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Why Bad Politics = Even Worse Markets

Want to fix the economy? Stop the partisan brinkmanship.

Like an earthquake rocking a house, the 2008 global financial crisis exposed a shaky new foundation underpinning Western economies. Just look at Europe, where cascading debt crises have made paupers of once-proud countries, where long-term joblessness and high youth unemployment have dulled the hopes of both recent university graduates and those nearing retirement, and where unusually wide income inequality has heaped social unrest atop financial turmoil.

This is part of what my colleagues at Pimco and I labeled a few years ago as "The New Normal." But something has changed as this crisis has continued. The systemic instability we saw then has continued to morph, fast and furious: The vicious feedback loops that turned bad economics into bad politics now convert bad politics into even worse economics, further threatening an already tenuous economic future.

Not so long ago, we used to think only of developing countries -- in Africa, Asia, the Middle East, and Latin America -- as the places where severe economic dissatisfaction fuels populist movements that sweep aside governments and sometimes even overthrow long-established ruling elites. Those were the old days. An increasing number of Western countries are now also in the grip of a similar dynamic. And the longer politicians and policymakers lag the realities on the ground, the greater the likelihood that markets will add to growing global insecurity. Indeed, for the first time in a very long while, our children's generation may be worse off than ours -- economically, financially, politically, even socially. Welcome to The New New Normal.

Even the United States is not immune from this disturbing phenomenon. The country is now in the midst of a bitterly contested national election, and for the last few years political bickering and brinkmanship have replaced virtually all efforts at the bipartisan compromise that is central to America's well-being.

The degree of political polarization has been so extreme as to undermine normal governance. Passing an annual budget should be a routine task; these days, it's a high-wire political drama, where politicians seem more likely to turn off the lights in Washington and walk away than to negotiate, much less compromise. And the partisan games can get out of control, as illustrated by last year's debt-ceiling debacle, which threatened a U.S. default and pushed Standard & Poor's to downgrade America's sacred AAA sovereign credit rating. Already, the upcoming fight over the $607 billion "fiscal cliff" of automatic spending cuts and tax increases set to go into effect next year -- a potentially devastating hit to an already sluggish economy -- is starting to roil markets, and rightly so.

Behind this disturbing new political reality in advanced countries is a common cause: the government's inability to deal with the aftermath of a huge wave of excessive debt creation and credit entitlement gone crazy. With economic growth stagnating and joblessness remaining way too high, this shortfall has now exposed troubling gaps in politics and social policies. But where politicians and public-sector institutions act ponderously, markets don't. They move at much faster speeds, anticipating uncertainty and amplifying it.

So as The New Normal morphs into The New New Normal, the economic and financial system risks breakages that the political system will be increasingly incapable of mending rapidly enough. The result: more political dysfunction and greater sluggishness in economic growth, unacceptably high youth unemployment and long-term joblessness, redoubled debt and deficit concerns, and worsening inequalities between rich and poor. (If you want to get a sense of how disruptive this could get in the United States if we're not careful, just look at the turmoil in Europe, where the region's historical integration project is at risk in ways that not so long ago would have been unthinkable.)

The markets understand these dynamics well, even as they contribute to it. Companies and investors in Europe and the United States have become much more risk-averse over the past few years. In record numbers, they are refraining from long-term investment activities, preferring instead to hoard cash in large quantities, despite what are historically very low, even negative nominal interest rates. The more this happens, the greater the withdrawal of the oxygen that is central to the vitality of market-based economies. And as the economy suffocates, a dysfunctional political sphere, instead of breathing life back into the system, seems content to apportion blame, aggravating a massively unstable economic picture.

No wonder it has become so hard to point to Western countries that have found consensus on the roots of their malaise, let alone come together to undertake the multiyear efforts needed to put their economies back on track. Already, almost half of the eurozone countries have kicked their governments out of office. Traditional political parties and ruling elites are increasingly discredited. Fringe parties are sprouting right and left, eager to dismantle the past but with little agenda for the future.

Will U.S. President Barack Obama be one of the last political leaders left standing when the dust settles in November? With Republican candidate Mitt Romney still struggling to unite his party, let alone capture the country's imagination, this may well happen. But there's no guarantee that either man has the ability to get at the root of the problem or even understand the severity of the crisis.

The stakes could hardly be much higher, particularly for Europe. While government leaders endlessly schedule meetings in Brussels, investors and companies are exiting the eurozone in ever larger numbers. If things get worse on the continent, few countries anywhere will escape without collateral damage. Ultimately, their ability to bounce back will be determined by how the world's largest single economy, the United States, navigates the aftermath of its own election cycle.

Sadly, neither Obama nor Romney has yet offered a meaningful, forward-looking economic reform program to address problems such as a malfunctioning labor market, unsustainable public finances, a broken credit system, inadequate infrastructure, and a lagging education system. The risk for the United States, as well as the global economy, is that a lack of vision and political courage ends up leading to even greater economic disappointment and financial instability, bringing with it the social unrest we've seen in so many other countries over the past 18 months. Occupy Wall Street and the Tea Party may have somewhat fizzled, but populist anger could return with a vengeance.

The longer America's interlocking economic and political challenges persist, the greater the number of companies and long-term investors that begin to worry -- and, more importantly, act on those fears. They hire fewer people and invest less in factories and equipment. As they increasingly sit on the sidelines, the country's fate will be left in the hands of tactical position players and short-term traders, further ramping up volatility and reducing future growth and job opportunities. And when day traders and company flippers start running a country's economy, watch out.

The warning bells are ringing, and they are ringing loudly. We've already allowed bad economics to lead to bad politics. Now, it's high time to put a stop to the cycle where bad politics undermines an already fragile economy.

Oli Scarff/GettyImages

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