The US government has shut down 17 times before. The worst was in 1995 and the market only dropped 3%. So, a government shutdown is not seen as a market moving event. Failure to raise the debt ceiling, which allows the government to keep borrowing and potentially avoid default, is another matter
What is going on in the US? Has the entire government lost their minds? Not only is the government shut down, but there is a remote possibility that the US will default on its debts. How has this possibly happened? But what is more interesting is why hasn’t the market reacted more dramatically?
Leader from Barak Obama to the Christine Lagarde, the head of the International Monetary Fund (IMF), have predicted a catastrophic melt down and no one seems to care. The US market is down only 2.5% from its all time high. Is it simply more political theatre like what just happened in Italy or is there a real possibility that the US could go over the cliff and take everyone else with it?
One reason that markets are so calm is that they have been through this before. The US government has shut down 17 times before. The worst was in 1995 and the market only dropped 3%. So a government shutdown is not seen as a market moving event. Failure to raise the debt ceiling, which allows the government to keep borrowing and potentially avoid default, is another matter. But the markets also have experience with a debt ceiling battle. On 2 August of 2011, the US was supposed to run out of money. But on 31st July, President Obama and the leader of the Republicans announced that they had an agreement raising the debt ceiling and the law was enacted by the 2nd August deadline. But it didn’t help the market, which plunged 20%. Still even that trauma was short lived. By March of 2012 the market had reached new highs.
But is this time different? Possibly. The difference is the basis of the dispute. In 2011, it was all about money. The solution was the supposedly dreaded austerity package known as the Sequestration, which since has gone into effect without much fanfare. This time it is about the signature achievement of President Obama, a program of universal health care known as Obamacare. You normally can reach a deal with money, but getting rid of a law passed by Congress and approved by the Supreme Court is impossible, unless you have the votes. The Republicans don’t have, at least in the Senate.
The difficulty of repealing Obamacare has not stopped the Republicans from trying. The lower house, the House of Representatives, which is controlled by the Republicans, has voted over 40 times to repeal the law. The repeal always dies in the Democrat controlled Senate. Even if repeal did get through Congress, it is the signature achievement of the President and he would veto it.
The reason why Obamacare is so important is that it was the reason why so many Republican got elected. Conservatives hate it. There are 435 seats in the House. The Republicans have 232 or 53%. The last time the government shut down, the Republicans also had a majority in the house, but then many of its members were from marginal districts. The success of the Republicans in the state legislatures has allowed them to redraw the voting districts.
The new districts are very safe for Republicans. Republican districts are overwhelmingly white and rural. The voters of a Republican Congressman are 72% white compared to 52% their Democrat colleagues. A Democratic district is usually urban with a population density of 4,385 people per square mile. Republican districts only have 567 per square mile. These white rural districts are very conservative. They are dead set against two things: government spending and Obamacare. So they vote in conservative Congressmen who win with bullet proof margins. 204 or almost 88% of the present Republicans won by margins of more than 10%, over 60% won with margins better than 20%. They are also new to their jobs. About half of the Republican Congressmen have less than three years experience and 30% less than two. They haven’t been in long enough to be subject to normal political pressure. So as long as these legislators do everything possible to cut government spending and kill Obamacare they have no fear of being re-elected.
The result is that the normal fear that a legislator might feel by following an unpopular policy is simply not there. These people will not suffer any consequences if they shut down the government. It will take weeks for anyone but a government employee to actually notice. Most of their constituents will hardly complain during the next two weeks left before the money runs out. On the contrary, they are cheering them on. So their incentives are just the reverse of what one might expect. So the odds are quite favourable that the Republicans will take this fight to extremes.
In such an environment one would think that the market would be plummeting. Quite the reverse. As I write this on Friday, 4th October, the market is actually up slightly. The four days of government shut down has hardly affected markets at all. Why are they so complacent? The easy answer is that they are always complacent.
When Lehman Brothers collapsed in 2008, there were far too many articles on so called ‘Black Swans’. In other words, the stock market collapse could not be foreseen because it was a rare event. This is simply foolish. Lehman’s collapse was forewarned by the collapse of another brokerage, Bear Sterns. By September, the stock markets had been falling for 11 months and the housing market for over a year.
European markets were theoretically surprised by the sovereign debt crisis in the summer of 2011. But there was plenty of warning. Greece had had problems for over year. Presently there are plenty of enormous risks that are not priced in. For example, problems with the deteriorating municipal bond market in the US. China’s corporate and household credit has risen from 120% to 170% in five years a level reached in the US in 2008. China has a massive housing bubble and Japan a massive sovereign debt. Other emerging markets are swimming in huge levels of consumer and corporate debt while their currencies continue to deteriorate.
It is not that markets do not know about these risks. They are more than aware of them. It is just that the market participants do not adjust their expectations to perceived extreme risks because it is expensive to do so. Hedging with options is expensive and if the risk does not materialize they can expire worthless. If you act too soon, your competitors who took greater risks may come out on top. This is especially true for political dramas as we just witnessed in Italy.
(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)