You might have thought it obvious that the stock market would go down after S&P downgraded US government debt. The bad news about US debt made investors worry, and worried investors are usually less enthusiastic about holding stocks.
But there is something wrong with this view. Ask yourself, when fearful investors sell their stocks, what do they buy? They sell their stocks for cash, of course; and then, being fearful, they typically want to keep the proceeds in the nearest thing to cash that pays interest: US government debt. Thus, as investors’ demand for stocks goes down, their demand for dollars and other US liabilities goes up. Such a surge in demand for US government debt would cause the price of US bonds to go up, which means that the interest rate on US debt would go down. Doesn’t it seem paradoxical, that a downgrading of US government debt could cause demand for this debt to increase?
But sure enough, the New York Times described with some surprise that the United States Treasury was actually a beneficiary of the market shifts today (Aug 8), despite the downgrade of its debt, as 10-year yields fell to 2.32 percent from 2.56 percent, and the yield on the two-year Treasury note hit a record low. Those who are worried about inflation should also notice that the decline in the stock market means that any given amount of dollars can actually buy more shares of the Dow Industrials.
So it is very difficult to see investors’ behavior today as a reaction to fears about inflationary deficits or a default on US government debt. If serious investors were actually worried about the real value of US government liabilities then they should tend to move out of bond markets and into real investments like the stock market, which should drive stock prices up. Such a move would help get real investment started, which would help get people back to work; but that is not what we saw today.
To understand what is really happening, we need to think more carefully about the risks that S&P was assessing. Of course the US government as a whole cannot be incapable of paying the dollars that it owes, because the US government has the ability to print dollars itself. So how can the S&P bond raters have any legitimate concerns about a possibility of the US government defaulting on its debt obligations? The answer is that a default could happen only if one part of the US government prevented other parts from paying the bills.
The bills of the US government are paid by the Treasury Department, but the ability to print dollars is vested in the Federal Reserve. The Treasury can get new dollars by issuing bonds that are purchased by the Federal Reserve. But, although the bonds in such a transaction would be held by the government itself, they would still be counted in the aggregate debt that is restricted by Congress’s debt limit. So when the US Congress refused to raise the debt limit, it was threatening to prevent the Treasury and Federal Reserve from working together to pay for the government’s budgeted expenses and debt obligations. In a situation like that, the President would indeed have to choose between cutting budgeted government expenses or asking the bond holders to wait.
We have seen, however, that the investors’ movement from stocks to bonds today is very hard to reconcile with fears of default on these bonds. So to explain the stock market decline, we have to look at the other side of the story, the very real possibility that a politically constrained US government might have to cut expenses for essential government services. Broad fears of a crippled US government that is unable to enforce laws or invest in infrastructure could do very serious damage to investment and economic growth in America. Indeed the possibility of such government paralysis could be far more economically damaging than any marginal increase in taxes.
Thus, there is every reason to believe that investors are reacting, not to fears of too much government debt, but to fears of too little government spending where it is needed. Investors are expressing fears that the US government may become unable to do its essential part in maintaining the strength of this country. Pundits and congressmen should take note.
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August 9, 2011 at 2:49 am
Economist's View: Why Didn’t the Stock Market Go Up?
[…] investors were worried about government debt, the stock market should have gone up: Why didn’t the stock market go up?, by Roger Myerson: You might have thought it obvious that the stock market would go down after S&P downgraded US […]
August 9, 2011 at 5:40 am
Lucien Renault
I do not normally comment despite being a frequent and often delighted reader of this blog, but today I just have to, because the reasoning is faulty to a degree not usually in evidence around here.
“Of course the US government as a whole cannot be incapable of paying the dollars that it owes, because the US government has the ability to print dollars itself.”
So what? It is entirely irrelevant to me as an investor whether the US government defaults formally or not, if the value I receive for my investment is inflated away when I get my return. That the US government owns the printing presses is part of the current problem, because it leaves them openings that are not available to, say, the Greeks.
“We have seen, however, that the investors’ movement from stocks to bonds today is very hard to reconcile with fears of default on these bonds.”
