Most Americans have shrugged off the budgetary antics in Washington, but the Federal Reserve hasn't. In fact, Fed Chairman Ben Bernanke is increasingly worried that bad government policies will harm the economy.
In the latest summary of the Fed's internal deliberations, there was new emphasis on the economic risks posed by recently passed austerity measures and ongoing budget battles. "Fiscal policy has become somewhat more restrictive," the Fed said in its usual dry tone. Translated, that means Congress and the Obama administration have flipped from policies that promote economic growth to ones that depress it.
The irony, however, is that the Fed itself has given politicians the wiggle room to pursue ideological goals at the expense of sound economic policies. "The Fed has enabled bad fiscal behavior," says Mike Thompson, managing director of global markets intelligence at S&P Capital IQ. "Fiscal policy is a joke. It's making the problem worse."
Basic economics teaches that the government has two powerful tools for aiding the economy during a downturn. Fiscal stimulus involves ramped-up government spending, tax cuts and other measures that temporarily generate extra economic activity, to make up for cutbacks in the private sector. Monetary stimulus involves interest-rate cuts and other policies meant to encourage private borrowing and spending.
Washington has done both during recent years. The big 2009 stimulus bill and other measures helped keep the recent recession from being worse, as the textbooks say it should. But those policies have mostly ended, and with Washington facing record debt levels, fiscal austerity has now replaced fiscal stimulus.
Tax hikes and spending cuts that have gone into effect this year will take $200 billion or more out of the economy. That's enough to cut GDP growth by nearly a full percentage point, which is a painful blow in an economy that's still anemic. Further battles over extending the government's borrowing limit this summer could restrain GDP even more.
Most economists agree that Washington needs to rein in the $16.5 trillion national debt. But abrupt, indiscriminate spending cuts and last-second tax hikes are an extremely clumsy way to do it.
An intelligent plan, by contrast, might include measures to boost short-term economic growth—such as a modest amount of high-return infrastructure investment—because faster growth boosts tax revenue and therefore reduces the need for federal debt. More importantly, austerity measures, while clearly necessary, should be scripted well in advance and go into effect gradually, so that everybody affected knows what's coming and has time to prepare.
Congress has gotten away with its awful handling of the economy for one big reason: The Fed has done a lot more to aid the economy than Congress has done to harm it. Unprecedented "quantitative easing" by the Fed has pushed interest rates far lower than they'd otherwise be, boosted stock values, accelerated a housing rebound and generally persuaded investors and consumers that there's some adult leadership in Washington.
Here's how powerful the Fed's policies have been. The spending cuts known as the sequester, which went into effect March 1, will cut about $85 billion in spending in 2013. That's a lot, which is why the battle over the cuts has been headline news. But the Fed is injecting $85 billion per month into the economy, through a bond-purchase program that's been in place since late 2008. "The Fed is putting liquidity equal to about 6 percent of GDP into the system each year," says Rick Rieder, chief investment officer of fixed income at investing firm BlackRock. "That's what's important to the markets."
Anybody who doubts that need only look at how the stock market has reacted to recent events in Washington. The stock market has completely shrugged off fiscal austerity measures, rising nearly 9 percent so far this year. After the sequester went into effect, the Dow Jones Industrial Average hit new all-time highs several times. Yet even a rumor of a pullback in Fed policy is enough to send markets lower.
If the Fed weren't so accommodating, Congress might be forced to act far more responsibly. At least twice during the last five years, Congress has approved essential economic measures when an imminent crisis required such action—the bank bailouts in 2008 and the debt-ceiling extension in 2011. But in each case, politicians dithered until it was obvious that neither the Fed nor anybody else could do their job for them. Even Congress likes to be bailed out.
Rick Newman's latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.