Looming Political Fights Over Spending, Debt Limit Threaten Economy

Tuesday, 01 Jan 2013 11:00 AM

 

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Even if U.S. lawmakers prevent the worst of the so-called fiscal cliff, the brinksmanship in Washington over taxes and spending is likely to continue damaging the fragile economy well into 2013.

A months-long political standoff over fiscal policy has already taken its toll, adding uncertainty that has discouraged consumers from spending and businesses from hiring and investing.

The squabbling seems sure to persist even if the House of Representatives goes along with a partial fix passed by the Senate in the early hours of Jan. 1. Under that plan, taxes will rise on individual incomes over $400,000 and household incomes over $450,000 and on the portion of estates that exceeds $5 million. The House is expected to vote Tuesday or Wednesday.

Editor's Note: How to Pay Zero Taxes . . . Legally

But lawmakers appear to have postponed tough decisions on government spending, giving themselves a reprieve from cuts that were scheduled to begin taking effect automatically Jan. 1. That just sets the stage for more hard-bargaining later.

And another standoff is likely to arrive as early as February when Congress will need to raise the $16.4 trillion federal borrowing limit so the government can keep paying its bills. House Republicans probably won't agree to raise the debt limit without offsetting spending cuts that Democrats are sure to resist.

"Even if they cut some small deal, the process and what is left undone still means there's a lot of uncertainty," says Stuart Hoffman, chief economist at PNC Financial Services Group.

After Jan. 1, asks Ethan Harris, co-head of global economics at Bank of America Merrill Lynch, "what induces the two sides to stop fighting and start compromising? ... We're kind of in the first act of a three-act play," Harris says. "One of the key messages from the cliff is that this stuff just doesn't get resolved quickly."

The fiscal cliff itself was created to force Democrats and Republicans to compromise.

To end a 2011 standoff over raising the federal debt limit, they agreed to a Jan. 1, 2013 deadline to reach a deal over taxes and spending. If they didn't, more than $500 billion in 2013 tax increases would begin to take effect, along with $109 billion in cuts from the military and domestic spending programs. The sharp tax hikes and spending cut would threaten to send the economy over the cliff and back into recession.

But negotiations to avert catastrophe have highlighted once again how far apart the two parties are on taxes (Republicans don't want to raise them) and spending (Democrats are reluctant to cut government programs).

"We're learning about how deep the impasse is," Harris says. "Both sides have decided that they were willing to go to the last minute."

Political gridlock has been rattling financial markets and shaking consumer and business confidence the past two years.

After a fight over raising the debt limit last year, the credit rating agency Standard & Poor's yanked the U.S. government's blue-chip AAA bond rating because it feared that America's dysfunctional political system couldn't deliver a credible plan to reduce the federal government's debt. S&P cited an overabundance of "political brinksmanship" and warned that "the differences between political parties have proven to be extraordinarily difficult to bridge."

The Dow Jones Industrial Average dropped 635 points in panicked selling the first day of trading after the S&P announcement.

Harris contrasted the latest budget brawls with previous budget agreements in the 1980s and 1990s. Those deals generally included deficit cuts that were spread out over time and were sometimes bipartisan.

That's better for business and consumer confidence than the repeated partisan standoffs and threats of sudden tax hikes and spending cuts that Congress now engages in.

"The process matters almost as much as what they actually do," Harris says.

Outside Washington, the economy has been getting some good news. Europe's financial crisis appears to have eased, reducing the threat of a renewed financial crisis. And the U.S. real estate market finally appears to be recovering from the housing bust.

But the old worries have been replaced by new ones about political gridlock, says Joseph LaVorgna, an economist at Deutsche Bank.

The partisan divide has left businesses and consumers wondering what's going to happen to their taxes and to federal contracts.

Companies have plenty of cash. But they reduced spending on industrial equipment, computers and software from July to September, the first quarterly drop since mid-2009 when the economy was still in recession. And hiring has been stuck at a modest level of about 150,000 new jobs per month this year.

"What we see is fear," says Darin Harris, chief operating for Primrose Schools, an Atlanta company with 250 franchised preschools in 17 states. He says franchise owners have been reluctant to invest in a second or third school until they know what tax rates are going to be and where government spending is headed. "All those things make our small business owners reluctant to reinvest."

Consumer confidence fell in December for the second straight month, according to a survey by the Conference Board, which blamed the drop on worries about the fiscal cliff. The uncertainty is also believed to have dinged holiday shopping, which grew at the slowest pace this year since 2008.

"Every kind of brinksmanship moment is a reminder to people to not trust the economy," Harris says.

Editor's Note: How to Pay Zero Taxes . . . Legally

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