Many people are asking why the financial markets have so far been unruffled by the political crisis which is playing itself out in Washington. That is a very good question. Yesterday was a case in point. The Financial Times website led with a story by Martin Wolf headlined “America is flirting with self destruction”. Yet equities were up on the day, and gold fell sharply.
The explanation for this conundrum, I believe, is twofold. Part of it is connected to the nature of markets, and part to the nature of this particular episode.
To start with the nature of markets, it has become very clear in recent years that asset prices are not necessarily very good at reacting in a smooth manner to changes in the perceived risk of extremely unlikely events taking place. For long periods, the markets do not react at all, and then they suddenly react in a discontinuous manner. The manner in which asset prices reacted to the risk of sovereign defaults in the euro area before and during the crisis of 2011-12 was a good example of this.
For many years, the markets acted as if there was no risk at all of default. Then, in the summer of 2011, they suddenly started to price a risk of 30 per cent or more that several sovereigns would default within the next 5 years, an assessment which now appears to have been a significant over-reaction. So the fact that markets do not price these risks for very long periods of deteriorating newsflow does not imply that the risks are in fact non existent, or that they will not suddenly appear in asset prices.
Why do markets behave in this way when, after all, the major participants are fairly rational, most of the time?
Having attended many risk committee meetings in different financial institutions, it is clear to me that the individual participants in the markets do in fact adjust their perceived risks of extreme events in a fairly smooth way. But they do not always act on these changes in risk assessment, because it is difficult to change large portfolios quickly, and costly to buy hedges through the derivatives markets.
If investors repeatedly buy more insurance than their competitors, and this insurance then expires worthless, the safety-first investors will under-perform their peers most of the time. The gains from this prudent behaviour will only become apparent on very rare occasions. “Tail risks” are therefore left unhedged.
It is only when the risk of an extreme event starts to appear very large over a fairly short horizon that they are willing to incur the costs of taking out insurance. Since many investors think in a similar manner, a tipping point is reached, and there is a sudden shift in the price of risky assets. This then triggers momentum trading, which can exaggerate the move in the same direction. Wild swings replace smooth adjustments, and these swings can appear irrational to outsiders. Yet the individual participants are acting rationally, given their objectives, throughout the process.
Turning to the latest political shenanigans in Washington, risk committees all over the financial world are undoubtedly thinking hard about how to hedge these risks. No-one believes that a temporary shut-down in some government activities is critical, but the debt ceiling is seen as a different matter entirely. A default by the US government on its debt payments could be very disruptive, and set in train a series of events which would be hard for the authorities subsequently to control.
However, the risk committees will have started with a strong pre-disposition to believe that the US democratic process will not entirely take leave of its senses, though much brinkmanship could be involved in the meantime. They will also know that the US political process has it within its power to end the uncertainty at very short notice when political calculations change. This is not a case of “can’t pay”, it is a case of “won’t pay”.
To a sensible outside observer, it seems improbable that enough members of Congress would act against the interests of the US to trigger a “won’t pay” catastrophe. For that reason, the nation state represented by the USA inherently possesses much greater credibility than the many different nation states of the euro area, where markets did think that the German electorate might be unwilling to act in the interests of Spain.
Investors also have very recent experience of very similar disputes in Washington, in July 2011 and December 2012. Certainly, there are political differences which make the current episode appear more intractable than those earlier spats. As John Kay points out, both sides have tried very hard to commit credibly to be irresponsible.
But market disruption in both of those earlier episodes turned out to be relatively minor and short-lived. Investors who purchased insurance probably incurred costs which did not prove worthwhile. Meanwhile investors who waited on the sidelines to enter trades when risk premia were temporarily elevated at the height of the crisis did well. These lessons are encouraging similar behaviour this time.
One consequence is that the normal feedback from political error to market disruption and back to improved political decisions is not really operating this time. This could make Washington more likely to go to the very brink, implying that the bout of uncertainty in markets could come very late in the day, and be more severe when it happens. We saw indications of that when the markets feared the approach of the fiscal cliff only on the very last day of 2012.
Hopefully, though, another feedback loop – between the politicians and their voters – will kick in before the markets need to react. A shift in the opinion polls will induce one side or the other to concede. At present, that is what the risk committees are probably expecting to happen, which is why the markets remain eerily calm amidst the heat of the political battle.