Viewpoint February 19, 2010, 5:05PM EST

Amid Gigantic Deficits, the Bond Market Shrugs

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Optimism in the Yield Curve

The U.S. economy has barely emerged from its worst downturn since the 1930s. Demand cratered, tax revenues fell, and unemployment soared. Money managers well know that the extraordinary fiscal and monetary policy initiatives in the U.S. and elsewhere kept the economy from falling off the precipice. It's still too early to remove the system from life support, although the recent increase in the yield curve—the spread between short- and long-term rates on Treasury debt—offers a slice of growth optimism. Rates could go higher, but not because the bond market vigilantes are running from the federal deficit and government debt. It's a well-tested rule of thumb that a steep curve indicates expectations of strong future growth and, by the way, flush government tax coffers.

Investors also seem to have faith that the Federal Reserve Board under Chairman Ben Bernanke will do a good enough job that inflation won't spiral out of control. The current core rate of consumer inflation remains tame. The 10-year Treasury Inflation Protected Securities (TIPS) are forecasting an average 2.3% inflation rate over the next decade. The Fed has already started its move from combating recession to dealing with an expansion with its hike in the discount rate to 0.75% from 0.50%.

The most important factor behind investor steadiness may be a considered judgment that the U.S. political system may be messy and noisy, but it has also proven itself to be highly flexible and adaptable. The insight was noted by Daniel Cohn-Bendit in the mid-90s. Better known as Danny the Red, the charismatic student who briefly led the 1968 revolt in France, Cohn-Bendit was equally dismissive of the French government three decades later when the mandarins abruptly announced a series of major policy changes to close yawning deficits. The nation was rocked by strikes, and the government retreated. "In America, before major changes in anything there are Congressional hearings, public debates between Congress and the President, and a whole process of public discussion that is completely absent in France," Mr. Cohn-Bendit told the New York Times.

From Deficit to Surplus

That conversation is in full throat. Despite widespread cynicism about the President's new blue chip panel on deficit reduction, he did get two respected power brokers to sign on as co-chairmen, Erskine Bowles, a White House chief of staff under President Clinton, and Alan Simpson, a former Republican senator. This type of initiative has worked before. When federal budget deficits threatened a tide of red ink "as far as the eye could see" after Ronald Reagan's Presidency, his successors Bush and Clinton, along with enough members of Congress, managed with time to bring the budget into surplus.

Resilience is a hallmark of the American political system. A major strand of America's political history is that whenever widespread economic abundance is threatened, the political system adapts. In his magisterial People of Plenty: Economic Abundance and American Character, the historian David Potter argued in the 1950s that what American democracy was really committed to "was realizing the potentialities of our unmatched assets and raising our standard of living." From 19th century land reform through the New Deal, the "tactics by which this was done changed as the form of abundance itself changed, but the basic purpose—to keep our population in contact with the sources of wealth—has remained steadily in the ascendant throughout our history."

Simply put: Wall Street is betting that history still holds. The rules will change if the deficit and debt truly threaten prosperity. Don't sell the American political system short—at least not yet.

Farrell is contributing economics editor for BusinessWeek. You can also hear him on American Public Media's nationally syndicated finance program, Marketplace Money, as well as on public radio's business program Marketplace. His Sound Money column appears on BusinessWeek.com.