"Why didn’t the stock market go up?"

"Cheap Talk" on the apparent paradox of Treasury bonds becoming more sought after as a secure investment in the wake of their "downgrade" by the "geniuses" at S&P:

You might have thought it obvious that the stock market would go down after S&P downgraded US government debt. The bad news about US debt made investors worry, and worried investors are usually less enthusiastic about holding stocks.

But there is something wrong with this view.

Ask yourself, when fearful investors sell their stocks, what do they buy? They sell their stocks for cash, of course; and then, being fearful, they typically want to keep the proceeds in the nearest thing to cash that pays interest: US government debt. Thus, as investors’ demand for stocks goes down, their demand for dollars and other US liabilities goes up. Such a surge in demand for US government debt would cause the price of US bonds to go up, which means that the interest rate on US debt would go down…

So it is very difficult to see investors’ behavior today as a reaction to fears about inflationary deficits or a default on US government debt. If serious investors were actually worried about the real value of US government liabilities then they should tend to move out of bond markets and into real investments like the stock market, which should drive stock prices up. Such a move would help get real investment started, which would help get people back to work; but that is not what we saw today.

To understand what is really happening, we need to think more carefully about the risks that S&P was assessing. Of course the US government as a whole cannot be incapable of paying the dollars that it owes, because the US government has the ability to print dollars itself. So how can the S&P bond raters have any legitimate concerns about a possibility of the US government defaulting on its debt obligations? The answer is that a default could happen only if one part of the US government prevented other parts from paying the bills...

We have seen, however, that the investors’ movement from stocks to bonds today is very hard to reconcile with fears of default on these bonds. So to explain the stock market decline, we have to look at the other side of the story, the very real possibility that a politically constrained US government might have to cut expenses for essential government services. Broad fears of a crippled US government that is unable to enforce laws or invest in infrastructure could do very serious damage to investment and economic growth in America. Indeed the possibility of such government paralysis could be far more economically damaging than any marginal increase in taxes.

Thus, there is every reason to believe that investors are reacting, not to fears of too much government debt, but to fears of too little government spending where it is needed. Investors are expressing fears that the US government may become unable to do its essential part in maintaining the strength of this country…