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Stock Market Falling, Paul Krugman’s Head Exploding

Everybody was predicting that S&P's decision to downgrade American debt would cause the stock market to decline. And, sure enough, the Dow is down more than 300 points as I write this.

But is the market reacting to the downgrade itself? Or the misguided reaction it might spark? That isn't so clear.

Consider the comments two analysts made to the New York Times earlier today:

The decision late Friday by the ratings agency Standard & Poor’s to downgrade the United States’s debt rating one level to AA+ from AAA has global implications, said Alessandro Giansanti, a credit market strategist at ING in Amsterdam.
“We can see that this may force the U.S. to move more aggressively to cut spending,” he said, something that could drive the already weak economy into recession and weigh on the economies of all of its trading partners. “That’s the main driver” of the stock market declines, he said. ...
While the debt downgrade was likely to continue to reverberate, investors are also concerned about the weak United States economy and Europe’s debt problems. ...
Kevin H. Giddis, the executive managing director and president for fixed-income capital markets at Morgan Keegan & Company, said the Federal Open Markets Committee was not likely to take action on interest rates, but would most likely discuss what policies would give support to the market.
“The rest of the conversations should happen in Washington,” Mr. Giddis said in a research note. “This country has an economic problem, which can only be fixed with jobs, not governmental liquidity, and that is the one that worries me the most.”

It sounds to me like those analysts are at least partly, if not mostly, concerned the U.S. will react to the S&P downgrade by cutting spending even more severely, slowing the economy even further. And that's a very realistic concern, given what lawmakers have been saying for the last few days.

Of course, I'm not an expert on the dynamics of Wall Street or even on the economy generally. But Paul Krugman is. And he seems to be thinking the same thing:

S&P declared that US debt is no longer a safe investment; yet investors are piling into US debt, not out of it, driving the 10-year interest rate below 2.4%. This amounts to a massive market rejection of S&P’s concerns.
The “signature” of debt concerns should be stock and bond prices both falling; what we actually see is those prices moving in opposite directions. And that’s normally the signature of concerns about a weak economy and deflation risk (see Japan, decline of).
What triggered economy fears? To some extent I think this is a Wile E. Coyote moment, with investors suddenly noticing just how weak the fundamentals are. Also, the mess in Europe.
And maybe, maybe there is an S&P story — but not the one you think. Arguably, that downgrade will bully policy makers into even more deflationary, contractionary policies than they would have undertaken otherwise, which has the perverse effect of making US debt more attractive, since the alternatives are worse.

Krugman asks whether these people are trying to make his head explode. I know how he feels.