Budget Impasse: Bad Politics Is Bad Economics

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Source: http://www.flickr.com/photos/kristinausk/

On Friday, the U.S. Senate voted to pass legislation — 54 to 44, strictly along party lines – that would fund the federal government through November 15, including the Affordable Care Act. This last bit comes despite the wholehearted effort of Sen. Ted Cruz (R-Texas), who spoke on the Senate floor for just more than 21 hours from Tuesday  to Wednesday, and other conservative policymakers to defund the ACA. From the outside, the vote looks somewhat like the Senate passing a hot potato back to the House of Representatives, which initially passed a short-term budget that would defund the ACA.

As much as investors would like to put on blast goggles, keep their heads down, and avoid the political trench warfare that is once again coming to dominate Washington, the situation is impossible to ignore. Fiscal policy in the United States defines a massive amount of the backdrop against which investment decisions are made and investors — not to mention the public at large — can’t turn away from, even if they don’t want to look.

Why? If Congress fails to reach a temporary budget measure known as a continuing resolution by October 1, many nonessential parts of the government will shut down indefinitely. This will have a tremendous impact on the U.S. economy and, if prolonged, could bring the struggling recovery to screeching halt.

The amount of damage that a government shutdown would cause the economy depends on its duration. If the lights are out for just a few days, Americans can expect to see just a few basis points shaved off third-quarter gross domestic product growth, and perhaps a few ghostly echoes down the road. A few weeks, though, and the damage to GDP moves from being measured in basis points to full percentage points. Moody’s chief economist Mark Zandi suggests that a three-to four-week shutdown could reduce third-quarter GDP growth by as much as 1.4 percentage points.

This is the kind of catastrophe that people want to see coming. But one of the compounding problems is that simply observing the dysfunction in Washington brews uncertainty, and uncertainty in and of itself has a negative impact on the economy. When businesses can’t predict future conditions, they reduce spending and pause hiring. Households could increase rainy-day savings (what else is political dysfunction if not clouds on the horizon?) and decrease spending themselves.

Consumer confidence, as measured by Gallup, as already tanked over the past few weeks because of the developing fiscal situation.

Gallup Economic Confidence

Drama over the fiscal situation in the U.S. is what caused Standard & Poor’s Ratings Services to first downgrade long-term U.S. sovereign debt in August 2011. At the time, the U.S. was involved in a “prolonged controversy” over the debt ceiling. Just a few months before S&P issued the ratings change, it looked as if the nation was hurtling toward another government shutdown. As usual, budget negotiations soured, with policymakers unable to reach a happy compromise, and bad blood boiled on either side of the aisle.

“The political brinksmanship of recent months highlights what we see as America’s governance and policymaking becoming less stable, less effective, and less predictable than what we previously believed,” wrote S&P Ratings. “The statutory debt ceiling and the threat of default have become political bargaining chips in the debate over fiscal policy.”

Two years later, as the nation once again stares down the threat of a government shutdown, S&P’s comments seem particularly prescient. This week, U.S. equities posted their first weekly decline since August.

S&P 500 Index Chart - Yahoo! Finance

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