The Exchange

How the Obama Scandals Could Hurt Financial Markets

It’s not exactly a Watergate moment (not yet, anyway), but the mounting controversies engulfing President Obama may mark the most difficult patch of his presidency to date. And they could eventually undermine the economy while rattling financial markets as well.

Obama faces a trio of political problems that seem to be cresting at roughly the same time. The squabbling over last year’s attacks in Benghazi, Libya—and the conflicting ways Obama and his deputies characterized them afterward—seems to be intensifying rather than petering out, as new information becomes available. Then there’s the IRS, which recently acknowledged targeting conservative political groups for aggressive enforcement of tax laws, while failing to disclose what it was up to.

The Justice Dept., meanwhile, still hasn’t explained why it secretly accessed the phone records of Associated Press journalists last year, in what appears to have been a heavy-handed effort to spy on reporters writing about U.S. counterterrorism efforts in Yemen.

None of those matters directly affects the economy. But they are changing the balance of political power in Washington, where Congress and the White House still have several major economic issues on the agenda. “Reaching agreements on raising the debt ceiling, the budget, and tax reform have become more difficult now that three political scandals are brewing,” financial firm Keefe, Bruyette & Woods wrote in a recent analysis. “Scandals that undercut a president's popularity … make negotiations more complicated.”

[Related: WSJ: Controversies Threaten President's Agenda]

Obama was in a strong position after winning re-election last November, allowing him to push through tax increases on the wealthy—an idea toxic to Republicans—as part of the “fiscal cliff” resolution at the start of the year. But Obama’s pull has eroded since then, evident in his inability to stop the spending cuts known as the “sequester” from going into effect March 1. At the same time, Obama’s approval rating has drifted down from around 53 percent at the start of the year to about 48 percent, according to RealClearPolitics.

Those ratings will probably dip further as the latest scandals drag on, directly affecting Obama’s ability to push through his agenda. Congressional Republicans who felt chastened after Obama’s decisive victory last year suddenly seem more emboldened, while Democrats may distance themselves from Obama if he starts to appear more vulnerable than usual. Relations between the two parties are fragile at best, with the slightest nudge liable to fracture them.

Washington also has a way of becoming distracted by scandal and allowing important legislative matters to languish. Politico reported recently that roughly one-third of the committees in the House of Representatives were busy investigating various aspects of the Obama administration rather than purusing more ecumenical matters of national importance.

Washington has arguably hurt the economy more than it has helped this year, since new tax hikes and spending cuts are likely to cut GDP growth by half a percentage point or more in 2013. So it might be tempting to conclude that bickering in Washington won’t affect the real economy any more than it already has.

But that’s a risky conclusion, because several looming policy decisions could have an outsized effect on investor behavior, consumer confidence and corporate decision-making—especially if Republicans and Democrats go to the mat as they have in the past. The first one on the agenda is the extension of the government’s borrowing limit, which will be necessary by late summer or early fall in order for Washington to continue functioning as normal (or what passes for normal inside the Beltway). If Republicans decide to force a showdown over the debt ceiling, as they did in 2011, it could easily puncture markets that have been remarkably buoyant so far this year. “Difficult negotiations exasperated by political scandals could roil the markets when the debt ceiling is ultimately reached,” KBW warns. The 2011 debt-ceiling standoff, for those with short memories, sent stocks into a nose-dive it took seven months to fully recover from.

The other two big priorities—tax reform, and further efforts to balance the federal budget—can be put off for a while and don’t even need to happen while Obama is president. But both of those issues could amount to a powerful and inexpensive stimulus program if done right, which is why there ought to be a strong incentive to take them on. Any worthwhile effort, however, will require compromises on all sides, which are unlikely if one party feels they’re in a strong position that doesn’t require them to give anything up.

A considerable amount of gridlock is inevitable when power in Washington is split between the two political parties, as it is now. So maybe the odds of Obama accomplishing much during his second term were always slim. Still, most Americans ought to look forward to the day when scandals generated in Washington stay in Washington.

Rick Newman’s latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.

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