As we’ve argued before, negotiations in the United States over the fiscal cliff aren’t about debt reduction; they are about figuring out how to borrow more. The markets get it: After Republicans in Congress failed to muster the votes to pass a bill to avoid the fiscal cliff, injecting more uncertainty into negotiations, equities went down, and it actually became even cheaper for the US government to borrow, with yields on almost all US debt sliding down. (The bond prices on the above chart are delayed, but you get the idea).
Why are investors behaving this way?
If we go over the fiscal cliff, the ensuing recession would hit equities more directly as business slows, so investors are more likely to invest in safer bonds. Those bonds are cheap for a lot of reasons: the Federal Reserve’s accommodative monetary policy and the global flight-to-safety, to start. But they are also cheap because there is no economic reason why the US would be unlikely to repay its debts. The biggest risk of US default is politicians deciding not to pay the bills in an attempt to push policies of their own.
The actual challenge of the fiscal cliff isn’t consolidation, or cutting the federal deficit. It’s consolidating less today to avoid a near-term recession, and then deciding who will bear the brunt of whatever limited reductions in spending and hikes in taxes do occur. If longer term cuts in spending over the next decade are included, particularly targeted at health care costs, that could make the budget more sustainable, but don’t forget that the US is already cuttings its deficit incredibly quickly.