How Washington is Wrecking the Economy, Part 3

Experts predict another economic slowdown after election results settle in.

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At the end of the year, tax rates might go up for most Americans, or they might stay the same. Congressional discord might cause a recession, or a last-minute compromise might avert one. Businesses might start laying people off again, or they might hire more.

[Slideshow: Obama's crackdown on corporate America.]

With a lot of big problems in the world, we've gotten used to a higher degree of uncertainty in the economy than there used to be. But the rest of 2012 is shaping up as unusually volatile, as investors, businesses and consumers wait to see what Congress does about a huge set of tax and spending decisions that needs to be made.

More than any other event, worries about whether the United States will tumble over a "fiscal cliff," as Federal Reserve Chairman Ben Bernanke has described it, are now beginning to dominate business planning and economic forecasting. "Policy uncertainty is really killing the recovery," says economist Nick Bloom of Stanford University, who helped develop an uncertainty index that shows how unpredictable events impact the economy. "I can't see an agreement in Washington until next spring at the earliest. The prognosis is pretty depressing."

Bloom's index, not surprisingly, shows that uncertainty skyrocketed in 2008 as the recession and financial crisis set in. Since then, it has yo-yoed at elevated levels, compared with the last 25 years. The peak of uncertainty came last summer, as Democrats and Republicans bickered over whether to raise the government's borrowing limit and Washington nearly defaulted on its debt. To some extent, that event was more disconcerting than the 2008 collapse of Lehman Brothers, because the drama was man-made and easily avoidable—yet policymakers courted disaster anyway.

[See how Washington is wrecking the economy—Part 2.]

Uncertainty is now building toward the 2011 peak, as lawmakers debate what to do about tax hikes and spending cuts that could slice 5 percent off of GDP beginning next year if Congress fails to reach some kind of deal that prevents them from going into effect all at once. That problem is compounded by this year's elections, which all but guarantee that Congress won't do anything until it's clear who will control the White House and Congress next year.

The blasé attitude in Washington suggests that all will be fine once the elections are over and Congress reaches some sort of compromise that averts disaster, such as a one-year extension of the current lower tax rates and a more gradual rollout of the spending cuts than now planned. But the disaster may be happening right now, as businesses and consumers prepare for the various scenarios that might unfold. And a pullback in the economy now may not be nearly as reversible as Washington politicians assume.

Bank of America Merrill Lynch, for instance, has been providing its clients detailed analysis of how an "uncertainty shock" related to Washington decision-making will impair the economy. "Most investors are well aware that a major fiscal cliff lies ahead," Merrill economists wrote in a recent research note, "but we doubt they understand the risk to growth before the cliff."

[See what might be hiding in Mitt Romney's tax returns.]

The risks include a sharp decline in sales of cars and other big-ticket items, a drop in business spending, more layoffs and less hiring. Those trends could intensify over coming months as Washington gets closer to decision time. Economic growth, meanwhile, could slow to nearly zero by the end of the year, in Merrill's worst-case outcome.

Uncertainty of the sort that Washington is now creating can also harm long-term economic prospects. When companies worried about the future cut spending, they typically protect must-have things needed to operate today, while slashing investments in training, research and development, and high-tech equipment. "That stuff is probably all being slashed right now," says Bloom. "That's what drives growth in the future, and it's why we may end up with 2.5 percent growth rather than 3.5 percent growth."

A one-percentage point drop in the long-term growth rate might not sound like much, but it can be devastating in an economy with high unemployment and downward pressure on wages. It could easily depress hiring enough to keep an extra one or two million people out of work, with many others working less than they want and falling behind.

Perpetual uncertainty can also leave the economy chronically weak and susceptible to the sort of backsliding we've seen each of the last three years, when strong growth in the first few months evaporated by mid-year. Bloom suspects that may happen again in 2013, given the hollowing out of the economy that may be occurring now. "My guess is we have the election, there's some sense of certainty following that, then the economy collapses again next summer," he says. If that pattern continues, the one thing that may become certain is disappointment, lurking around every corner.

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