How Washington Is Wrecking the Economy, Part 2

The biggest problem right now isn't businesses or consumers, it's politicians in Washington.

job losses

What in the world could be wrong with the dormant economy?

Europe's chronic debt crisis has been an obvious concern, but recent measures seem to have reduced the odds of a dramatic meltdown in the euro zone.

Gas prices close to $4 per gallon were spooking consumers for a while, but they've since fallen to about $3.40, bringing drivers relief.

[Photos: Sounds of Summer]

Still, the economy weakens. Hiring has dropped off and the unemployment rate remains at 8.2 percent. Confidence levels have plunged recently, and consumers have reined in spending. Three years after the Great Recession officially ended, economic growth is a paltry two percent, perhaps even less.

More and more, economists are pointing the finger at Washington and faulting a dysfunctional political system for the worsening economic outlook. Without any action by Congress, tax hikes and spending cuts scheduled to go into effect at the beginning of 2013 could shave 4 percent off the nation's GDP. If that happens, we'll have a Made-in-the-USA recession.

Congress may strike some kind of last-minute deal to avoid pushing the economy over the "fiscal cliff," as Federal Reserve Chairman Ben Bernanke has called it. But until the government comes up with clear cut policies, businesses seem likely to delay hiring plans and hold off on the kinds of big investments that keep the economy humming. "We're already seeing the negative impact on household and corporate confidence," says Peter Fisher, a senior managing director at the big investing firm BlackRock. "There's an enduring diminution of growth because of the fiscal outlook."

President Barack Obama and Congressional Republicans are free to make a deal any day to steer around the fiscal cliff and ease all the economic worry. But of course, that's not likely to happen until after the November elections, as each side of the aisle plots for how to gain for maximum negotiating leverage. And even then, a compromise could remain elusive.

[See how Washington wrecked the economy, Part 1.]

Business leaders remain painfully aware of last year's shenanigans over raising the government's borrowing limit, which needlessly went down to the wire and nearly led to a default on U.S. debt. Standard & Poor's was so appalled at Washington's performance that it lowered the U.S. credit rating for the first time in the country's history. The whole fiasco sent stocks into a two-month swoon, startling global investors who realized that Washington politicians really could wreck the economy for the sake of their own political goals.

So this time around, everybody is preparing for the worst—and the stakes are higher than they were during last year's debt-ceiling debacle. If the Bush-era tax cuts expire as scheduled at the end of this year, virtually every American will face a significant tax hike—a shock few people are prepared for. If the spending cuts Congress has already approved go into effect, it could promptly force thousands of layoffs at defense contractors and other companies dependent on federal spending.

[See why we are all outsourcers.]

Common sense suggests that legislators who answer to voters won't let that happen. But common sense is scarce in Washington. Bank of America Merrill Lynch recently advised clients that both political parties might have an incentive to "go over the cliff" by allowing all of the more than $500 billion in tax hikes and $100 billion in spending cuts to go into effect as scheduled, beginning January 1, 2013. That would set the stage for a dramatic political showdown early next year, after the next president and next Congress take office.

If that scenario unfolds, however, it will probably be accompanied by a plunging stock market, mounting layoffs and sharp cutbacks in spending by business and consumers alike. Skeptical business leaders are already hunkering down. "Anecdotal evidence that fiscal uncertainty is having an impact on business decisions continues to build," Merrill Lynch wrote in its recent client note. "As the year progresses, we expect more businesses to react the same way to the looming cliff."

Such warnings are themselves an alarming negative indicator. Many businesses base investing priorities on the guidance they get from Wall Street firms, which means that prominent forecasts of economic paralysis can become self-fulfilling.

Meanwhile, it's well-known that Washington needs to get the mushrooming national debt under control and curtail spending financed by debt. The business community would prefer to see a long-term debt-reduction plan that goes into effect gradually, with predictable deadlines and no ugly surprises. Whether the next Congress can enact such a plan will be a key test of the nation's economic resilience.

But the next year or so is likely to be hairy, as normal economic activity slows and the focus shifts toward political combat in Washington. Here we go again.

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