In Box

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

In Box

Liar, Liar

Are politicians really less honest than the rest of us?

Is there any profession so disliked and distrusted as "politician"? Only 7 percent of poll respondents give U.S. elected officials "high" or "very high" ratings when it comes to honesty and ethical standards, according to the latest Gallup figures. That's on par with those paragons of dishonesty, car salesmen, and a step below telemarketers. The guys who invented credit-default swaps and bundled your home loan into mortgage-backed securities (you know, the friendly bankers at Lehman Brothers et al.)? They rank almost four times as high on the trustworthy scale.

To be fair, it's not as if politicians haven't earned the reputation -- from Richard Nixon ("I'm not a crook") to George H.W. Bush ("Read my lips") to Bill Clinton ("I did not have sexual relations with that woman") to Anthony Weiner ("That's not my …"). No wonder, then, that in a U.S. election year with two relatively squeaky-clean men running for the White House, it's still fraught with rumors of hidden offshore bank accounts and fake birth certificates. And in a billion-dollar campaign with both sides spending lavishly on ads that accuse the other of dishonest dealings and spreading lies, it's hardly a surprise that we tend to think of elected officials as professional fabricators.

Yet when my colleagues and I conducted a series of experiments, we found that people on Wall Street were more than twice as likely to lie as those on Capitol Hill. Even after the financial crisis, they get a pass. Why? Are we focusing on the wrong bad guys?

Let's be honest. We all lie. We embellish our accomplishments to impress others and sugarcoat our insults to avoid offending them. We tell our wives they've lost weight, we say we're sorry when we're not, and we claim to be avid recyclers. And we lie to strangers, too, often without realizing it. University of Massachusetts psychologist Robert Feldman found that pairs of strangers meeting each other for the first time were much more inclined to lie to the other person than they realized. After reviewing video of their conversations with strangers, 60 percent of participants admitted that they told two to three lies in the first 10 minutes. Now imagine what a professional politician does on the campaign trail, where he might meet thousands of strangers every day.

In a number of experiments I've conducted over the years, I've found in general that very few people take full advantage of the ability to cheat -- mostly we just massage things a bit. We're not awful, immoral people, yet almost all of us want to gain from cheating. We're hard-wired to be competitive, and in experiments that create conditions where there's a presumption that others will fib, people cheat more.

The main culprit is rationalization. Forces that increase our ability to rationalize lying (such as when our peers are doing it, when we think the party we're deceiving is corrupt, or when we think our actions are for a good cause) serve to increase the level of dishonesty that we are comfortable with. But the forces that decrease rationalization (reminders of our moral obligations, realizing the consequences of our actions, and so on) have the reverse effect of decreasing our dishonesty. Funny enough, the fear of getting caught plays almost no role at all.

In other words, a lot of people cheat, at least just a little bit. So why do we expect our politicians to be any different?

Politicians are, by definition, in positions of power. They are elected to represent large groups of people and make important decisions for all these constituents. The problem with power is that it comes with some nasty side effects. When you put people in a position of power, they very quickly assume that position and, whether intentionally or not, start to abuse it. In a 2010 study investigating the moral hypocrisy of the powerful, researchers at Tilburg and Northwestern universities found that when people are assigned to powerful positions, or even if they are merely put in the mindset of having power, they cheat more and think of their own transgressions as less bad. At the same time, they tend to hold their underlings to higher standards.

Another byproduct of being a politician has to do with the fact that politicians make decisions that influence the well-being of others. As such, they're actually more inclined to tell half-truths or even outright lies because they believe it will ultimately serve others. I've examined this sort of "altruistic cheating" and found that while people will cheat a bit to help themselves, they cheat more when someone else also benefits. In fact, as the number of beneficiaries increases, so does the level of cheating. Study participants also experience less guilt when cheating for others, as compared with when they are just cheating for themselves.

Washington itself is undoubtedly part of the problem -- because politicians are social animals, and lying, it turns out, is very much a social disease. When a rookie politician looks around and sees that his peers are behaving dishonestly, he determines that this behavior is acceptable and will be likely to follow suit. Party affiliation may also play a big role. In a study that my colleagues and I ran at Carnegie Mellon University, we planted a fake participant who looked like either a fellow student (wearing Carnegie Mellon attire) or a student from a rival university (wearing a University of Pittsburgh sweatshirt). We then asked the plant to make clear that he was cheating. When the student was wearing the Carnegie Mellon sweatshirt, his behavior signaled to his peers that it was OK to cheat -- and their cheating increased. But when he was wearing the Pittsburgh sweatshirt, his dishonesty made cheating appear less acceptable, and it thus decreased. This applies to politicians as well: When a senator sees her fellow party members lying or misrepresenting the truth, it becomes the moral standard.

With all these forces combined, is it any wonder that politicians are deemed the most untrustworthy characters? Still, the question remains: Do politicians cheat more in their professional lives than the rest of us? Given their position of power, the easy justification that fibbing has an altruistic end, and the prevailing norm of dishonest behavior that is so commonplace in the halls of politics, I suspect that the answer is a resounding "yea."

But there's a wrinkle here that I feel compelled to admit. In that study in which folks on Wall Street cheated twice as much as those on Capitol Hill, we ran the experiment at bars in New York where bankers hang out and similar haunts in Washington. And anyone who has been to a happy hour on Capitol Hill knows these places are packed with bright-eyed, bushy-tailed young congressional staffers. Most probably haven't been on the job long enough to learn to lie yet. So maybe the bankers aren't so much worse after all.

Illustration by Oliver Munday for FP