Markets snooze though the deficit and debt debate

Fiscal hawks (including me) often warn about what would happen to financial markets if Washington doesn’t get the deficit under control, and, worse, can’t manage its debt limit mess. I am convinced that, sooner or later, investors will stampede for the exits, leaving not only government but the rest of us to suffer the consequences of both skyrocketing interest rates and plunging stock prices.

But I have to admit, there is absolutely no sign that the markets care at the moment. They are far more obsessed with tiny Greece than the massive U.S. debt. And some of the most outspoken bond vigilantes, such as PIMCO’s Bill Gross, sound like they are far more worried about the federal government’s investment deficit than its red ink.

Paradoxically, all this scares me more than ever. Washington and New York have never understood each other, and we could be heading for yet another of their periodic failures to communicate. This last happened in 2008 when Congress briefly rejected the financial market bailout–the TARP. The stock market, not understanding the need for many pols to first protect themselves with a “no” vote before doing what they had to do, promptly plunged 770 points.

There is nothing more frightening than a surprised market. And my fear is that if Washington miscalculates in its game of debt limit chicken later this summer, the markets will be very surprised indeed, and the results could make the post-Lehman Brothers financial collapse look like a sunny day on the beach.

How little are the Wall Street gurus focused on this possibility? In a remarkable letter to his investors, Gross, who claims to have sold all of his Treasuries, says, “Fiscal balance alone will not likely produce 20 million jobs over the next decade. The move towards it, in fact, if implemented too quickly, could stultify economic growth.”

He adds, “In times of extremis, pushing on the private sector string is ineffective, especially within the context of a global marketplace that offers alternative investment locations. Government must temporarily assume a bigger, not a smaller, role in this economy, if only because other countries are dominating job creation with kick-start policies that eventually dominate global markets.”

And Gross is not alone. At a recent Morningstar investors conference, money managers were reportedly far more concerned about the slumping economy than the deficit.

While the rating agencies mutter about downgrading Treasury debt, the markets seem absolutely copacetic about the risks of a late summer U.S. bond default. Bond yields continue to fall. The cost of credit default swaps (insurance against the risk of a Treasury default) has bumped up a bit in recent weeks, but just a bit, and in a thinly traded market (at least the part of the market we see is thinly traded, but let’s not go there).

It is true that there are fundamental reasons why big short-term deficits may not lead to higher interest rates. For example, companies are sitting on so much cash at the moment that there is little risk that private investment will be crowded out by lots of government borrowing. It is also true that Treasuries, for all their risks, may still be the safest investment on the planet.

But the long-term fiscal situation in the U.S. is not sustainable. And there is a non-trivial chance that the Washington will bungle the hot-button debt limit negotiations. Wall Street is notorious for its ability to focus on only one thing at a time, and at the moment that thing seems to be the Eurozone. One of these days, it will obsess on something new. And when it does, things could get very scary.

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