Putting a price on political stupidity Just what depths of political stupidity are markets discounting? The partial shutdown of the US government passed with little or no impact on the markets that stood to be most affected, even though there was uncertainty about it to the end. Almost all European stock markets opened higher, despite the news from the US. The dollar index dropped 0.35 per cent in the minutes following the realisation that the shutdown would happen, and then recovered somewhat. The yield on the benchmark 10-year Treasury bond gained 5 basis points to 2.66 per cent - still far below the 3 per cent it briefly touched a few weeks ago. So what has happened so far - the failure to agree on a budget and an initial shutdown of the US government - has evidently been priced in. This is impressive, because stock markets entered the period of political drama looking strong. The MSCI World index, covering all developed markets, enjoyed its third best September on record with a gain of 4.8 per cent. The S&P 500 itself has recently touched an all-time high. The Federal Reserve's decision to delay "tapering" the stimulus it was providing to markets - itself perhaps partly influenced by concerns about the political situation in Washington - has for the time being more than counteracted concerns about deadlock. So for now, not only has a short shutdown been priced in, but investors have convinced themselves that it can be survived without significant damage to an economy that is in decent shape. This is not unreasonable. According to the Congressional Research Service, there have been 17 federal government shutdowns since 1977, most lasted only a few days, none lasted more than three weeks, and none caused lasting damage to the economy. But market prices also imply confidence about an event that conventional wisdom holds would be far more important - a refusal by Congress to raise the federal government's debt limit, which could potentially force the US into defaulting on its debt. This, more or less everyone agrees, would be far more serious, but with no precedents to guide them, it is hard for analysts to work out what would happen. The last time Republicans in Congress played brinkmanship on the issue, in August 2011, they forced a brief bear market in stocks, which fell more than 20 per cent. That incident also appears to have triggered a move by emerging markets to stop accumulating reserves and reduce their dependence on the dollar. But it also, counterintuitively, drove a flight to the safety of Treasury bonds. Even though their creditworthiness had been called into question, yields on Treasuries dropped during the fall-out from that debt ceiling struggle. This means that the full effects of an actual default would be very hard to predict. Predictions of a crisis to match the fall-out from the bankruptcy of Lehman Brothers in 2008 are not far-fetched. The cosy consensus, however, is that this will not happen. Not only that, but the politics over the separate issue of the shutdown might help avert a default over the debt ceiling. One scenario widely touted is that the Republican leadership is letting the troops have their "red meat" on this issue, and will then whip them into line to avert a default. A second version holds that Republicans will see from the polls that the country is not with them over the shutdown issue, and feel forced to climb down over the debt ceiling. But one way or another, the belief is that this shutdown will play out politically like the last one did. Republicans in the House will overreach and take the blame, weakening them and strengthening the hand of the Democratic president who had previously looked weak and insecure. Meanwhile, the uncertainty will force the Fed to keep pouring out the QE stimulus. On balance of probabilities, this looks like a decent assessment. But the chances of a surprise to the downside look higher than any possibility of an "upside" surprise. The shutdown could drag on, until it begins to exert a serious drag on an economy that was not looking robust in the first place. Or Republicans might win the battle for public opinion, strengthening their hand for the debt ceiling tussle. The market is probably right that what has happened so far is not a big deal. But there remains a non-negligible risk of something worse in the near future, and that has not yet been priced in.