What Does Wall Street Want?

I've been having some disturbing conversations with both finance people and Washington people over the last few days, that have only confirmed the disconnect I wrote about a few weeks ago. Each side is sending signals that the other side is not reading correctly.  And this is getting more dangerous by the hour.

The core fact is that markets haven't sold off nearly as much as you'd expect if Wall Street were really freaking out.  This is not because Washington pols have told their Wall Street paymasters about a secret deal that just hasn't reached the ears of those of us reporting from down here.  Nor are they calm because they think that a failure to raise the debt ceiling will be no big deal.  They certainly don't believe that a forced spending cut of 40% will somehow make us extra-super-more-likely to make us pay off our debt.

No, they're relatively calm because they simply cannot bring themselves to believe that we're not, in the end, going to raise the ceiling.  It's too outlandish that we would, through the collective action of our congressmen, suddenly and for no apparent reason shoot ourselves in the head.

This is sound reasoning, as far as it goes.  But it doesn't get you very far.  They're deriving a theory of the debt ceiling like Aristotle, from first principles rather than data.  In general, my non-representative sample of people working on or near Wall Street is that they are now noticeably more sanguine about the prospects for a deal than people working in the city where the deal is going to get made.

And even so, they're getting a little nervous.  I hear rumors some on Wall Street have been quietly parking their own funds on the side, in cash or gold.  I can't vouch for this, of course--I haven't talked to a representative sample, much less checked bank statements.  But it would certainly make sense. There's little downside for a money manager in being caught out in a storm that also drowns everyone else.  So there's not much reason for them to try to hedge, and at any rate, many of them operate under restrictions that prevent them from going to all cash, gold, or foreign currencies.

This week brought the news that people are starting to prepare for a possible shutdown and/or ratings downgrade: corporations preparing for higher interest rates and tighter credit; money market funds hoarding cash. (More on this in a later blog post).  It isn't showing up much in prices so far, but yes, Wall Street thinks this will be a big deal if it happens.

Meanwhile, just as Wall Street doesn't have much insight into what's going to happen in Washington over the next week, I don't think Washington really understands what will happen in the markets.  I think Stan Collender is right: Washington, particularly the GOP bit of it, is interpreting Wall Street's lack of a reaction as a sign that it's maybe not such a big deal to breach the debt ceiling.  But the real message Wall Street is sending is "You can't be serious!  Not raising the debt ceiling would be a disaster!"

Even to the extent that they do understand that it's a problem, there's a lot of confusion about what, exactly, the problem is.  I've heard progressives arguing that "defaulting" on our Social Security obligations will somehow spook the markets, which is just nonsense.  Wall Street does not care whether Granny gets paid; they care whether they get paid.

But on the other hand, the Republicans seem to be under the illusion that Wall Street are avid supply siders who want them to cut spending in order to restore our long-term growth prospects.  This is also not true.  Wall Street are not advanced economic theorists; they are people who want to get paid.  They do not need massive supply-side growth to get paid; they just need tax revenue.  They do not care how we generate the surplus to pay them: spending cuts, higher taxes, whatever.  I mean, individually, some of them do care; finance guys have ideology, just like the rest of us.  But professionally, this is not about ideology; it's about math.  All they want to know is whether the economy can plausibly generate enough tax surplus to pay our debts.  And right now, the answer is yes.

In the long run, of course, it's a different story.  But neither bond markets nor ratings agencies are looking at 2035, at which point the bond traders will mostly be retired, and the ratings agencies--well, imagine an economic forecast for this year written in 1986 and you'll have some idea why they don't spend a lot of time worrying about forecasts that far out.  They're looking loosely at the next ten years.  And over the next ten years, yes, Republicans, we can keep spending this much.  I think we shouldn't, for all sorts of reasons.  But people mostly don't sell their bonds to express a deeply held conviction about social democracy.

What Wall Street, and the ratings agencies are worried about is not whether we can pay--we can--but whether we will.  A lot of Republicans seem to think that we can secure our AAA rating by showing the agencies--and the markets--that we've made serious cuts.  But if you achieve this end by holding the debt ceiling hostage, what you're really demonstrating is not a tough-minded commitment to entitlement reform, but a political system so broken that it has trouble taking even simple, obvious steps to keep the fiscal engine running.  Our AAA is not at risk because our current fiscal path is unsustainable, but because ratings agencies know what many GOP freshman and party activists apparently do not: that doing the unpopular things required to get the budget in balance is going to require both parties to hold hands and jump together.  Otherwise, whoever forces through their unpopular plan (huge tax increases/massive spending cuts) is going to get trounced at the next elections by an opposition party promising to undo whatever it is the party in charge has just done.

My reading of what the ratings agencies have said is that if the GOP somehow manages to force the Democrats to do everything their way, this will not secure our AAA; it will guarantee that we lose it, because it will show that we are currently unable to make the ugly bipartisan compromises that long-term budget balance requires, and raises the risk that sometime in the not-very-distant future, the other party will retaliate by threatening default.  That's what Wall Street cares about.  Not saving social security. Not lower spending.  They just care about getting enough consensus to keep the checks flowing.