Think this economy is bad? Wait for 2012.

By Greg Ip - Sunday, October 24, 2010

We're barely two years past the banking crisis, still weathering the mortgage crisis and nervously watching Europe struggle with its sovereign debt crisis. Yet every economic seer has a favorite prediction about what part of the economy the next crisis will come from: Municipal bonds? Hedge funds? Derivatives? The federal debt?

I, for one, have no idea what will cause the next economic disaster. But I do have an idea of when it will begin: 2012.

Yes, an election year. Economic crises have a habit of erupting just when politicians face the voters. The reason is simple: They are born of long-festering problems such as lax lending, excessive deficits or an overvalued currency, and these are precisely the sort of problems that politicians try to ignore, hide or even double down on during campaign season, hoping to delay the reckoning until after the polls close or a new government takes office. Perversely, this only worsens the underlying imbalances, making the mess worse and the cost to the economy -- in lost income and jobs -- much higher.

Election-year prevarication has a storied history in the United States. In the summer of 1971, President Richard Nixon imposed wage and price controls in hopes of suppressing inflation pressure until after the 1972 election. He succeeded, but the result was even worse inflation in 1973 and a deep recession starting that fall.

During the 1988 presidential campaign, Vice President George H.W. Bush and Democratic nominee Michael Dukakis largely ignored the mounting losses in the nation's insolvent thrifts for fear of admitting to taxpayers the price of cleaning them up. The delay allowed the losses and the price tag to grow, and the burden of bad loans hamstrung the economy into the early 1990s.

Go back to 1932 for an even more dramatic example: After defeating Herbert Hoover that year, Franklin D. Roosevelt refused during the four-month transition to say whether he'd support the lame-duck administration's policy for fixing the banks and keeping the dollar linked to gold. Depositors fled banks and investors dumped the dollar, resulting in another wave of bank failures that vastly worsened the Depression.

But perhaps the most poignant example of election-year myopia came in 2008. After agreeing to an ad hoc bailout of Bear Stearns that March, then-Treasury Secretary Henry Paulson knew he needed authority and money to deal with such situations. But he didn't ask Congress for either, reasoning that lawmakers would never approve something so contentious just months from a presidential election. (He was probably right.) So when Lehman Brothers foundered that fall, Paulson, with no orderly way to wind the company down, let it fail.

He then proposed the Troubled Assets Relief Program to deal with the resulting chaos, but the House, gripped by an election-year aversion to bailouts, voted it down. The defeat sent markets into a tailspin. Lawmakers changed their minds and passed the TARP, but the intervening panic worsened the economic pain.

Elections are even more of a trigger for crises in other countries. When Greece's national election campaign began in September 2009, the government claimed that the budget deficit was more than 6 percent of gross domestic product, high but manageable. Yet shortly after the socialist government took power, it revealed that the deficit was in fact closer to 12.5 percent. The previous government, it turned out, had been issuing optimistic forecasts and hiding some of its spending. As foreign investors' confidence in Greece evaporated, interest rates on its debt soared. To avoid default, it was forced to seek a bailout from the International Monetary Fund and the European Union. The Greek economy will probably shrink at least 3 percent both this year and next.

Mexico's financial crises regularly coincide with presidential elections. In early 1982, the government knew that its deficit was too large and that its currency was overvalued. Investors were pulling their money out, draining the nation's foreign currency reserves. Government officials hoped to postpone action until after the July election, and the Federal Reserve helped by making short-term dollar loans to Mexico designed solely to make its reserves appear larger.

"We were trying to buy time until the election and new government. We failed," recalls Ted Truman, a Fed official at the time. Money continued to flee, and a month after the election, Mexico announced it couldn't repay its bank loans, triggering the Latin American debt crisis, a severe recession and what many called the region's "lost decade."

A similar dynamic brought on Mexico's election-year "tequila crisis" of 1994, which forced a massive and sudden devaluation of the peso and required tens of billions of dollars in international assistance.

Even when a government tries to do the right thing, electoral politics make it difficult. During the 1997 Asian financial crisis, South Korea negotiated a $55 billion loan from the International Monetary Fund, the World Bank and others to avoid defaulting on its private bank loans; in return, it promised reforms such as closing weak banks. But confidence evaporated and the currency plunged when the leading opposition candidate in that year's presidential election attacked the agreement.

A similar situation occurred in the election to succeed Brazil's President Fernando Henrique Cardoso, who had brought stability to his country during the 1990s after decades of inflation and default. When it became apparent that his handpicked successor would lose in 2002 to leftist challenger Luiz Inácio Lula da Silva, Brazil's stock markets and currency plunged, and the government lost the ability to issue long-term bonds. Inflation and interest rates shot up, hammering the economy.

These countries actually offer an uplifting lesson: The damage wrought by the crises helped build support for solutions. In Korea in 1997 and Brazil in 2002, populist challengers ultimately embraced their predecessors' reform plans. Greece's socialists campaigned last year promising to raise public salaries, invest in infrastructure and help small businesses. But they are now undertaking painful reforms, such as raising retirement ages and injecting more competition into protected industries such as trucking.

Of course, these countries are relatively young democracies with legacies of economic mismanagement. It couldn't happen here anymore, right? Think again. Yes, this year the United States passed the sweeping Dodd-Frank Act, seeking to make financial crises a thing of the past. But there are countless problems that can develop into disasters (think Foreclosure-Gate). And Dodd-Frank is useless if the next crisis involves our tattered government finances.

Which brings us to 2012.

Let me take a stab at what the next crisis will be. Our deficit, as a share of GDP, is at a peacetime record, and the debt is climbing toward a post-World War II record. Thoughtful economists agree on the response: Combine stimulus for our fragile economy now with a plan to slash the deficit and stabilize the debt when the recovery is more entrenched.

Yet the approaching November midterms have made it impossible to advance a serious proposal for doing that. Congress has been unable to pass a budget, and the government is operating on a short-term "continuing resolution." President Obama's plan for reining in the national debt consists of appointing a bipartisan commission that won't report until after the midterms. Even if the commission can agree on a realistic plan to chop the deficit, the polarized state of Congress suggests slim odds of adoption.

With neither party able to muster the support to get serious about reducing the deficit, both may prefer to kick the problem down the road to after 2012, in hopes that the election hands one of them a clear mandate.

For now, there's enough risk of Japanese-style stagnation and deflation that U.S. interest rates could remain very low for a while yet. But if that risk fades, investors in U.S. Treasury bonds will want to know how we'll get our deficits and debt under control -- and could demand higher interest rates to compensate for the uncertainty. By then, though, the 2012 campaign may be upon us. The Republican nominee will assail Obama's fiscal record and promise a determined assault on the debt. Obama will respond by blaming George W. Bush and promising to unveil his own plan once he's reelected. Neither will commit political suicide by specifying which taxes they'll raise or which entitlements they'll cut.

Will investors trust them, or will they start to worry that the endgame is either inflation or default, two tried-and-true ways other countries have escaped their debts? If it's the latter, we'll face a vicious circle of rising interest rates and budget deficits, squeezing the economy and potentially forcing abrupt and painful austerity measures.

And if, instead, the markets continue to give us the benefit of the doubt, relieving our politicians of the need to act: Circle 2016 on your calendar.