4 Fresh Fears About Washington Wrecking the Economy

Here are some dark scenarios that investors and economists worry about.

By SHARE

It's a timeless adage: Be careful what you wish for.

The conventional wisdom prior to the midterm elections was that investors and business honchos would welcome a Republican sweep, since it would mean less regulation, leaner government, and maybe even lower taxes.

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The Republicans did their part, of course, winning control of the House of Representatives and gaining more power in the Senate. And they've wasted no time pushing new ideas for cutting government and trimming Washington's outsized role in the economy. A few likely developments are encouraging to businesses. A divided government means there's little chance of new energy or immigration rules they'll have to sort through. A few of the new healthcare requirements passed last year could be simplified or even eliminated. And the Bush tax cuts seem likely to be extended for most taxpayers—and perhaps all, including the wealthy—either late this year or early next. All of those moves would make the economic climate more predictable, and they might lower costs for businesses.

But anxiety is rising over many other possibilities, especially with a weak economy that doesn't seem ready to stand on its own without the extraordinary government support of the last few years. Most economists and business leaders, for instance, feel it's vital for Washington to come up with a plan for reducing the government's annual deficit and paying down the national debt. But they also fret that if it's too abrupt, it could destabilize a fragile economy and perhaps even trigger another recession. "With unemployment so high," writes economist Mark Zandi of Moody's Analytics, "the collective psyche remains on edge and vulnerable to anything else that could go wrong. It is not difficult to conjure up dark scenarios." Here are four specific ones that investors and economists worry about:

Unspent stimulus funds will be recalled. About $120 billion of the $800 billion in stimulus funds appropriated in 2009 remains unspent, according to Onvia, a private firm that tracks stimulus spending. Many Tea Partiers and small-government advocates would like to see that money returned to the Treasury, to help reduce the deficit. But if that happened, it would cost the economy jobs at a time when the private sector still isn't generating enough of them to bring unemployment down. Onvia says that $76 billion worth of projects funded by the stimulus bill so far have helped keep 800,000 people working. (The rest of the $800 billion went toward tax cuts and aid to the states for Medicaid and other programs). Most of those early jobs were temporary, Onvia says, whereas future jobs funded by the stimulus would be related to longer-term infrastructure projects and clean energy, making them more permanent in nature.

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It's valid to question whether funding jobs from Washington is the best use of $120 billion in taxpayer funds. But simply pulling the plug on all those programs might do more harm than good. What many economists really want to see is continued stimulus spending until the economy is healthier, coupled with a credible plan to prune the government starting three to five years from now. Slashing spending would be counterproductive if it made joblessness worse, caused another recession and further reduced tax revenues to the government, resulting in even bigger deficits.

Other cuts in government will happen too fast. New members of Congress will face several immediate tests of their spending plans as soon as they take office in January. In addition to the Bush tax cuts, they'll have to decide whether to approve another extension of unemployment insurance for those who have been out of work for more than 26 weeks, for one, and whether to extend some two-year tax breaks that were part of the 2009 stimulus plan. Economists at Bank of America Merrill Lynch estimate that those two measures combined would pump about $132 billion into the economy if extended through 2011—a much bigger impact than extending the Bush tax cuts for wealthy earners, which would account for only about $36 billion next year. (Of course, the same amount would be added to the debt if those measures pass.) Bank of America estimates that if Congress lets the two Obama measures lapse, personal income will actually fall next year, when it ought to be rising at this point in a recovery.

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It's also likely that state and local governments will continue to slash their payrolls, as they come up short on tax revenue and aid from Washington peters out. At the current pace, Bank of America estimates that state and local cutbacks will detract about half a percentage point from GDP growth in 2011. Anything deeper could shock the economy, especially if the Tea Party calls for a balanced budget gain traction. "The Tea Party push for immediate balancing of the budget deficit would be self-defeating," says a recent Bank of America analysis. "It would likely push a crippled economy back into recession, causing tax collections to collapse and the deficit to rebound."

There will be no new efforts to aid the economy. Some business leaders have been looking forward to political gridlock, hoping that it means no new regulations or other measures for them to contend with. But others feel the economy still needs help it won't get from the private sector. Mohammed El-Arian, CEO of the bond-trading firm Pimco, recently told the New York Times that the economy still needs a "comprehensive policy response"—which remains nowhere in sight. El-Arian feels the government needs to do more to help the unfortunate and stimulate demand for goods, while also addressing the actions of other countries like China that may drive their own currencies lower and hold back U.S. economic growth. If Washington does nothing new, he says, we'll have another three years of what we've got now: weak growth and high unemployment. In other words, stagnation will settle in for a while unless the government intervenes.

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QE2 will flop. With the rest of the government withdrawing from the economic stimulus business, the pressure is on the Federal Reserve to revive the economy almost single-handedly, at least until private hiring doubles or triples. That could force the Fed to overreach, causing excessive inflation or other conditions that harm the economy down the road. Some think the Fed's latest "quantitative easing" program—known as QE2—may already be doing that. The Fed's plan to buy huge amounts of U.S. government securities will force investors around the world to put their money into stocks, commodities, and other types of assets, which could create bubbles that pop when the Fed decides it's time to unwind its holdings. Quantitative easing is also likely to force down the value of the dollar, distorting the currency markets and leading other countries to protect themselves by manipulating their own currencies.

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Protectionism rarely helps during a downturn. "If policymakers can avoid erecting barriers to trade, investment and immigration, then global prospects should brighten," writes Zandi of Moody's Analytics. "If they can't, the fragile global and U.S. economic recoveries will unravel." Fed chairman Ben Bernanke has made no secret of the fact that he'd like to see more fiscal stimulus for the economy, in addition to the Fed's moves. But he's also said the Fed will be aggressive whether it has Congress as a partner or not. A lone gunslinger may be better than no sheriff at all, but it still leaves a lot of dark corners unpatrolled.