Wall Street Calm as Rhetoric Over Debt Ceiling Raises Heat in D.C.

Insiders are worried about the debt ceiling—and wondering why investors aren't.

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It used to be said that when the president sneezed, the stock market caught a cold. And yet, while Washington's blood pressure is rising, spurred by a congressional stalemate, escalating rhetoric on both sides, and a looming Treasury Department deadline to raise the $14.3 trillion debt ceiling or watch the U.S. government go into default, Wall Street remains serene, with little effect on the stock or bond markets. Many D.C. political observers are beginning to wonder whether investors' confidence is prescient, or misplaced. [Read the U.S. News debate: Should Congress raise the debt limit?]

"I'm absolutely mystified in the level of confidence that Wall Street seems to have that this deal is going to get done," says Scott Lilly, a senior fellow at the left-leaning Center for American Progress. Even if Obama and the Republican leadership strike a deal by Treasury's August 2 deadline, Lilly questions whether they will they be able to sell it to their respective caucuses, which very likely feel that they've already compromised enough. "I think that you have a very strong possibility that whatever they come up with will fail to get a substantial number of Republican votes, but will contain so many onerous policy choices that a lot of Democrats will vote against it as well." Barry Bosworth, a former economic adviser to President Carter and a senior fellow with the Brookings Institution, questioned whether either side could afford to back down. "I'm just beginning to become impressed with the flatness of the statements that politicians are making," Bosworth says. So far, investors haven't begun to unload their U.S. bonds, or make investments such as credit default swaps to hedge against a possible default. "So far, it seems pretty clear that investors just think this will never happen, because 'they can't be that stupid,' " Bosworth says. "But these things don't tend to happen gradually. I think that sentiment could change pretty fast."

One reason Wall Street may not be reacting is that, historically, Congress has always found a way to raise the debt ceiling no matter how hard it is politically. "We've been here before," says Kent Smetters, a professor at University of Pennsylvania's Wharton School. "This is not a new game that's played, where both sides play chicken." In 1995 and 1996, President Clinton and then-House Speaker Newt Gingrich squared off over the debt ceiling, but ultimately resolved it without a default. Another reason, Smetters says, is backup plans the Treasury Department might use to ward off a possible default, including issuing I.O.U.'s instead of bonds to get around the debt limit. So far, the Obama administration hasn't revealed any possible backup plans if a deal isn't reached, insisting that the August 2 deadline can't be broken, and also reportedly warning Congress that a deal needs to be in place by July 22 in order to be passed in time. "When you plan a game of chicken, you never want to reveal all of your cards," Smetters says. "You basically want to have something that looks like mutually assured destruction." [See a slide show of 6 ways to raise the debt ceiling.

But any sign that a deal might not be reached, or that Washington will have to use creative legal technicalities to get out of the situation, could be the tipping points for the markets. In fact, a common idea in Washington is some type of market reaction is necessary to jolt Congress into action, just as the stock market crash pushed the House of Representatives to pass the financial bailout in 2008. The country is waiting to see who will blink first—Democrats, Republicans, or Wall Street.