Debt negotiations: How Congress is already dragging down the economy.

Commentary about business and finance.
July 21 2011 5:33 PM

Default Position

How Congress' dithering on the debt ceiling is already dragging down the economy.

Illustration by Robert Neubecker. Click image to expand.

In 12 days, the Treasury Department will "exhaust its borrowing authority," which means it will not be able to spend more than it takes in. The government will lose the ability to pay about half of its bills—sorry, troops, doctors, and/or seniors!—and the monthly GDP could drop by 10 percent. Yet Congress continues to dither on lifting the debt ceiling, though both sides agree that they have to. As this characteristically droll Economist headline puts it: "Biggest unforced error in history still on schedule."

Yes, the stock market is up, and bond yields are low. And the government's borrowing costs remain cheap: Interest on a 10-year Treasury bond is less than 3 percent. But a closer look shows that Congress is starting to spook investors, business owners, and individuals. It has introduced a modicum of much-dreaded uncertainty into their lives. And when investors are uncertain and businesses are afraid, they hunker down in ways that are very bad for the economy. So Congress may not have succeeded in blowing up the markets just yet. But fear not. There are signs it is weakening the anemic recovery.

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To be fair, Congress doesn't have to do much (literally and figuratively) to make economic conditions worse. If, upon hearing the news from Washington, consumers feel more pessimistic and decide to save rather than spend, that hurts the recovery. If bond investors decide to hang on to cash rather than buying corporate debt until this all blows over, that hurts the recovery. If contractors hold off on hiring workers until they are certain they are going to get their check from Washington, it hurts the recovery. And there is evidence that all of those things are starting to happen.

This Northern Virginia consulting firm, for instance, has recommended that companies "collect any fees owed your company by the government as soon as contractually possible, just in case" and "anticipate delayed program starts (for the limited number of new programs), and delayed acquisitions for upcoming solicitations." If the Federal Reserve is doing contingency planning for a potential default, shouldn't you be too?

Wall Street is also preparing for the possibility that the government might miss its deadline. According to a New York Timesstory, investment banks and boutique firms alike are looking for ways to reduce exposure to a possible default—and even to make money off of it. For example, at Wells Fargo "executives said they had been keeping close tabs on the bond market and making sure they had ample cash on hand." The Times report adds: "[E]ven if a deal is reached in Washington, some in the industry fear that the dickering has already harmed the country's market credibility."

Hedge funds and venture capital firms—major investors in new and growing businesses—have also changed their ways, just in case. George Soros' $25.5 billion Quantum Endowment Fund has pulled back trading and is now holding a whopping 75 percent of its assets in cash—just hanging onto them, not investing them, not using them to help the economy grow. Why? In part the debt crisis in Europe, in part China's tamping down on inflation, and in part the "debate over the U.S. debt ceiling," Bloomberg reports. Many other money managers, like the giant asset manager BlackRock, are doing the same.

The almighty American consumer has also started getting worried, according to a Goldman Sachs note this week. Goldman attributes the recent hit to consumer confidence to a few things, including high unemployment and the failure of the recovery to pick up steam. But it says that all the news reports coming from Capitol Hill about the world's biggest economy teetering on the verge of an unnecessary default are starting to have an impact too.

"A sharp drop in measures of consumer confidence in recent weeks coincides with a surge in news coverage on the debt ceiling," the company notes. "A model incorporating lags of the unemployment rate, the year-over-year change in the unemployment rate, real average hourly earnings, the S&P 500 index, home prices, and consumer lending standards … explains only about half of the recent drop," it says, suggesting worry over the debt ceiling makes up much of the rest. "Confidence in government economic policies" has fallen to the lowest level in 50 years.

How is that lack of confidence playing out among individuals? Well, there we delve into the realm of anecdata. But in the past few weeks, I have heard a number of stories about people changing their ways in case the markets blow up. One guy is closing on his house faster to lock in current interest rates. (In that way, what Congress is doing might be stimulative.) Another said he wanted to move his money into German bonds. Maybe they are outliers. But maybe not.

In short, the government has already managed to spook consumers, investors, and contractors, sapping confidence and an appetite for risk from an already ailing economy. Granted, the effect should be temporary. As soon as Congress approves a raise in the debt ceiling, everyone should breathe a sigh of relief and get back to business. But, as noted in the Times, some investors may feel that Washington has damaged its market credibility, possibly raising its borrowing costs. That ill effect of this nonsense might be permanent.

Annie Lowrey is a contributing editor for New York magazine. She can be reached at annie.lowrey@gmail.com.

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