Okay, everyone, for this post to make sense, you're going to have to think all the way back to 2008, when credit default swaps were all the rage.
Remember what a credit default swap is? No? Well, they're actually quite simple: in simple terms, credit default swaps are insurance that a lender can buy for a loan. In other words, if I loan out money, I can buy a CDS on that loan, and then if the borrower fails to pay me back, whoever sold me the credit default swap will pay me back instead. Naturally, the riskier a loan looks, the more expensive it is to buy insurance for that loan, in the same way it's expense to insure a risky driver or a beachfront property in Miami.
So one way to measure the perceived riskiness of a loan is to look at the price CDS sellers are asking to insure it. If it's high, the loan seems risky. If it's low, the loan seems safe. And if it's going up, the loan seems to be getting riskier.
With that in mind, check this out this graph of CDS prices for the debt of various countries:
Note the sudden sustained spike in the CDS price for US debt a couple of months into 2011. That indicates that CDS sellers think that US debt got significantly riskier in that period.
What could be causing this very sudden change in perceptions? The economy? No, the economy has been in the toilet for many months no . High government spending? No, there's been no sudden change in government spending priorities to cause that sort of reaction.
Most probably, the spike is being caused by ongoing fight in Congress over the debt ceiling. Investors are worried that the US might not actually raise the debt ceiling, causing a sovereign default, and they're pricing their insurance on US debt accordingly.
In short, this chart shows exactly why Congress needs to just bite the bullet and raise the debt ceiling already. ASAP.
The current spike in CDS prices illustrates the completely loopy reasoning of the members of Congress (also known as Republicans) who are refusing to raise the debt ceiling until the deficit gets cut. That's because the number one danger of high government spending isn't actually sovereign default -- it's that lenders, wary that their loans will never get paid back, will demand higher interest. The increased cost of borrowing would create all sorts of difficulties for the United States, which, like all modern economies, will always rely on a certain degree of borrowing to finance its government.
But this chart illustrates that what worries lenders the most isn't government spending at all! No -- lenders are much more concerned about the prospect of a congressionally-induced default than they are about runaway spending. And this worry isn't just theoretical or speculative -- the debt ceiling standoff is impacting the market around US debt instruments as we speak. What we fear is already happening, and we're causing it.
Obviously, the chart hardly illustrates an impending crisis. For reasons that aren't quite clear to me, there was a similar spike -- though only half the size -- at the same time in 2010. And if Congress does manage to reach a bargain (and that bargain doesn't include economy-killing spending cuts), everything will hopefully return more or less to normal.
But maybe not. Because even if a compromise is reached, the financial world will remain acutely aware that one day, the debt ceiling will need to be raised again. And they'll know just how close to the line Congress is willing to walk. They'd be crazy not to price that possibility into their financial instruments.
In fact, if anything, I think the financial world remains underappreciative of the Senate's dysfunctionality. It's hardly inconceivable that some mixture of congressional brinksmanship and parliamentary procedure could cause an accidental default -- particularly if recalcitrant Tea Party Republicans, many of whom seem to genuinely believe that the debt ceiling doesn't need to be raised, get involved. The debt ceiling represents a truly horrendous piece of institutional design -- essentially a sort of reverse self-destruct button, which must get pressed every year or the country automatically destroys its own economy -- and one day it's going to come back to haunt us. Just because we avoid disaster this one time doesn't mean everyone will forget that the potential for disaster is still built into the system.
But all prognostication aside, the chart suggests that, already, right now, today, the quantifiable negatives of a political fight over the debt ceiling have eclipsed the quantifiable negatives of actually having a large national debt in the first place. Damage has already been done to lender expectations, and as long as Congress holds this issue on its plate, there's a risk it'll get worse. If Republicans had any sense at all, they'd take evidence like this as a sign that they should back off and find new avenues to pursue deficit reduction. (Might I suggest fixing health-care spending?) Instead, they seem determined to forge ahead, causing the damage they're ostensibly trying to prevent.
(h/t Felix Salmon)