Politico Op–Ed: Debt ceiling: Capital vs. the Capitol

July 31, 2011

“Surely they wouldn’t?”

Until last week, that was the reaction from market types, who couldn’t believe that Washington pols would play a full-out game of political chicken with an economy still struggling to rouse itself out of recession. An economy with unemployment topping 9 percent that added only 18,000 new workers onto payrolls in its last jobs report; an economy where corporations clutch on to nearly $2 trillion in cash piles, while gross domestic product growth tracks at a worse than tepid 1.3 percent and the housing market continues to sputter. An economy facing not just a short-term setback, but a long-term stall.

Even now, just days shy of the Aug. 2 deadline, almost no one in the financial markets will admit the possibility that a debt deal might not get done.

During the past three decades, the debt limit lifts have gotten shorter and more frequent – in 10 of the last 30 years the U.S. government has operated under legislation lasting less than a year. Surely Congress will find a way to pass one more of these short-term fixes — even if it can’t come to a long-term deal?

But it might not. For reasons that market folks understand: incentives. Investors answer to those who hire them to manage their capital. And Washington politicians respond to those who send them to the Capitol.

The vote offers an irresistible platform for House members who oppose the debt limit lifting and want to send a message to Washington — and the country — that enough is enough. The debate gives them a megaphone, and the chance to show the voters who elect them every two years that they mean business.

If their individual vote eventually leads the country toward collective economic destruction, they can answer that they were representing the voices of those who elected them. They are, in their view, responding rationally to the demands of their employers — in this case their constituents.

For market players, the idea that unhappy constituents, fed up with government spending, would determine the fate of a vote on a topic as both arcane and critical as the debt ceiling is ludicrous. Of course, these same folks found it inconceivable that the House would vote “no” on the TARP in 2008 — until it did.

Investors believe in rational responses to rational incentives. It is beyond irrational to them that anyone would tamper with the sacredness of Treasury bonds, the ultimate ‘risk-free’ asset, the baseline against which all other market risk is judged.

Every day, a billion times a day, market players across the globe weigh the risk of new investments against the riskless choice to invest in U.S. Treasuries. This financial security is precisely what makes the United States the “safe haven” foreigners flock to when storing their spare cash.

Keeping that status quo in place is critical to markets’ stability. Altering that equation by considering default as anything other than economic suicide goes beyond what investors can come close to conceiving.

In the markets’ view, once the genie comes out of the bottle, she doesn’t go back in and live happily ever after. She casts a shadow of uncertainty over everything that comes afterward. Uncertainty that means the costs of borrowing in what once was a risk-free world could soar sky-high.

The deficit in understanding between the two worlds is clearly enormous and consequential. Political and campaign rules govern Washington. Economic and market imperatives govern investors.

Washington players and financial markets each respond rationally to the incentives that govern their success — and each believes deeply that the way it views the world is right and correct.

The problem comes when these two world views collide, as they do today and will for as long as the U.S. economy struggles. Collateral damage in the form of a sliding stock market, choked-up credit markets and shrunken 401ks ensues. And there is no common ground to draw on when the economic avalanche begins.

What markets once thought financially unimaginable has now become politically possible. And the gap in world views between Washington and Wall Street may lead us all straight over the economic cliff.


Gayle Tzemach Lemmon analyzed public policy for the global investment firm PIMCO, after working as a journalist for the ABC News Political Unit and “This Week with George Stephanopoulos.” She is now a fellow at the Council on Foreign Relations and author of “The Dressmaker of Khair Khana.”