Will Wall Street Snap?

For the past few weeks as the debt-ceiling crisis has intensified in Washington, financial markets have been acting on the assumption that a deal will be done. This weekend, that changed.

House Majority Leader John Boehner’s decision Friday evening to walk away from the table (surely not coincidentally after the U.S. markets closed for the weekend) acted as the proverbial smelling salts that snapped global markets out of what had been a pleasant dream that all will be well before it’s too late. As the folly continued, slow-motion, across the weekend, governments and market makers throughout the world seemed finally to realize what some had long suspected: saner heads do not control Congress—and may not prevail.

Accordingly, financial markets are finally acting as if a U.S. default is a genuine possibility. Asian markets dropped 1 percent Sunday night, and the Dow struggled to catch up to a similar drop at the opening on Monday—on what should be a positive day, given the good news coming out of Greece. Gold has started to spike, a sure sign of a “fear trade.” And while bond markets have stayed contained, Mohamed El-Erian of the world’s largest bond manager PIMCO warned late Sunday that it’s only been by a thread.

Yes, a small window of time remains. August 2 is not—as is widely being reported—the day of default. In that respect, the Republicans are correct. To maintain the full faith and credit of the United States, the White House will surely prioritize interest payments once the debt ceiling is reached. There are more than sufficient tax revenues to make those payments (which amount to about $25 billion a month), but not to keep the rest of the government functional and also pay everything from military salaries to Social Security.

But Republicans also grievously underestimate what will unfold both short and long term in financial land if they push this anywhere close to August 2. We’re already seeing, as of this weekend, cracks in the global consensus that even a troubled U.S. can ultimately be counted on to “do what is right.” The U.K. business secretary referred to the Tea Party radicals advocating no increase in new debt as “nutters” who threaten the global economy. The Chinese have been notably quiet in public, but are apparently quite concerned behind the scenes that their trillion dollars (give or take) in U.S. Treasuries might lose value should the U.S face a debt downgrade from the ratings agencies. Even the Argentine president Cristina Fernández de Kirchner piled on and made some passing remarks about the American Dream becoming a nightmare.

OK, the Argentines are hardly in a position to scold, and we shouldn’t take global schadenfreude too seriously, given how many would take real pleasure at yet another American self-inflicted wound.

But it is also true that what is unfolding hastens the erosion of American global economic leadership. The dollar has been the financial safe haven for the world—why did the Chinese first tether their currency to the dollar, after all, if not because of a belief that the United States had the world’s most dominant economy and the only way to thrive was to join the American pax economica.

But the events of the past three years have led to a profound shift. America in the financial-crisis era is seen not as an anchor but a liability, and this latest descent has confirmed what most have long suspected: the United States government—long the arbiter of what constituted good economic policy—is now as dysfunctional and politically inept as any of the governments that it browbeat throughout the later part of the 20th century.

Ironically, this is occurring as corporate profits soar, from Apple to IBM to GE, with stocks buoyed as a result. Investors have been betting that a debt deal may go down to the last minute, but in the end a deal will be struck. Now, they’re starting to get jittery, and as we know, investors don’t stay jittery for long. They either snap out of it or descend into full-scale panic. When that happens, stocks plunge, bond spreads widen, yields jump, and the system starts to bend. Remember, this is a scarred and scared system, which has neither recovered structurally or psychologically from what happened in late 2008 and 2009. It seems fine, until it isn’t.

It’s wise to harken back three years, to the early weeks after the collapse of Lehman Brothers. Then, complacency turned to white-knuckled panic, first when the government didn’t bail out Lehman and then when Congress rejected the first bailout bill on September 29, 2008. The result was a plunge in the U.S. stock market of nearly 800 points, one of the worst days the index had ever suffered, followed by sharp selloffs in the subsequent days. The implosion of the financial markets snapped Congress awake and made even diehard opponents recognize that theory and ideology are about as useful as an extra copy of Hayek in a hurricane.

Some on Wall Street are saying that it might take another financial-market heart attack—plunging stocks, sharply widening bond spreads, strain on money markets—to get the House Republicans to yield. And that could be self-fulfilling, as investors start Monday to scramble to guard against that possibility.

Whatever happens at that point, it would signal another Rubicon being crossed, and not at all in a good way for the future of American global economic leadership or long-term affluence. It’s said that reputations are hard to build and easy to lose, and the United States in matters economic is demonstrating that adage over the past few years. As long as America remains a large and powerful market, it will command a central position—but as Japan knows, that is not the same as leadership, respect, or the power to move allies and adversaries.

Markets are discounting mechanisms—factoring in future events in today’s prices. This week, markets may just begin to discount the future leadership of the United States. They may plunge if a deal isn’t reached, or rally impressively if one is. Money—and lots of it—will still be made in those markets, by investors, by institutions and by companies. But as an indicator of future American preeminence, they are pointing unequivocally in one direction, and it isn’t up.