What are financial markets telling us about the debt ceiling?

For the past two years, staunch monetarists and economic conservatives have warned about the evils of massive deficit spending and quantitative easing.  They have argued that such policy measures are inevitably inflationary and will debase the currency and raise nominal interest rates.  By and large, supporters of Keynesian policies have responded by loudly pointing to the data on core U.S. inflation and the dollar’s performance as falsifying the conservative argument.  And, by and large, they have a point.  If inflationary concerns really were prominent, the dollar should have depreciated in value an awful lot, and nominal interest rates should have soared.  Neither of these things have happened.  Point for Keynesians.    

Right now, however, markets are providing a pretty powerful data point for Tea Party supporters who argue that hitting the debt ceiling is not the end of the world.  Last week Moody’s issued the following warning: 

Moody’s Investors Service said today that if there is no progress on increasing the statutory debt limit in coming weeks, it expects to place the US government’s rating under review for possible downgrade, due to the very small but rising risk of a short-lived default. If the debt limit is raised and default avoided, the Aaa rating will be maintained. However, the rating outlook will depend on the outcome of negotiations on deficit reduction. A credible agreement on substantial deficit reduction would support a continued stable outlook; lack of such an agreement could prompt Moody’s to change its outlook to negative on the Aaa rating.

 

Although Moody’s fully expected political wrangling prior to an increase in the statutory debt limit, the degree of entrenchment into conflicting positions has exceeded expectations. The heightened polarization over the debt limit has increased the odds of a short-lived default. If this situation remains unchanged in coming weeks, Moody’s will place the rating under review.

Make fun of the ratings agencies all you like, but this was front-page news last week.  One would think that markets would be pricing in the possibility of institutional investors diversifying away from dollar-denominated debt, a collapse in the dollar, skyrocketing interest rates, a drastic reduction in nominal GDP, dogs and cats living together, and so forth.  Or, as Tim Geithner put it, "catastrophic economic and market consequences." 

And yet…. last week, the yield on 10 year Treasuries fell below three percent.  Maybe markets are underestimating the likelihood that a debt ceiling deal won’t happen, maybe they are underestimating the damage caused by hitting the debt ceiling, or maybe they think the Chinese will continue to buy dollar-denominated debt no matter what happens on the debt ceiling (though read this).  Or… maybe the Tea Party activists have a point. 

So, my question to readers, investors, and experts on the global political economy — why aren’t markets freaking out more about the rising probability of hitting the debt ceiling?