Many people are asking why the financial markets have so far been unruffled by the political crisis which is playing itself out in Washington. That is a very good question. Yesterday was a case in point. The Financial Times website led with a story by Martin Wolf headlined “America is flirting with self destruction”. Yet equities were up on the day, and gold fell sharply.
The explanation for this conundrum, I believe, is twofold. Part of it is connected to the nature of markets, and part to the nature of this particular episode.
To start with the nature of markets, it has become very clear in recent years that asset prices are not necessarily very good at reacting in a smooth manner to changes in the perceived risk of extremely unlikely events taking place. For long periods, the markets do not react at all, and then they suddenly react in a discontinuous manner. The manner in which asset prices reacted to the risk of sovereign defaults in the euro area before and during the crisis of 2011-12 was a good example of this.
For many years, the markets acted as if there was no risk at all of default. Then, in the summer of 2011, they suddenly started to price a risk of 30 per cent or more that several sovereigns would default within the next 5 years, an assessment which now appears to have been a significant over-reaction. So the fact that markets do not price these risks for very long periods of deteriorating newsflow does not imply that the risks are in fact non existent, or that they will not suddenly appear in asset prices.
Why do markets behave in this way when, after all, the major participants are fairly rational, most of the time?