No. What we see is the effect of long-established trade patterns where the risk of formal default isn’t high enough to warrant disruption. Very few investments have the capacity to absorb the volumes liberated by a serious stock market downturn, and treasuries are simple and liquid. As inflationary pressures increase I fully expect investors to copy the Chinese in their new investment habits.
Investors are, of course, fearing a long-term reduction of profitability of US investments. But apart from sectors that have been on the public teat – aerospace, agriculture and now, sadly, health care – the fear that the US government will spend _too little_ has nothing to do with it.
August 9, 2011 at 9:18 am
wellplacedadjective
i agree that printing money devalues your (previously purchased) investment, but — when the govt prints $$ — all cash-holders pay the cost… not just you as the bondholder. formal default is, in fact, much worse for the bondholder. so, in that sense, it’s probably not irrelevant to you as an investor.
August 9, 2011 at 6:04 am
Tuesday 7atSeven: passing panic | Abnormal Returns
[…] didn’t the stock market go up yesterday? (Cheap Talk via […]
August 9, 2011 at 6:53 am
Why Didn’t the Stock Market Go Up? | FavStocks
[…] investors were worried about government debt, the stock market should have gone up: Why didn’t the stock market go up?, by Roger Myerson: You might have thought it obvious that the stock market would go down after S&P downgraded US […]
August 9, 2011 at 7:59 am
TK
I’ve been saying this all along. The mkt went down after the debt ceiling deal because investors, hit with more news about a weak economy, realized that the gvt had just agreed to abandon its most effective tools. With that surrender to the far right in place, it is almost impossible to carry out the short-term Keynesian steps that are obviously required. That is bad for stocks.
March 18, 2014 at 7:53 pm
Billy
. In order to hold the highest ofifce in the land (Presidency), you must be a Natural Born American. He is an American, and I could question that, but he is not a Natural Born American. In order for him to be that, BOTH HIS PARENTS AT THE TIME OF HIS BIRTH WOULD HAVE NEEDED TO BE BOTH AMERICAN CITIZENS, and they were not. Is our Constitution wrong? or are we just not paying attention to it any longer?He could even because his father was African, he maybe could have dual-citizenship.But no matter what, no matter how you look at it, he is not a Natural Born American.
August 9, 2011 at 10:31 am
Tuesday 7atSeven: passing panic | Abnormal Returns |
[…] didn’t the stock market go up yesterday? (Cheap Talk via […]
August 9, 2011 at 11:19 am
A bad few days for the press—and the president, again | The Observer
[…] Myerson writes: So it is very difficult to see investors’ behavior today as a reaction to fears about […]
December 2, 2012 at 12:56 am
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August 9, 2011 at 12:34 pm
wd40
As a micro-economist isn’t the more puzzling result that the US treasury rates for 6 months and above were lower on August 8 then August 3. Lower ratings should result in higher interest rates, not lower. Of course, one could say that the rating change was anticipated. But if that is the case, then why would the stock market respond to an anticipated change.
As long as we are coming up with theories, maybe its all about increased expectations about a double-dip recession, which would mean that stocks would go down and bonds would go up in price. A double-dip recession would also mean increased US debt as tax collections would go down. So this may be the story regarding the rating change–increased likelihood of still greater debt.
August 10, 2011 at 12:02 am
Microtimer
The drop in yields was driven by other more powerful factors. I am an investor. And like many investors I move into bonds when I exit the stock market. Treasuries are a safe haven for parking money. The yield is not important to me. When the crowd does this the bond yields drop, even though on their own merit, the rates should rise.
August 10, 2011 at 4:44 am
Crisis update | eco.nomie.nl
[…] Myerson probeert te snappen waarom een downgrade van de VS toch leidt tot hogere prijzen van Amerikaans […]
August 30, 2011 at 7:09 am
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September 1, 2011 at 11:06 am
Beijing: Day 5 – WHAT I BELIEVE
[…] 1. Reading: a) Why didn’t the stock market go up? by Roger Myerson https://cheaptalk.org/2011/08/09/why-didnt-the-stock-market-go-up/ […]
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