The Independent Market Observer

8/27/13 – The Boiled Frog Effect

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Aug 27, 2013 7:49:56 AM

and tagged Fiscal Cliff, Market Updates

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In what I really hope is an apocryphal story, it is said that frogs don’t notice small temperature changes. You can, therefore, put a frog in a pan filled with cold water, and, as long as you heat it very slowly, you can actually boil the frog without it jumping out. If you keep the temperature changes slow enough, it will never realize that the heat is rising to harmful, and then fatal, levels.

I have, obviously, never tried this, but something similar has been happening in the U.S. economy. I am pleased to find, however, that people appear to be somewhat smarter than frogs. The heat I’m referring to is the pending debt ceiling crisis.

I was talking to a reporter for the Financial Times the other day, and, at the end of the conversation, he asked me what I thought the biggest pending problem was. I trotted out the debt ceiling and mentioned that no one else was talking about it, and he laughed and said something like “We are all so sick of typing that from the last time. No wonder no one is willing to listen.”

I appreciate the feelings, as I too am sick of it. I’ve mentioned the debt ceiling periodically over the summer, just to keep it on the radar, but in the absence of an immediate blow-off, the urgency just wasn’t there.

The lack of urgency surrounding what really could be a major issue for the U.S. and world economy—again—arises directly from the boiled frog effect. We’ve all gotten so used to a situation where the economy can be held hostage to political posturing that we tend to shrug it off. Even as the heat rises, we refuse to jump, as we’ve gotten comfortable there.

That comfort is, fortunately, starting to crack. Yesterday, the Treasury issued a warning that the U.S. will run out of financial room to maneuver in mid-October, sooner than had been expected.

This is a wake-up call to Congress, but, in fact, we hit the debt ceiling in May, about three months ago. Since then, we’ve been using the “usual extraordinary measures” to manage U.S. finances. The fact that the “extraordinary measures” were front-page news the last time they became necessary, and that we’ve been using them for three months this time with no real media coverage, shows just how far the normalization process has gone—and how hot the water is getting.

The debt ceiling debate will be combined, due to the timing, with the debate on how to continue to fund U.S. government operations. The possibility of a government shutdown at about the same time as a politically driven potential default on U.S. debt payments, while still distant, is real. This certainly isn’t inevitable—we’ve been through this twice now, and although the first time was a mess, the second time was relatively painless—but the risk is certainly there.

Even if a deal is cut, though, the uncertainty is a problem. A large part of what drove the poor economic performance at the end of last year was the uncertainty around the fiscal cliff and the risk that the government would allow significant, avoidable economic damage to happen. Recent signs of a slowdown in the economy could be leading indicators of a similar trend this year, based on the pending debt ceiling and government funding debates.

The problem we face is that, as frogs, we have nowhere to jump as the water gets hotter. Therefore, we have to pay attention and do what we can to make sure the water gets no hotter than we can stand. Let’s hope our representatives get the message.

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