The Economic Damage of Political Instability in the United States

There is a significant amount of literature that discusses the impact on inequality on economic growth and political stability. One logical hypothesis is that inequality impact economic growth through political instability. Political instability in its extreme form is open conflict between the government and its population. This form of political instability is all too common in Latin America. Developed nations are more likely to experience sub-optimal fiscal policy and government regulation as a less threatening, but still damaging, form of political instability. The United States is a good example of how the second form of political instability can hamper economic growth.

The current levels of inequality is the United States created a less stable economy that has struggled to recover from a debt driven financial crisis in 2008. Fed Governor Sarah Bloom Raskin gave a speech at the 22nd Annual Hyman P. Minsky Conference on the State of the U.S. and World Economies in April that strikes at the heart of how inequality has weakened the economy. Member of the middle class and below had the majority of their wealth tied up in home equity that was destroyed by the collapse of the housing bubble. The past five years has been a painful period of deleveraging (see chart) as many families were stuck with unrealistic mortgages as a result of irrational exuberance in the housing market. Families most damaged by the housing collapse were also the ones most vulnerable to the increase in unemployment. The wealthiest members of society have fared well since the financial crisis while others are still struggling to regain financial stability.

The result of the dramatic disparities in economic circumstances for the different income classes since 2008 has lead to a disturbing increase in political polarization. Below is the Political Polarization Index developed in a study by Marina Azzimonti at the Philadelphia Fed. Polarization has been trending sharply upward since 2008 and reach its highest level at any point from 1981-present during the 2012 election. To a large degree, the political polarization of the country has been driven by inequality and the result of the 2008 financial crisis. Republicans are sternly on the side of low taxes and reduced welfare benefits, which is supported by many extremely wealthy donors and social conservatives. Democrats have been advocating increased taxation of the rich and financial relief for those hit hardest by the financial crisis. The two sides of the wealth spectrum have been placed on opposite ends of the wealth spectrum, and the result has been a contentious partisan environment.

The polarized political environment has done far more than slow down the legislative branch and inspire hateful debates in the last election cycle. It has created sub-optimal policy initiatives that are actively harming economic growth in both the short and long-term. Political polarization has created instability in the legislative process that has damaged fiscal policy in the U.S. Sequestration was intended as a bitter pill to end debt ceiling squabbles that Republicans have been all too eager to swallow. In reality, Sequestration is a temporary band-aid that serves very little purpose in the long-term debt ceiling or budget battles but causes very real damage to portion of society that have been hurt the most by the financial crisis. Long-term unemployment is still a pressing issue for legislators who are barely able to keep the government operational. The future growth path of the economy gets bleaker every day as long-term unemployment remains an issue that politicians are content to stash on their shelves until it becomes politically useful during 2014 or 2016.

Political instability even shares part of the blame for the botched implementation of Obamacare. The Obama administration has been forced to expand the scope of the federal exchange due to state-level intransigence and even the development of the project was damaged by party politics. The administration felt the need to be secretive and insular during the development of the federal exchange because of constant attacks from the right. Now the country gets to wait with bated breath for another doomsday deadline to see if the exchange can be fixed in time to avoid extensive damage to insurance markets. Politics is not an excuse for the mismanagement of the launch, but it is still a reality of the situation.

There is a long strand of literature in academic economic journals discussing the theory of how economic growth might be damaged by inequality and political instability. Lucky for us, we get to see the dirty details of it firsthand.

The Continuation of the Government Shutdown Could be a Reason for Optimism

The current impasse in the US government has become more convoluted with each passing hour. Reports continue to surface about the shocking level of intransigence in the right wing of the Republican party and its willingness to breach the debt ceiling. However, throughout the process, the battle over the debt ceiling and the battle over the government shutdown have been kept separate. The separation of the two situations is very important and it is even a reason for optimism. It is widely agreed that the government shutdown is a troubling situation but it is one that can be survived. "Essential" functions of the government are kept open with only a limited portion of the population bearing a heavy burden during the shutdown. It is also widely agreed that the debt ceiling would be a catastrophic scenario that should be avoided at all costs. The actual fallout from a debt ceiling breach is up for debate but the potential scenarios are not something to be chanced. Each scenario represents a different level of bargaining leverage and political exposure for the GOP. The government shutdown is a bargaining chip that is not difficult for many Republicans (and their voters) to accept. The government shutdown is acceptable because it fits within the party's demand for smaller government and it provides a forum to advocate for greater power at the state level. On the other hand, the debt ceiling is a poor bargaining chip because it impacts the government as a whole and provides no ancillary political benefits. A question has been posed by many and Ross Douthat's tweet is a good example:

