Why Washington, Not Europe, Will Roil Markets for Rest of 2012

Once again, D.C. politics hovers over the broader economy.

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Will Europe unravel?

That's the main question dogging the stock market these days, with worrisome news from Spain, Italy, and even France stalling a market that rallied for the first three months of the year. But the bigger worry for 2012 may be what happens in the United States, and especially in Washington.

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There's likely to be little meaningful activity in Washington until the November elections, but after that, a series of momentous decisions needs to be made—no matter who the next president is. The Bush-era tax cuts are due to expire at the end of the year, which means virtually every American will endure a painful tax increase unless Congress decides otherwise. Sharp cuts in government spending are due to kick in starting in 2013. And early next year, Uncle Sam will need another increase in its borrowing limit in order to stay in business.

The last time Washington faced a major economic decision, it botched it. Last summer's fiasco over raising the government's borrowing limit led to the first-ever cut in the U.S. government's credit rating and slashed stock values by about 17 percent. That's why Federal Reserve chairman Ben Bernanke calls the upcoming set of decisions a "fiscal cliff." If we fall off, it could mean another recession.

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Of course, it's possible that Democrats and Republicans will make a deal that straightens out Washington's finances without harming the economy. But it could be ugly, too. "I think we'll go over the fiscal cliff," said Jared Bernstein of the Center for Budget and Policy Priorities, at the recent Milken Institute financial conference in Los Angeles. "Then in January or February of next year, there will be a compromise that will be retroactive."

That would be better than no deal at all, but it would still roil the markets. Investors may already be getting nervous about the next round of fiscal follies in Washington. "We're going to see volatile markets between now and the end of the year," says Jim McGaughan, CEO of investing firm Principal Global Investors. "There will be a messy compromise, but the market won't like the process."

McGaughan remains bullish on U.S. stocks, saying they could rise 10 percent to 20 percent over the next 12 months—once Washington gets out of the way. But a lot of others doubt Washington can make a deal on spending, taxes, and debt without a lot going wrong. "I'm very worried," said Citigroup chief economist Willem Buiter at the Milken conference." I see complete paralysis. The United States has social-democrat spending preferences and Tea Party tax preferences. It's a very tight course between too much fiscal tightening or having complete gridlock and no deal."

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If Washington fumbles, the consequences could include lower growth, falling stock values, and rising interest rates. The Fed could ride to the rescue with more monetary easing, but that might be a desperation move that depresses investor confidence instead of boosting it. Then again, the United States is known as the country that eventually does the right thing, after exhausting all other options. Too bad there are so many other options.

Rick Newman is the author of Rebounders: How Winners Pivot From Setback to Success. Follow him on Twitter: @rickjnewman.