How the Debt Fiasco Damaged the Economy

Washington has created a "toxic environment for business."

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The data is in, and it's rather damning of the reckless politicians who thought it would be jolly good fun a few weeks back to threaten the world with a U.S. government default.

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The economy has been weak all year, on account of rising oil prices, European insolvency fears, stubborn joblessness, and consumers who are too indebted to spend much. Now, the midsummer fiasco over paying down the national debt seems to have cold-cocked the economy at a particularly vulnerable moment. It's painful to recount, but the last-minute debt deal that Republicans and Democrats finally reached after weeks of needless bickering will reduce the national debt by about $2.4 trillion over the next decade, provided that Congress goes along with a dubious plan to approve $1.5 trillion worth of debt-reduction measures that haven't even been identified yet. Even if it happens as promised, the debt deal would still fall short of the $3 trillion to $4 trillion in savings many analysts feel is needed. It does nothing to create jobs, either. So for all the risky brinksmanship, what we got was a deal that accomplished far less than either side said was necessary.

Now, as markets digest the implications of a do-nothing Congress--or worse, a do-damage Congress--the economy has suffered "an extraordinary reversal of fortune," as Moody's Analytics puts it. Most economists are slashing their growth forecasts for the rest of the year and for 2012. Some feel a new recession could occur, or might already be underway. Venal politicians in Washington aren't the only problem. The unresolved debt problems in some European countries could trigger a financial crisis there that leaches into the economy here. But many investors and business leaders now view Washington politics as one of the biggest threats to the economy. Morgan Stanley, for instance, said that a "policy-induced slowdown" was one of the reasons it recently downgraded its economic outlook. Here are four ways the debt fiasco has directly harmed America's economic prospects.

It wrecked consumer confidence. The latest reading in the Reuters/University of Michigan's consumer-sentiment survey is worse than the lowest point during the recession—which occurred in early 2009—and the lowest reading since 1980. For all the problems in the economy, it's still much stronger than it was in 2009, so the dismal confidence numbers must reflect something beyond pure economic performance. And sure enough, a sharp dropoff in confidence between June and July coincides with the appalling follies in Washington. What's dismaying is that confidence had stabilized earlier this year, despite a spike in oil and gas prices and other turbulence. But lost faith in the ability of political leaders to solve problems seems to have torpedoed Americans' outlook for the future.

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Consumer confidence is extremely important, because a gloomy outlook among consumers can become self-fulfilling in an economy that's heavily dependent on personal spending. In the recent past, government action such as the 2009 stimulus plan, the 2010 tax-cut extensions, and various moves by the Federal Reserve have helped boost confidence, because they provided a glimmer of hope that somebody was doing something to turn the economy around. They also helped revive the stock market, which affects consumer confidence directly. When confidence goes up, even by a little, consumers tend to spend a bit more and create new demand. Now, however, consumers sense that their leaders are inept and that they'd better prepare for worse times ahead. That's one reason economists expect weak spending and depressed growth.

It cuts into growth. New spending cuts over the next year will total about $71 billion, which is a tiny portion of GDP but will still cut economic growth by about 0.2 percentage points. Deeper cuts would have been worse, but with many forecasters lowering their expectations for GDP growth to well below 2 percent, any government move that cuts growth right now seems foolish. What would have cheered the markets: a plan to further stimulate the economy now, while laying out phased-in spending cuts—and tax increases—to begin in a few years, when the economy is stronger. The decision to cut spending with another recession possibly looming seems economically absurd and conveys the strong impression that Washington has no idea what it's doing.

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It created a precedent for ongoing dysfunction. One hope over the summer was that a comprehensive debt deal, if reached, would eliminate a lot of uncertainty about what's likely to happen with taxes, government borrowing, and other key federal policies. Instead, uncertainty got worse because politicians proved they're unable to compromise and delayed all of the most important and controversial decisions. In a recent briefing for clients by forecasting firm IHS Global Insight, chief economist Nigel Gault said that one of the biggest economic worries now is a "high risk of policy mistakes" such as new spending cuts or a failure to renew tax cuts or extended unemployment benefits that expire at the end of this year. He also listed several dates over the next 18 months that represent deadlines for various kinds of political action, such as Nov. 23, 2011, when the "supercommittee" created by the debt deal must present its plan for another $1.5 trillion in debt reduction. Each of those deadlines, Gault warned, could bring a repeat of the destructive brinksmanship we went through over the summer. "It means enormous uncertainty, with decisions postponed till the last minute or after the last minute," he said. "It's a toxic environment for business."

One factor in the recent stock-market tumble has been a rapid diminishment of expectations for what Washington is able to accomplish, which in turn has lowered the outlook for the whole economy. In its forecasts, for example, IHS assumes that Congress will fail to reach agreement on how to achieve the remaining $1.5 trillion in debt reduction, which would trigger across-the-board spending cuts of an equal amount, including a sharp contraction in defense spending. In a convalescing economy that's highly vulnerable to shocks, that would be about the worst possible way to tackle the debt. Doing nothing would almost be better, which is why Washington's sorry performance now casts such a pall over the economy.

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It dismayed business leaders. The economic uncertainty and political incompetence generated by Washington is now one of the main factors discouraging businesses from hiring. With a weakening economy, and rising odds that Washington will make it worse, few businesses will take on new workers unless they're absolutely needed to meet existing demand. Starbucks CEO Howard Schultz has even called on his fellow business leaders to withhold political contributions to both parties until Washington resolves the government's debt problem for good and does something productive to help the economy. "Because of the crisis of confidence and uncertainty, American business people [will] not invest as much as they could or should in the American economy right now," Schultz told Piers Morgan of CNN recently. "We're tired of what's going on in Washington. America deserves better."

Schultz wants businesses and their CEOs to use money they might spend on political campaigns to hire more workers instead. It's an ennobling idea, but it also seems improbable. Businesses will only take on the expense of new workers when they need them to meet demand. Right now, most of them don't. That leaves nobody really in charge of mending the economy. Thank Washington for that.

Twitter: @rickjnewman

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