As somebody who started out as a financial reporter in New York before transitioning into political journalism, I was intrigued by Washington Post economic writer Neil Irwin’s item, “Markets to Washington: You know nothing of our work.” (Plus, the “Annie Hall” reference earned an automatic click.) It’s true, as Irwin notes, that markets often behave in counter-intuitive ways that are misunderstood inside the Beltway. But there’s also a danger in letting current market sentiment dictate policy.
I want to focus on one thing in particular that Irwin argues: “The markets are not demanding deficit reduction now.” He makes his case by noting the lack of correlation between bond/currency prices and deficit reduction progress (or lack thereof) in Washington. And I admit, I wouldn’t have been able to predict that interest rates on U.S. debt would remain so low for so long in the face of mounting debt and even a credit rating downgrade. Therefore, I won’t dispute his point that right now, markets aren’t noticeably signaling they want immediate action on deficit reduction. Having said that, it would be a mistake for lawmakers to base their policy decisions on Irwin’s observation, for a number of reasons. One, it’s wrong to assume that market conditions that exist now will continue to persist forever. And two, markets can change trajectory very rapidly, without much warning, and it’s far worse to make policy under emergency conditions than to craft it in a thoughtful manner that hopefully averts an emergency. To give a few recent examples, consider the tech bubble of the 1990s and the housing boom of the last decade.
In late 1998, when the NASDAQ index crossed the 2,000-point threshold, you could have made a compelling argument that tech stocks were overvalued and that the fundamentals didn’t support their prices. You would have looked like a fool in the short term, as the index soared to over 5,000 points early in the year 2000. But in time, you would have looked prescient, as the index tumbled to around 1,100 in 2002.
A similar case could be made of the housing boom. At the top of this post, I’ve produced a chart of fourth quarter housing values in 1996 through 2011, based on the index created by Yale economist Robert Shiller. (The underlying data, which goes back to 1890, can be downloaded on Shiller’s website here.) In 2002, somebody might have looked back at the growth in housing prices over the previous six years and warned that continued increases were unsustainable. That person would have looked silly up through 2006, but would have been hailed as an oracle by 2008. When financial markets collapsed in the fall of 2008, there were all sorts of hindsight solutions about what policymakers could have done differently if they could go back in time. But while the housing market was booming and financial markets were signaling they were happy about it, nobody in power wanted to disrupt the status quo. As then Fed Chairman Alan Greenspan infamously insisted in a 2004 speech, “Overall, while local economies may experience significant speculative price imbalances, a national severe price distortion seems most unlikely in the United States, given its size and diversity.”
This brings us back to the issue of deficits. For all the disagreement about the advisability of running up massive short-term deficits, there’s much less debate about whether the nation’s long-term debt trajectory is sustainable given current policies. Just because, thus far, markets haven’t panicked about the nation’s growing debt burden, it doesn’t mean that will be the case in perpetuity. For now, bond investors have determined that whatever budget problems the U.S. is facing, they are less bad than other countries. And those who have bet against U.S. Treasuries in the past few years (such as the major bond investor Bill Gross) have lost big, just as somebody who bet against tech stocks in 1998 would have. But though Gross’s timing was off, it doesn’t mean that his underlying fears were unfounded.
A big part of the resilience of U.S. Treasuries is rooted in the assumption that eventually lawmakers will work out a long-term deficit reduction compromise. But if lawmakers take the calmness of markets as an excuse to do nothing, then eventually, something has got to give. If and when markets turn on U.S. debt, there won’t be much warning. Coming up with ways to rapidly slash deficits during a financial market meltdown would be ugly and produce bad policy that had severe, immediate, effects. So it’s best not to wait around for markets to signal they want deficit reduction before acting responsibly.
UPDATE: On Twitter, Business Insider’s Joe Weisenthal takes issue with my drawing a connection between the resilience of U.S. Treasuries and the assumption of some future deficit compromise. He’s right that I should have phrased things more carefully. The point is that the low interest rates for U.S. bonds reflect the fact that investors think it’s a relatively good bet that the U.S. government will pay back its bills over time. When it downgraded U.S. debt in 2011, Standard and Poor’s cited the lack of progress on deficit reduction and diminished confidence that any compromise could be reached. Investors shrugged off S&P, but it would be unwise to assume they will do so forever.