Barack Obama’s Democrats were hammered in the U.S. mid-term elections last night. Candidates were plagued by stubbornly high unemployment and a large fiscal deficit – exploited by a resurgent Republican Party that put the blame squarely at the door of the Democrat-controlled federal government.
Control of the House has swung back to the Republicans (who lost it in 2006) and the Democrats’ Senate majority has been slashed, with Senate Majority Leader Harry Reid only just hanging on. Importantly, many new congressmen and women are so-called ‘real’ conservatives, propelled in by the Tea Party movement. The Tea Partiers are intent on eliminating the Government’s fiscal deficit solely by rolling back state spending – not by raising taxes.
That’s because much of the public dissatisfaction with the Democrats stems from a perception that public debt has blown out of control. For the record, George W. Bush was no fiscal conservative. He borrowed stacks of money to cut taxes and buy lots of planes and tanks. So the U.S. was already at a high starting position when the worst financial and economic crisis in 80 years hit in 2008, just as Obama was set to take office.
The bank bailout, the car bailout, and the record fiscal stimulus package all followed. Now with the crisis receding, growth has only slowly returned – and with few jobs. Republicans have capitalised on this frustration by finding their ‘conservative roots’. They link U.S. economic ills to the size of public borrowing and debt and supposed reckless spending from Democrats, notwithstanding extraordinary economic circumstances.
Of course there is broad agreement even amongst Democrats that public spending needs to be reined back in the U.S. Next year the fiscal deficit is projected to be around $1.1 trillion and though it is projected to slowly fall, this is on the assumption that current laws allowing for the expiry of tax cuts continue - which Republicans oppose. Obama accepts that more needs to be done and has said it is his top priority for 2011.
Reducing the deficit is important because it is not sustainable to finance spending through more and more borrowing. Continued spending beyond means leads markets to doubt the Government’s ability to reduce the deficit without sending the economy back into recession, discouraging private investment and hiring as companies foresee higher future taxes and/or reduced demand.
Many would also put forward a moral argument about reducing the burden on future generations to repay spending of which they will receive little benefit.
But there are many questions about when and how to pull back spending, especially as growth in the U.S. is still weak.
A recent Economist article noted that ‘QE2’, the imminent second round of quantitative easing by the Federal Reserve is unlikely to be as successful as the first round. This is particularly the case if it is accompanied by fiscal contraction. The liquidity of the U.S. financial system is nowhere near as dire as 2008 (meaning QE2 will not deliver as big a bang) and for many cash-flow positive businesses, interest rates are not holding back investment. A lack of demand is.
So if the Republicans press for a reduction in government spending immediately without the private demand to pick up the slack they could prolong the U.S.’s current stagnant growth performance. This is even more of a concern if the U.S. economy deteriorates further and yet more fiscal stimulus, or at least a delay in cuts, is called for.
U.S. growth is what is of most relevance to us here in the UK. A weaker U.S. performance is bad news because lower growth will impact on export demand. Not just demand for our exports but – because of the size of the U.S. – for exports around the world, which in turn has secondary effects on demand coming from our other trading partners. The size of the U.S. also has implications for global economic confidence – which can spill into real effects if investment and spending are affected.
And confidence could well be what actually takes the biggest buffeting. Not so much because of what the Republicans might do but because their opposition to the President’s agenda may cause policy gridlock. Progress on agreeing a deficit reduction plan may grind to a halt and this in turn could lead to uncertainty. And as we all know, markets and investors respond very poorly to uncertainty.