If this really isn't going to be settled until the debt ceiling deadline, can't we just get a 2-week CR till then?
— Ross Douthat (@DouthatNYT) October 2, 2013

The issue is that passing a two week CR right now is not something that Democrats are willing to do. A two week CR only serves as a way to delay the current shutdown. The only option right now is to sign the clean CR that Democrats have been proposing from the start. However, the only way such a clean CR will get passed is if the GOP is willing to go all in on the debt ceiling. An all in move to the debt ceiling would be a signal that the reports about Republicans are true. The removal of the government shutdown as a bargaining chip for the Republicans would signal that they view a breach of the debt ceiling as a real possibility. If Republicans anticipate a resolution to the debt ceiling standoff (which I believe they do), then the only way to avoid a total defeat is to move forward with the government shutdown. The party leadership anticipates that the debt ceiling will be resolved before the government shutdown, and that is a reason for optimism on the debt ceiling front. The continued government shutdown is a sad reality for the United States but it is a positive signal that the macroeconomy is not the hostage in this negotiation.

Why the GOP Kamikaze Strategy Won't Work for Democrats

A few days ago Joseph Weisenthal tweeted that the Democrats need a Ted Cruz of their own:

Dems need their own Ted Cruz. Someone to say: No deal unless it includes a debt ceiling hike and a return to pre-sequester spending.

— Joseph Weisenthal (@TheStalwart) October 2, 2013

This idea was simultaneous appealing and repulsive to imagine as an established part of the American legislative system but there is an important reason why the tactics currently being employed by the GOP would not work for Democrats.

The problem is that there is legitimate uncertainty about the willingness to default on the part of a coalition within the GOP. It is generally believed that the majority of the elected officials on the right are not brazen or stupid enough to force a default of the US government. However, the expected probability of such an event is uncomfortably high due to a growing track record of extremist rhetoric and actions. The existence of this asymmetric information is the source of power being exploited by House leaders.

If the current situation were mapped as a game tree, last year's dabble with the debt ceiling set us down a previously ignored path because the expected payoffs to both political parties was assumed to be negative. However, now there is the creeping doubt that some House Republicans mistakenly believe that there is a positive expected payoff waiting for them at the end of the road.

The same strategy would not be credible if threatened by a coalition within the Democratic party for a number of reasons. For one, the Democratic party has exhibited more effective control of its members in recent history and the growth of such a faction within the party structure would likely be powerless. One motivation of rogue GOP members is the idea that they have nothing to lose from staking out this position. Voter groups adversely affected by the tactic of a government shutdown are can ignored for some Republicans. However, Democrats have built their party image around duty and fidelity to the suffering individual which makes a kamikaze threat by the party ineffective.

More importantly, at the core of the Democratic party, there is a feeling of something almost akin to manifest destiny. The history of the 20th and early 21st century has been a steady (and seemingly unstoppable) movement of progressiveness and liberalism. In the last two decades, America has become more liberal economically and socially. Time has been symbolic ally of liberals and conservatives feel the pressure. Ross Douthat wrote an excellent column about why the right is fighting this battle over Obamacare and the debt ceiling that touches upon the pressures of history. The Democratic party doesn't have a feeling of exasperation that has swelled over the previous decades to embolden them to take extreme measures.

Without the pressure of history and endogenous movements within the Democratic party toward a fervent ideology, there is no asymmetry regarding the intentions of Democrats. Such threats would sound like hollow, desperate attempts to fight fire with fire.