As 'fiscal cliff' looms, stock markets shudder at economic 'uncertainty'

For an election that was largely about the economy, the result this week leaves a lot of economic doubts in its wake.

President Obama scored a clear win, but now has unanswered policy questions piled on the White House doorstep.

First among those is what to do about the “fiscal cliff” of scheduled tax increases and federal spending cuts. Unless the president and a politically divided Congress take action, the economy drives over that cliff on Jan. 1.

That may explain, in large measure, why US stock indexes fell sharply on the morning after the vote. The Dow Jones Industrial Average slumped more than 2 percent in early trading Wednesday.

“The re-election of President Obama removes one uncertainty” for investors, economists Paul Ashworth and Paul Dales of Capital Economics wrote in a Wednesday analysis. “But they are none the wiser about if, how and when Congress will deal with the colossal tightening in fiscal policy scheduled to occur early next year.”

The tax hikes and spending cuts would dampen consumer spending (by households and by the government), threatening a new recession. Forecasters widely expect some bargain designed to change the cliff into more of a gradual slope.

But how such a deal will shape up, in the current partisan climate, remains unclear. Will Mr. Obama seek to hold firm on his view that an extension of Bush-era tax rates should exclude the rich? Will resistance to tax hikes within the Republican-controlled House stymie efforts to strike a “grand bargain” that mitigates the cliff in the near term while also reducing long-term deficits?

The analysts at Capital Economics in Toronto predict that Obama “will struggle to garner bipartisan support for a more comprehensive agreement [on] how to put the nation’s finances back on a sustainable path.”

Obama used his victory speech, delivered in the wee hours of Wednesday morning, to focus above the partisan fray – on things that unite Americans rather than divide them.

With the cliff just weeks away, however, bargaining on the issue is moving immediately into high gear.

Senate majority leader Harry Reid (D) said Wednesday that any solution should include higher taxes on "the richest of the rich," but also that he’s “not for kicking the can down the road" into next year.

Delaying the issue until next year could be hazardous to an economy that’s already fragile, growing at an annualized pace of 2 percent or perhaps a bit less. Current forecasts, which assume some resolution of the "cliff" problem, call for similar tepid growth in 2013.

Wednesday’s stock market weakness was also fueled by reminders that the economic clouds aren’t limited to the US. Traders were also listening as European Central Bank President Mario Draghi spoke of economic weakness in the wider euro zone.

Back in the US, investors are also weighing what Obama’s win will mean for other economic issues, ranging from energy policy to restructuring the corporate tax code. Obama has called for tax reform, but has sketched a different vision from that of House Republicans.

And in the run-up to Tuesday’s vote, Obama voiced support for expanded development of domestic energy sources, but it’s not clear if energy policies will change substantially in a second term.

Where the election does provide some new certainty is on health care and banking regulation. Obama’s Affordable Care Act and Dodd-Frank financial rules now appear set to be implemented, whereas Romney had pledged to seek repeal of those measures.

On monetary policy, too, Obama’s victory may also be a win for “status quo.” Romney had pledged to replace Federal Reserve Chairman Ben Bernanke. Although it’s not clear whether Obama will reappoint the chairman in 2014, investors now aren’t expecting a significant shift in Fed policy.

Markets were spared one major form of uncertainty: doubts about the election outcome itself. Despite a close-fought race and some concerns about voting-machine irregularities, the overall outcome Tuesday was clear. No season of recounts or court review awaits.

The fiscal cliff, coupled with the need for Congress to revisit its “debt limit” on Treasury borrowing, would have made the coming weeks a period of high uncertainty no matter who won.

Longer term, some economists say that the most important task for Washington policymakers may be to improve the very institutions – from elections to public schools – that undergird economic growth.

That’s the view of Daron Acemoglu, a Massachusetts Institute of Technology professor who has studied how countries prosper or decay. In a book this year written with James Robinson of Harvard University, he argues that nations prosper by nurturing inclusive institutions, which in turn spread economic opportunity and lay the foundation for innovation.

In a recent e-mail interview, Mr. Acemoglu cited several trends that raise worries about the future vibrancy of the US economy. Those include rising income inequality, lagging school performance, and a rising role of money and lobbyists in politics.

The good news, he says, is that “US institutions have shown great flexibility … in the face of similar challenges in the past.” But he argues that, with these issues posing a challenge for Republicans and Democrats alike, there is little room for complacency.