How Washington Can Save—or Wreck—the Economy

A convincing deal on the debt could be just the spark the economy needs--but don't hold your breath.

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It's bad news when a healthy economy hinges on government action. That's why businesses and investors are increasingly worried about Washington.

The U.S. government has obviously played a key role in the economy since the Great Recession hit in 2008. Stimulus plans, bailouts, and aggressive intervention by the Federal Reserve might have been ugly and inefficient, but all that aid helped end the recession and avert a bigger calamity. Washington is now ending many of those stimulus programs and trying to wind down others. But while extracting itself from the private sector, Washington is having a harder time doing something just as important: managing itself.

[See how Washington is killing jobs.]

This summer's battle between Democrats and Republicans over how to cut spending by $2 to $4 trillion over the next decade is likely to determine whether the weak recovery gains strength, or peters out and gives way to another recession. Businesses and investors are pessimistic. "The best thing would be for them to get their act together and reduce this game of uncertainty they're playing in Washington," says Ethan Harris, head of North American economics for Bank of America Merrill Lynch. "I don't think that's possible in this environment. I don't think they can work that well together in Washington."

The most maddening thing about the debt drama is that the problem, though big, is readily solvable. Washington now spends about 40 percent more than it earns through taxes and other forms of revenue, borrowing to finance the difference. Deficit spending over the last decade has produced a staggering national debt of about $14 trillion. Everybody knows such profligate spending is unsustainable, and if not corrected will cause the kind of economic pain that citizens of Greece are now enduring. But an abrupt drop in spending—which would happen if Congress refuses to raise the "debt ceiling" over the next couple of weeks, preventing the government from borrowing any more money—would torpedo the weak recovery and probably make the debt problem worse, not better.

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There's no shortage of solutions: Budget experts have produced reams of thick reports on how to better balance spending and revenue. If Washington were run like a business, a compromise solution would already be in place, lest shareholders revolt and defenestrate everybody in charge. But Washington, of course, operates more like a wealthy, dysfunctional family than a rationally run business. "The economic problem in the United States is really not that big," former White House economist Laura Tyson said recently. "It's a political problem. Polarization in politics is the worst since the Civil War."

If politicians could stop sniping and forge a convincing budget deal, they might just furnish the fuel that the sputtering economy seems to be craving. A credible plan to reduce the debt would boost sagging confidence and make America's leaders seem statesmanlike rather than self-absorbed. It would also curb fears of rising interest rates, runaway inflation and other nasty problems usually associated with a debt crisis. A real solution would involve dozens of tough decisions about Medicare, Social Security and many other federal programs, but here are four broad guidelines for how Washington could boost the economy by striking a deal on the debt:

Start small and get big. Deep spending cuts now would be damaging. The economy has been growing at a weak 2 percent pace so far this year, and sudden cuts could easily induce a recession. But if cuts start small and intensify over a decade or so, that would allow time for the economy to strengthen before the toughest measures kick in, and it would also provide plenty of predictability. Investors are growing so skeptical of Washington that a genuine show of resolve would be a happy surprise likely to boost optimism and goose markets.

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Assure there will be no backsliding. A deal that relies on voluntary agreements or future compromises won't convince anybody. Skeptics want to see a plan that guarantees action even if it's five or 10 years in the future, and can't be undone by regime change in Washington or the predictable onslaught of influential lobbyists. It will be disappointing if the best deal possible is a small-bore agreement that leaves all the big problems till later. Both Republicans and Democrats have cast this summer's debt smackdown as a high-stakes moment. If they deliver a low-stakes solution, they've failed.

Include both spending cuts and tax increases. The gap is simply too huge to accomplish with spending cuts alone—unless politicians are willing to slash benefits for Medicare and Social Security, which are popular programs that account for about one-third of all government spending. Hammering seniors would obviously be a losing gambit, which is why both parties need to compromise on cherished and in some cases dogmatic principles that have so far stood in the way of a deal. "The Democrats need a reality check. We need to have entitlement reform," says New York University economist Nouriel Roubini. "Republicans have to stop the delusion that they can have economic growth and a reduced deficit without raising taxes."

Spread the pain fairly. A true solution to the debt problem will entail many unpopular measures, such as tax increases for the wealthy, lower mortgage-interest deductions for middle-class homeowners, a tax on the value of employee healthcare, cuts in benefits for the elderly and the needy, and many additional cutbacks in programs a lot of people take for granted. Any deal that appears to benefit some groups more than others will be vulnerable to populist politicking that could unravel it.

[See 5 reasons taxes are going to rise.]

If President Obama and Congressional Republicans could reach that kind of deal this summer, they could springboard the economy into a much more robust recovery. On the other hand, if gridlock prevails, the economy could get weaker. Here's how:

An impasse over the debt produces an economic shock. Despite deep skepticism of Washington, the prevailing view on Wall Street is that Republicans and Democrats will make a list-minute deal to extend the debt ceiling, so the government can continue functioning normally. If that doesn't happen and deep cuts are suddenly necessary, it will be a severe negative surprise that markets aren't prepared for. Stocks would probably plunge and there might even be some kind of bank run that sharply curtails lending. U.S. Treasury securities are still considered one of the safest investments in the world, and if that suddenly changed, the reaction in the markets would be chaotic and destructive.

U.S. debt could get downgraded. If there's a deal that extends the debt ceiling but accomplishes little else, the markets will relax, but doubts will continue to grow about Uncle Sam's long-term solvency. Rating agencies like Moody's and Standard & Poor's have already warned that America's AAA rating is in danger. Failing to make meaningful progress on the debt could be enough to trigger a downgrade. Falling a notch in the ratings wouldn't necessarily be catastrophic, but it would probably raise Washington's borrowing costs, making the debt problem even worse. It would also raise further worries about inept American leadership and the nation's ability to solve problems.

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Investors could shun the United States. As skepticism grows about Washington's ability to act decisively, America begins to look like an undesirable investment. That goes for global fixed-income investors who flock to Treasury bonds for a guaranteed, safe return, and for corporations who have to decide where to build factories, set up customer-service centers and direct capital. Investors like clarity and predictability, not shiftiness and volatility. When a nation fails to provide a stable business climate, business leaves. That means it will take even longer for unemployment to come down and growth to recover.

The lame economy shambles along. We're stuck with an economy in a state of drift. It's not so bad it needs emergency stimulation, like a few years ago, but it's not strong enough to lower unemployment or convince consumers that good times are returning. Politicians in Washington are mostly criticizing each other's ideas and posturing for public advantage, with little focus on areas of agreement that could help heal economic wounds and generate prosperity. Apparently that's good enough for them. The rest of us need something better.

Twitter: @rickjnewman

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