Seance on Wall Street

Financial analysts predicting a default on US government debt need a new crystal ball. The market tells a different story

There is a long history of mediums
who claim to communicate with the dead. They sell their services to
people anxious to talk to relatives or great figures of the past. Such
exercises can be dismissed as harmless entertainment - people spend a
few dollars to be treated to tall tales.

There is a Wall Street
equivalent to these seances. People who claim to be knowledgeable about
financial markets tell policy makers and reporters what the financial
markets are thinking about current policy. These Wall Street seers
claim to interpret events in financial markets for those of use who are
less familiar with the mysteries of market movements.

In recent weeks, the Wall Street seers have been spinning stories about how the financial markets are very worried over the US budget deficit. They have told us that the markets are concerned about the government's ability to repay its debt. The seers tell us that the markets may soon demand much higher interest rates, if the government does not get its deficit under control.

seers tell us that the government must take steps to rein in the budget
deficits projected for the future by cutting back Medicare and Social
Security. They also warn us about the risks of adding to the deficit
with healthcare reform. And, the seers tell us that we certainly should
not try to tackle the problem of 25 million unemployed or underemployed
workers with another big round of stimulus. That would make the
financial markets very angry.

Those of us who were not born with
the gift of being able to communicate with financial markets cannot
directly evaluate the information that the financial markets are
passing on to the Wall Street seers. However, we can easily determine
the risk that investors assign to holding long-term US government debt.
This requires looking at interest rates.

Interest rates appear to be directly contradicting the seers' assertions about financial markets. The interest rate on 10-year Treasury bonds
is currently near 3.5%. The interest rate is not determined by people
rattling off their visions about future debt defaults. It is determined
by investors putting their money on the line.

These investors
are willing to hold hundreds of billions of dollars in long-term
government debt at a return of just 3.5%. By contrast, they demanded a
return of more than 5% in 2000,
back when the US government was running a large budget surplus. If
there is widespread fear in financial markets of a default on
government debt, it is difficult to understand why investors would be
willing to hold it at such a low rate of return. Usually investors
demand high returns for holding risky assets.

In addition to
interest rates, we could evaluate the seers' assessment by trying to
carry through other implications of the bad news debt default scenario.
Presumably, the stock market would be headed downwards with the
financial sector stocks leading the way. After all, a default on US
government debt would be cataclysmic for the US economy and especially for the banks who hold trillions of dollars in government debt or government-backed debt.

Here also the news doesn't seem to fit the seers' vision. The markets have been rallying lately, and many financial stocks are doing quite well.

One piece of evidence that these seers have occasionally used to support their case is the fact that the price of credit default swaps on US debt has risen. Credit default swaps
(CDS) are in effect insurance against default. If the price of this
insurance rises, then presumably the markets judge default to be a more
likely event. That is the reason that people in their 60s pay more for
life insurance than people in their 20s.

There is one problem
with this story. The payoff of a CDS depends not only on the default
but also, as those who did business with AIG know, on the ability of
the counter-party to pay. What is the likelihood that JP Morgan,
Goldman Sachs or anyone else will be left standing in a world where the
US government has defaulted on its debt? It's not clear what the price
of CDS issued on US government bonds means, but it is not a
straightforward assessment of the probability of default on the
government's debt.

It should not be surprising that the vision of the Wall Street seers seem to be far from reality. After all, their crystal balls could not see the $8tn housing bubble, the collapse of which has wrecked the economy.

fact, the self-proclaimed seers are using their visions to try to
discourage the public from supporting policies that the seers don't
like. These people want to see cutbacks in Social Security, Medicare
and other social programmes. They are more concerned that higher
deficits could mean higher taxes on the wealthy at some point in the
future than they are about the tens of millions of unemployed or
under-employed today.

In short, those who want fantastic stories
about the unknowable would be much better off visiting the people who
promise to communicate with the dead than listening to the Wall Street
spokespeople. They will learn more and be associating with people of
greater integrity.

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