Fiscal cliffhanging causes national nervous breakdown

By Josh Boak

Paging Dr. Freud! The fiscal cliff has the country in need of some serious therapy—and maybe a Xanax or two.

Many economists are warning about the possible psychological scars left by the cliff, not the relatively straightforward cash flow issues that Democrats and Republicans must reconcile before the start of next year.

Beneath the debate about potential tax hikes and spending cuts, there lurks fear, paralysis, wild optimism and basic questions of trust. The country already views government leaders with skepticism, a feeling that could become even more pronounced if the fiscal cliff talks fail.

“Much like the finale in some kind of horror movie, you know something big is about to happen and are just waiting to see what,” said Stanford University economics professor Nick Bloom.

The game inside the White House negotiations involves tough budgetary math. But for the investors and consumers without a seat at the table, it is a matter of debilitating suspense. Stocks rally on canned statements by congressional leaders that sound positive. Upper-income Americans spend less in anticipation of higher taxes. It’s open speculated whether film legend George Lucas sold-off the Star Wars franchise to avoid higher taxes—and which other billionaires might follow suit.

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Along with two other economists, Bloom developed the policy uncertainty index to gauge the financial impact of escalating political tensions. The daily index has steadily climbed over the previous three months—dipping only after House Speaker John Boehner, R-Ohio, and other congressional leaders emerged from the White House on Nov. 16 to call the initial discussions with President Obama “constructive.”

The index currently stands at an elevated 180, its increase tracking with alarmist quotes from CEOs about the cliff and a slowdown in business investment. But that reading remains below the critical 230 level reached last year during the debt ceiling negotiations, when the government nearly defaulted and economists actively warned of an oncoming recession.

Surprisingly, Americans care more about federal spreadsheets than scandalous bed sheets. The fiscal cliff has generated more interest than the juicy extramarital affair involving former CIA director and retired Army Gen. David Petraeus, according to a survey by the Pew Research Center for the People & the Press.

As the details of any bargain get sorted out, some of the usual partisan bile will start pumping. Republicans have historically resisted the tax increases being pushed by Democrats, who in turn oppose the dramatic overhaul of entitlement spending that would likely be part of any deal. The celebrating over friendly tones will give way to sharp doubts, which should take stocks on a volatile ride.

“Despite last week’s kumbaya moment, I’m still expecting to see brinksmanship, posturing, statements to keep the base intact, I expect to see some real conflict and the market is not going to like that,” said Jerry Webman, chief economist for Oppenheimer Funds.

Administration and congressional officials are deeply aware about the role played by animal spirits in the economy. Alan Krueger, the president’s top economics adviser, recently voiced his concerns about the breach of public trust if negotiations disappoint.

“What’s to me much more worrisome is the psychological effects of falling off of the cliff in a number of respects,” Krueger told the Economic Club of Washington. “It would mean to many people that the government is not there to solve the problems it was meant to solve.”

The challenge is that these psychological responses approach the limits of data-driven economics. Consumer confidence is at a five-year high of 82.7 according to a University of Michigan index, despite all the understandable carping about uncertainty.

Swarthmore College professor Barry Schwartz recently proposed that Obama create his own “Council of Psychological Advisers.” This group of PhDs would complement the existing council of economists led by Krueger, helping the president to think through how government policies impact behavior.

“The recent financial crisis and its persistent aftermath make it clear that ignoring the real psychology of ‘irrational’ enthusiasm (or pessimism) can be perilous,” Schwartz wrote this month in The Atlantic.  “This is not to say that macroeconomic variables don't matter and that the behavior of the economy is completely driven by the psychology of participants. Of course macroeconomic variables matter. But they are not, and never have been all that matters.”

But a major part of the fiscal cliff is, in fact, the result of a psychological trick by policymakers. When the bipartisan super committee was unable to agree on spending reductions last year, they set into motion the budget sequestration that will slash $109 billion for Defense and domestic expenditures next year.

Because Congress has a short-term incentive to keep splurging, it created a cliff as a mechanism to curtail the growth of a national debt that now tops $16 trillion. Obama and lawmakers were lashing themselves to the mast just like the mythical character Ulyssess did in order to hear the mythical sirens.

“They've basically said, we're going to force ourselves to do the responsible and right thing by setting up a cliff,” Shankar Vedantam, author of “The Hidden Brain,” recently explained on NPR. “And the cliff is so bad, and its consequences are going to be so detrimental, that it's going to force us to get our house in order. So essentially, what the cliff does is it makes the long-term challenge salient in the short-term. It puts a looming catastrophe right in front of us and says, this is going to get everyone's attention to sit down and focus.”

But even if the cliff succeeds in imposing discipline, any deal is unlikely to instantly produce much certainty—one of the most important psychological salves that the government could offer.

“Frankly, I think the markets have this wrong,” said Greg Valliere, chief political strategist for Potomac Research. “A deal around Dec. 21 probably would be an agreement in principle, with a commitment to fill in the blanks during the first quarter.  So there potentially will be another three months of uncertainty in 2013.  So the good news may be that we won’t plunge over the cliff in early January; the bad news may be still more months without clarity.  If you believe, as most economists do, that businesses aren’t spending or hiring because of all the uncertainty, this scenario is no prize.”

In other words, politicians don’t just have the mission of talking the government off the cliff. They also just might need to talk the nation off the ledge.

Josh Boak is a National Correspondent at The Fiscal Times. Subscribe to The Fiscal Times' FREE newsletter.