indiscriminate budget cuts known as sequestration, which both parties had previously 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 only 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 forwards. 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 U.S. 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.”

'It always gets solved at 11:59'

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 officer 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, a Connecticut Democrat.

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 the 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.

Could Congress fail? (Photographer: Andrew Harrer/Bloomberg)
Could Congress fail? (Photographer: Andrew Harrer/Bloomberg)

'It’s a terrible way to go about this'

Standard & Poor’s downgraded the U.S. 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, CEO 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 U.S.’s two major parties are more polarized now 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.


The two parties have never been more polarized. (VoteView.com)

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 U.S. -- 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 Inc. “But so far the outcomes have been OK. 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.

'A default would be unthinkable.'

Process, however, matters. These last 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 U.S. 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 only last 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 U.S. will have done something previously 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 can’t 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.

This part comes later. (Jewel Samad / AFP/Getty Images)
This part comes later. (Jewel Samad / AFP/Getty Images)

'Where else will you put your stuff?'

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 U.S. “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 the U.S.’s political problems are, Europe’s are worse. Investing in the euro area because you’re worried about political dysfunction in the U.S. is like buying an 8-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. Treasuries.

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’ current 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 LLC, “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, a Republican from Florida, said that piercing the debt ceiling “would bring stability to the world markets.” Orrin Hatch, the top Republican on the powerful Senate 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.

Related:

- 13 reasons Washington is failing.

- Everything you need to know about the debt ceiling.

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