4 Ways Congress Could Screw Up the Economic Recovery

Speaking before Congress last week, Chairman of the Federal Reserve Ben Bernanke made it clear that the responsibility of ensuring long-term economic growth in the United States was not the job of monetary policy. The tools available to the central bank are appropriately referred to as stimulants: low interest rates and quantitative easing can provide a short-term boost to economic activity, but Bernanke and the FOMC board do not control the long-term economic environment.

That responsibility rests largely with fiscal policy, which is the ward of Congress. As Bernanke put it in his testimony, monetary policy does not have the capacity to offset the economic headwinds created by restrictive fiscal policy. Over the past year, sequestration spending cuts, the effects of the debt ceiling, tax increases, and the expiration of tax cuts has created an economic drag that the Congressional Budget Office expects to slow the rate of economic growth by 1.5 percentage points relative to what it would have been otherwise.

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What this all points to is the fact that the Fed is doing its job: it has opened the monetary fire hose and is pumping liquidity into the market. The problem is that the economy is full of holes and is leaking fuel just about as fast as the Fed can pump it in, and patching those holes is the job of policymakers in Washington.

Let’s take a look at a few ways that Congress could drop the ball.

1) Failing to address damaging inefficiency

The recent IRS scandal and the tax ordeal involving Apple’s (NASDAQ:AAPL) offshore cash has called renewed attention to a problem that many businesses and policymakers have been trying to solve for years: the U.S. tax code is ridiculous. It is ridiculous to the point of being toxic, requiring a tremendous amount of effort and resources simply to maintain, interpret, and enforce.

The cost of running the IRS has come down slightly — the agency was not spared the axe of sequestration — but the amount of funding and staffing required is still enormous. Enacted funding for fiscal year 2012 was $11.8 billion, down from $12.1 billion in fiscal 2011. However, the agency is asking for $12.8 billion for fiscal 2013, an increase of about 8.5 percent.

The recent targeting scandal painted a picture of an IRS rife with institutional inefficiency and even incompetency.  The image of the IRS held by most is that of a poorly managed organization enforcing an archaic and overly-complex tax code. Taken together, America’s tax environment has become a serious drag to economic growth, and if Congress fails to improve it, it will only continue to be an anchor.

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But, as the Daily Show’s Jon Stewart points out in a bit on Apple’s hearing before Congress, change is an uphill battle against special business and political interest.

2) Failing to make decisions

Perhaps the only thing worse than making the incorrect choice is making no choice at all. Political trench warfare and the resulting gridlock in decision making is another reason why complex issues that must be addressed — like the tax code — rarely are. Partisanship and a nightmarish web of bureaucracy and special interest has brought the process of affecting change pretty much to a halt.

The consensus among the American public is that Congress is simply dysfunctional. A recent Gallup poll showed that just 15 percent of Americans approve of the way Congress is doing its job, which is actually up slightly from the preceding period.

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Congress Approval

The sequestration spending cuts are a prime case study of how Congress failed to make decisions. As a result of gridlock, spending cuts that were originally designed to be too damaging to conceivably enact are currently pulling dollars out of the economy and hurting growth. The Congressional Budget Office estimates that current deficit reduction policies will reduce 2013 GDP growth by about 1.5 percentage points relative to what it would have been otherwise.

3) Fostering uncertainty and a perception of incompetence

What is arguably the most damaging impact of complexity and indecision is uncertainty and the perception that America’s leaders are incompetent. In the post-crisis era, many economists have made a study of the effects that uncertainty has on financial markets, consumer confidence, and overall economic growth. While there is disagreement of the effects of uncertainty at the academic level, Main Street and Wall Street certainly seem sensitive to it.

Ahead of the fiscal cliff and the eleventh-hour solution at the beginning of the year, uncertainty about the future tax environment was cited as a primary reason businesses were slowing investment and hiring. Consumers, sensitive to economic conditions, were widely expected to close their wallets and taper holiday spending. At best, uncertainty created a huge amount of noise in the market that distracted from relevant data and clouded decision making. At worst, it caused consumers and businesses to withdraw from the economy and weather the storm.

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The fact that the sequestration spending cuts are now a reality has sorely undermined the credibility of policymakers. Previously, market participants held a modicum of hope that Congress could at least reach last-minute solutions to major problems facing the nation and the economy, but there is now little reason to believe that Congress will act to avoid a ‘worst case’ scenario.

4) Austerity

With all that said, the economic recovery has continued to soldier on despite the onset of the sequestration budget cuts. The downside impact of the cuts have always been expected to grow over time as opposed to land all at once — and policy is slowly easing the future burden of cuts — but the economy has shown some resilience despite a huge decline in government spending.

Still, the effects of austerity are evident. Eric Rosengren, president and CEO of the Federal Reserve Bank of Boston, gave a speech in May exploring the effects of fiscal austerity on monetary policy and the U.S. economic recovery. Broadly speaking, he argued that restrictive fiscal policy tends to reduce inflation and increase unemployment. This creates serious headwinds for the Fed, which holds a dual mandate of maintaining a healthy inflation rate and striving for maximum employment.

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The current economic environment is one where inflation is actually too low, meaning downward pressure from restrictive fiscal policy suggests that the Fed should actually engage in more easing. This is undesirable given the tremendous amount of easing already in place. The same can be said about the unemployment rate, which is still too high. Restrictive fiscal policy puts an upward pressure on unemployment, suggesting that the Fed would need to engage in more easing to counteract the headwind.

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