A Panic?

BarroMetrics Views: A Panic?

So far there have been little signs that the markets have panicked at the twin problems of the debt level and shutdown. There appears a belief that the debit ceiling will be rspoved and in the process, the uS will find a way around the shutdown. There is also a sentiment among main street media that the longer the crisis continues, the more it will hurt the Republicans.

A piece in Reuters (“Game theory and America’s budget battle”, by Anatole Kaletsky) illustrates the reasons for the view.

Kaletsky suggests that if the shutdown is not resolved by Oct 17, then “all hell could break loose” unless the debt ceiling crisis is resolved. He argues as Oct 17 nears….

“Republicans will be the ones facing maximum pressure as the debt limit draws near. ….Game theory teaches that in such confrontations we must assess the costs to the players of fighting and also of backing down. Republican Congressmen, if they continue fighting right up to the debt limit, will have to answer to voters for the economic mayhem that a Treasury default could cause. Obama, on the other hand, has nothing to fear from elections since he will never run again.

The costs of retreat also favor the White House. For the president to back down and gut Obamacare would destroy what he sees as his greatest achievement and would confirm his lame duck status. For the Republicans, by contrast, allowing the budget and debt ceiling to pass would leave them exactly where they were a few weeks ago.

In logic, such calculations should force the Republicans to back down quickly, extracting whatever small face-saving concessions the White House might offer them to avert any further political embarrassment and economic harm”

For me, there is a problem  with the reasoning – the same flaw this is found in the ‘efficient market hypothesis’.

Kaletsky assumes that all choices are made rationally. He fails to take into account that among the hard core Republicans their actions are dictated by principles and that at times this motivation causes us to act against our ‘rational interests’. (No doubt you will see some Republican Tea-Party members start to back down this week. I believe though there will be enough holdouts to maintain ‘the hard-line’).

He makes the same mistake with Obama – he correctly identifies that the President would be unwilling to suffer yet another defeat if the ‘enemy were the Republicans’. But failing to act against ‘a default’ would be measured not against the Republicans. If a ‘default’ does occur, then Obama will be forever known in the history books as the President on whose watch the FIRST US default occurred.

The choice for Obama is ‘giving up his greatest achievement’ or forever be known as ‘the Default President’.

It is also likely that both the Republicans and Obama  will recognize, only after Oct 17, the motivation of their counter party. Hence my belief we have a 50-50 chance we see Oct 17 come and go without resolution.

That brings me to the final question: Does failure to resolve the debt ceiling necessarily mean the US will default on its Treasury obligations. The answer is ‘no’. The interest payments amount to about 20% of the revenue. At worst, some payments may be late. But the adverse effects of failing to lift the debt ceiling on the US economy is another story. Worse still will be the shaken confidence of investors in US treasuries.

The closer we come to Oct 17 without resolution, the greater the probability that US stock prices will drop, Bond prices will rally, and US $ will strengthen as ‘a flight to quality’ occurs.

1 thought on “A Panic?”

  1. Irene raised a question that is relevant to the blog so I posting here the question and my reply:

    Irene said: “it seems counterintuitive why “The closer we come to Oct 17 without resolution, the greater the probability that US stocks and Bond prices will rally”. I thought US-based assets be vulnerable in such uncertain circumstances. Or do these rally because of further (inevitable) QE?”

    I replied: Thanks for pointing that out. I ‘swallowed’ some words. The blog should read:

    “that US stocks will drop and Bond prices will rally”.

    I have amended the blog.

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