With a shutdown, the government could lose the market’s trust

March 30, 2011

I don’t want to start a market panic here. But it’s safe to say that much of Washington finds the low, low yields on Treasurys — which represent the market’s serene confidence that the U.S. can handle its debts — a little baffling. Senior government officials have told me they think Treasurys are probably a bit overpriced, which is a bit like the executives of GE privately wondering why investors are so sure they won’t go bankrupt. The investors might be right, but it’s not comforting to hear.

The market isn’t totally wrong, of course. The federal government probably won’t default on its debt. But it’s pretty hard to explain how we get the spending line and the revenue line to match. And we have a really dysfunctional political system.

We’ll figure it out somehow. We always do. But our low borrowing costs are an advantage we want to preserve for as long as possible. That means keeping the market from realizing that partisan polarization mixed with our weird legislative system makes insane outcomes possible.

This is why a shutdown would be so dangerous. A last-minute deal tells the market that America is a country that dithers and anguishes but eventually makes the necessary decisions to avert terrible outcomes. A shutdown says that our political system is so dysfunctional that it cannot be trusted.

Asger Lau Andersen, David Dreyer Lassen and Lasse Holbøll Westh Nielsen have looked into how the market treats late budget decisions in states — and those, it should be noted, are less public and psychologically disruptive than a shutdown of the federal government. The answer is: not kindly.

“We estimate that a budget delay of 30 days has a long run impact on the yield spread between 2 and 10 basis points,” they conclude. To put that in context, economists estimated that if the Federal Reserve pumped $400 billion into the economy, it’d lower yield spreads by about 20 basis points, or two-tenths of a percent. And it gets worse: “Markets also punish late budgets much more harshly if they occur during times of fiscal stress.”

I think it’d be fair to characterize this as a time of fiscal stress, don’t you?

There are reasons for optimism here. Markets seem to punish fiscal mismanagement more lightly if the state has access to lots of money, which usually means reserves. The federal government has access to lots of money — though through borrowing, not reserves.

At any rate, do we really want to test this? The tea party types are already promising to oppose an increase in the debt ceiling in the absence of massive entitlement cuts. Sen. Marco Rubio says he’ll oppose lifting the debt ceiling unless it’s accompanied by “a plan for fundamental tax reform, an overhaul of our regulatory structure, a cut to discretionary spending, a balanced-budget amendment, and reforms to save Social Security, Medicare and Medicaid.” That’s quite a list of demands in order to avoid economic catastrophe.

The irony of this is that if the market comes to believe our debt is too large for our political system to pay back, they’ll become more skittish about buying government debt, and that’ll send interest rates higher and the economy lower. But if we have a series of shutdowns while we argue over how much to cut and how fast, our paralysis will convince the market we can’t get our act together in time to pay off our debts and they’ll send interest rates skyrocketing anyway. We’ll have caused exactly what we sought to prevent.

As I said, I’d sure hate to be known for causing an economic crash. How about you, Congress?

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