How Government Gridlock Would Harm the Economy

A continuation of political warfare and failed economic policies is the worst thing that can happen.

By SHARE

Relief, at last.

That's the view of many business leaders, who feel that a highly anticipated Republican triumph in the midterm elections will unchain the economy and make life easier for their firms. President Obama and his Democratic allies in Congress have dominated the Washington agenda for the past two years, using their majorities to pass healthcare reform, financial reform, and other measures that raised costs and regulatory burdens on businesses. There could be more of that in the future, as the need for new taxes, to help pay down the national debt, seems likely to hit businesses hard. So if Republicans seize one or both houses of Congress in the midterms, they'll have the power, theoretically, to limit government involvement in the economy and promote "pro-business" policies.

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This is the "gridlock" scenario that has buoyed investors and sent the stock market upward as Republicans have surged in the polls. Divided government in Washington tends to lock the status quo in place, with plenty of political fireworks but little new legislation. Sometimes very little gets done at all. The ultimate gridlock occurred in 1995, when President Clinton and the Republicans who took control of Congress the year before clashed so fiercely over the federal budget that the feud temporarily shut down the government. Clinton moved from the left to the center as a result, and was only able to pass legislation that had considerable Republican support.

Polls now show that business leaders and many other Americans hope something similar will happen to Obama, with Republicans gaining enough power to thwart presidential priorities like energy and immigration reform and higher taxes on the wealthy. But political gridlock in 2011 may not favor business nearly as much as Obama's critics hope, and if Republicans and Democrats prove incapable of compromise it could unnerve investors more than the extremes of single-party control. "We believe investors are overemphasizing the market impact of potentially divided branches of government," Oppenheimer & Co. analyst Brian Belski advised clients recently. "Be careful what you ask for."

Political gridlock isn't that big of a deal when the economy is healthy and the future looks bright; employers and their workers mostly just chug along, with no need for major help from Washington. The problem today is that the economy is far from healthy and still needs help. Plus, the status quo is actually the problem: If Washington effectively does nothing over the next several years, it will lead to a bankrupt government and a wrecked economy.

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The first test of the gridlock scenario is coming very soon. The Bush-era tax cuts are set to expire at the end of the year, and if that happens as scheduled, the impact on the weak economy could be so severe that it triggers a new recession. There are several options. Obama and the Democrats want to extend the tax cuts for all but the wealthy, while Republicans want to include the wealthy as well. There's also the question of whether the cuts should be extended permanently, or only temporarily, until the economy is in better shape.

Extending the tax cuts for any group, for any length of time, will add to the national debt, which is now so big that it's a threat to the economy in itself. So unfunded tax cuts could ultimately be self-defeating. But letting the tax cuts expire—which is the gridlock scenario that will occur if Congress does nothing—would reduce Americans' disposable income and depress GDP by as much as 1.5 percentage points, according to the Congressional Budget Office. Since the markets expect some kind of extension, gridlock would be unwelcome. "The inability [of] policymakers to compromise on the extension of the Bush-era tax cuts could shock the economy," according to analysis by Bank of America Merrill Lynch. The stock markets would probably plummet in response.

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The new Congress won't be sworn in until January, so the tax issue will most likely be settled in a lame-duck session controlled by Democrats after the November elections. Still, if Republicans enjoy big election gains, they'll have more sway in the lame-duck session by virtue of their popular mandate and the ability to rescind certain measures once they take over next year. So we're likely to have a preview of the coming gridlock before the new Congress even arrives in Washington.

If Congress can handle the tax cuts without disrupting the markets, the next question will be how to further stimulate the economy. That's right: More stimulus. Plenty of people think Washington should put its pocketbook away and let the economy stand on its own. But it's barely strong enough to do that. Many economists forecast anemic GDP growth of 2 percent or less in 2011, which would be a sharp drop from growth in 2010, due mostly to the wind-down of stimulus spending. If the economy is that weak in 2011, unemployment will stay near 10 percent, home prices will keep falling, and confidence will remain dismal.

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A Republican sweep would bring many new small-government advocates into Congress and add to the ranks of deficit hawks insisting the nation can't afford any more government bailouts. Even so, the pressure to fix the economy and get Americans back to work will remain intense. Economists are increasingly calling for solutions similar to what CBO director Doug Elmendorf proposed recently. "If policymakers wanted to achieve both stimulus and sustainability," he wrote in his blog, "a combination of policies would be required: changes in taxes and spending that would widen the deficit now but reduce it relative to baseline projections after a few years."

Gridlock won't produce that. In fact, a new set of policies that salvages the economy, curtails government spending, and gets the debt under control—without provoking an even wider voter revolt—is likely to require the most intricate and delicate negotiations Washington has seen in a generation. It would probably entail a combination of many things that are perennial hot buttons: continued short-term spending programs, like extensions to unemployment insurance; tax reform, including a reworked income-tax regime and possibly a new valued-added tax; reduced benefits for Medicaid and Medicare recipients; a pushed-back retirement age; and deep cutbacks in defense spending and other government programs. Economically, it's not difficult to craft solutions that bring government spending in line with revenue and make the nation solvent again. The whole problem is political: Agreeing on the tradeoffs necessary to reach solutions that are best for everybody, overall.

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If there really is gridlock in Washington, here's what is likely to happen instead: Politicians will keep calling each other names and distorting the facts while the government continues to spend more than it takes in, driving the debt ever higher. We can probably get away with that for a few more years. But by 2020 or so, America's debt-to-GDP ratio will be close to the 100-percent threshold that can trigger a ratings downgrade and has proven to be a danger point in Japan and other downward drifting countries. We'd feel the pain sooner than that. Uncertainty about Washington's ability to solve problems is already a factor depressing consumer and business confidence, which in turn tends to lower spending and production. If Democrats, Republicans, and Tea Partiers continue to conduct political warfare—a basic tenet of gridlock—it will only add to the sour mood in the country.

On the other hand, true power-sharing in Washington could force all parties to seek real solutions, lest they bear the blame, separately or together, for the epic American debt crisis, whenever it hits. Obama would have to abandon his more controversial priorities and lean toward the Republicans on tax cuts for the wealthy and streamlined regulations. Republicans would have to stop pushing for the pointless and divisive repeal of healthcare reform and other Obama initiatives, and come up with their own agenda instead of just bashing Obama. Tea Partiers, a small but vocal faction, would have to stop speaking in hollow generalities about the Constitution and come up with workable ways to make government better.

Above all, everybody in Washington needs to get real about the spending cuts and tax increases that are coming one way or another. In a gridlock scenario, they might get away with another year or two of happy denial. But gridlock isn't governing, which for better or worse is what we need right now.