For political leaders and policymakers in Washington, two things about the market meltdown have been particularly striking.
First, the plunge had nothing to do with the debt-ceiling and deficit-reduction battle that consumed Congress and the White House for much of the past month. The debt-ceiling deadline did not spook the markets very much. Nor did they react much, either way, to prospects for a “grand bargain” on deficit reduction.
What has been rattling confidence is the slew of new data suggesting that the already-feeble U.S. economic recovery is stalling.
Second, today's market panic began in Europe and was driven by fears that the eurozone debt crisis will spread from Greece and Ireland to much bigger nations, Italy and Spain.
If that second point sounds comforting, it’s not. What markets here were demonstrating is that the U.S. economy is much more affected by outside shocks than it was before the financial crisis.
Economists at Bank of America warned on Thursday that the United States faces a 35 percent chance of slipping back into recession, summing up the fragility this way: “One shock away.”
The disconnect between Washington and the real economy has been unusually wide ever since the debt-ceiling battle got serious about a month ago. Republicans, pushing brinkmanship to new limits, insisted that businesses need confidence that can only come from deep and immediate cuts in government spending. President Obama and Democrats in Congress warned that the brinkmanship itself threatened to destroy such confidence, noting that many Republicans were openly ready to push the government into default.
In some ways, both sides were wrong. Wall Street never really believed that the stalemate was more than a game. But markets showed only limited relief when Congress finally settled for the $2.4 trillion deficit-reduction deal this week.
It’s always dangerous to infer meaning from sudden stock-market movements, and the plunge on Thursday had a lot of components. Eurozone debt fears had been building steadily all week, and worldwide markets were tanking on Thursday before Wall Street trading began. Markets were also rattled by two big central bank interventions: The Bank of Japan intervened heavily to bring down the surging value of the yen; and, in a bigger surprise, the European Central Bank halted its plans for raising interest rates and began intervening to help calm markets for Italian and Spanish bonds.
In years gone by, such European jolts had fairly little effect on the United States. But the housing bust and the financial crisis wiped out something on the order of $13 trillion in wealth, creating a balance-sheet recession that left the United States much weaker for a long time after the downturn.
Last week, the Commerce Department shocked investors by reporting that U.S. economic growth during the second quarter was only 1.3 percent – much slower than most analysts had thought. But the big surprise was the government’s revision of estimates about earlier growth, which showed that the Great Recession had been even worse than originally thought.
That wasn’t the only bad news, of course. Job creation, which seemed to be picking up steam last year, has slowed to a crawl in recent months – not what’s supposed to happen. Analysts are predicting that the Labor Department will report on Friday that the nation added 85,000 to 100,000 jobs in July. That would be disappointing and not nearly enough to reduce unemployment, but it would be better than in recent months.
Vincent Reinhart, a former director of monetary affairs at the Federal Reserve Board and now a fellow at the American Enterprise Institute, said that the debt-ceiling battle was a huge distraction from problems bubbling up in the real economy. The drama may have distracted financial analysts as well as policymakers in Washington, he said.
“The debt-ceiling fight was a two- or three-week diversion, in which financial analysts focused on the status of legislation and didn’t notice that the economic data was coming in weaker than expected,” Reinhart said.
The fall in stock-market prices last week, as the debt-ceiling fight came down to the wire, may well have reflected a new sense of alarm about the political dysfunction in Washington. But it also reflected a deepening gloom about slowing growth and employment.
There are good reasons worry about a second recession. In a paper presented at the Federal Reserve’s conference in Jackson Hole, Wyo., last August, Reinhart and his wife, Carmen, reported that about half of 15 countries that experienced a severe financial crisis in recent years suffered a second, milder recession after the first one. In 10 of the 15 countries, unemployment hadn’t declined to its pre-crisis levels one decade after the crisis had ended.
None of that seems to have registered in Washington. Although Republicans have been the main champions of fiscal austerity and immediate spending cuts, Obama and Democratic leaders in Congress had embraced the deficit-reduction mantra almost as fervently. The main difference was that Democrats wanted to narrow the deficits in part through tax increases.
There was one piece of good news out of Washington this week. Many analysts had warned that immediate cuts in spending would slow the economy even more, and at just the wrong time, but the actual deal postponed almost all of the spending cuts until 2014.
The bottom line: Washington was largely oblivious to the real economy, but at least it didn’t make things even worse.