The Economic and Financial Implications of the 2012 US Presidential Election

Perceptions Die Hard

The uncertain outcome to the US Presidential election was cited by many commentators as to why corporate risk-taking has remained subdued in 2012. The political landscape is essentially the same as to what prevailed prior to the election. There was a widely-held presumption that a Romney victory would be bullish for equities, while the re-election of President Obama would be supportive for US Treasuries. This perception was based on the wide gulf in the ideologies of the two candidates, arguably the most extreme since 1980.

President Obama was perceived as being in favour of further financial market regulation, greater health care insurance and higher marginal tax rates on the wealthy. Meanwhile, Governor Romney was seen to champion de-regulation of Wall Street, lower marginal tax rates for the wealthy and less comprehensive health care coverage. Risky asset prices during 2012, however, appeared to be agnostic about the outcome of the election. The dynamics that drive risky asset markets will often overwhelm the personal political views of the investors that control the assets. For example, US equity markets in Q3 were principally driven by expectations of further quantitative easing from the Fed, while Q4 has been dominated by greater scrutiny of corporate profit results. Will this change now that the election outcome produced a return to the status quo? Will the fiscal cliff be avoided?

Potential Fiscal Policy Scenarios

Political gridlock prior to the election was synonymous with brinkmanship. Risky assets did not take kindly to the brinkmanship that surrounded the last increase in the debt ceiling in 2011. The economic risks attached to future political brinkmanship are, however, now much higher in the form of the fiscal cliff. There could be important ramifications for financial markets. I have argued that a return to the status quo after the election would produce some fiscal tightening, although nowhere near the order of magnitude of a fully-blown fiscal cliff.

The Congressional Budget Office (CBO) recently published a report outlining the possible economic implications of the fiscal cliff. According to the CBO, the economy would contract in 2013 H1, before staging a recovery in H2. Real GDP would contract -0.5% on a Q4/Q4 basis. Corporate profit expectations would require revision under this scenario. Meanwhile, the unemployment rate would rise to 9.1% from its current 7.9%. If this scenario transpired, the economy’s growth path would, once again, fall back below its potential growth rate. President Obama and Fed Chairman Bernanke clearly wish to avoid this outcome. How would an alternative fiscal scenario impact the economy and financial markets?

The CBO’s alternative fiscal scenario is simple: current policies would be extended for another two years. It concludes that the alternative fiscal scenario would provide meaningful short-term support for the economy, boosting real GDP by 2.25% in 2013. This constitutes a benign economic outcome for financial markets. The key task facing financial markets is to discern just what type of political compromise may be likely in the coming weeks.

Possible Compromise Outcomes for Fiscal Policy

It is doubtful that we will get a full-blown fiscal cliff or alternative scenario outlined by the CBO. Compromise will be required to achieve progress, and it appears that House Republicans are now at least open to the idea of examining new sources of revenue via an overhaul of the tax code. Their opposition to higher marginal tax rates remains, however, embedded. Meanwhile, President Obama appears adamant that higher marginal tax rates on the wealthy will have to be part of any deal on fiscal policy, while extending the lower marginal rates for other income groups.

An obvious starting point for compromise would be to extend emergency unemployment insurance and the 2% cut in payroll taxes. This outcome would boost real GDP by 0.75% in 2013, according to the CBO. Postponing the automatic spending cuts demanded by the Budget Control Act (2011) would produce a similar boost to GDP.

With respect to tax revenues, there are a number of policy permutations: 1) extending current marginal tax rates for 2 years, but not the payroll tax reduction or the indexation of the Alternative Minimum Tax (AMT), and 2) extending current marginal tax rates with the exception of those in the top income bracket, as well as not extending the payroll tax reduction or indexation of the AMT. The first scenario would, according to the CBO, boost real GDP by 1.5% in 2013. Meanwhile, the second scenario would boost the economy by an identical amount.

The economy seems to get a bigger boost under the CBO’s analysis by postponing the spending cuts. The impact of extending the current marginal tax rates in supporting economic activity appears more muted, largely because the CBO assumes that lower marginal tax rates would result in higher saving, as opposed to spending.

Debt Ceiling Negotiations

The issues of raising the debt ceiling and making progress on long-term fiscal sustainability became joined at the hip during the summer of 2011. The standoff on raising the debt ceiling was resolved with the passage of the Budget Control Act which also determined the structure of the spending cuts that are due on January 1. The US will hit its debt ceiling ($16.4 trillion) at the end of 2012. Thereafter, the ability of the federal government to fund operations will depend on the accounting ingenuity of the US Treasury.

The Budget Control Act was a flawed piece of legislation, because it tied long-term deficit reduction to access to government funding. It partly created the fiscal cliff and set the stage for another round of Congressional brinkmanship. The lame duck session of Congress will use the remainder of its tenure to avert a fiscal cliff, but the issue of the debt ceiling will probably be tackled with the arrival of the new Congress in 2013. It will probably be linked, once again, to deficit reduction.

Obama Victory Reduces Political Pressure on the Fed

Governor Romney’s apparent opposition to quantitative easing led many commentators to conclude that, under a Romney Presidency, Fed Chairman Bernanke would potentially have been replaced in 2014. There is no longer this risk: Chairman Bernanke enjoys the trust of President Obama, who, in turn, has respected the independence of the Fed. The feeling is that Chairman Bernanke will be offered another term in 2014. This should be good news for financial markets, since it would signal continuity. There is, however, no guarantee that Chairman Bernanke will accept a third term.

Fed Vice Chairman Janet Yellen would be the natural successor to Chairman Bernanke: she is well-respected in Washington, having worked many years at the Fed, as well as having served as President of the Federal Reserve Bank of San Francisco. Outside contenders to replace Chairman Bernanke include former Fed Governor Donald Kohn and Lawrence Summers (who has also been touted for a return to the Treasury).

In the near-term, the most important implication of President Obama’s re-election for financial markets is to remove all potential political constraints on the Fed invoking a fourth tranche of quantitative easing if required. The Fed will be paying close attention to the conduct of fiscal policy. If there is a risk of fiscal tightening harming the momentum of the economy, then the Fed will potentially alter its asset purchases to invoke offsetting monetary stimulus.

US Protectionism: Less Threatening Under Obama

One of the more sinister policies espoused by Governor Romney during the campaign was his apparent willingness to engage in a trade war with China. This would have produced disastrous consequences for the global economy and financial markets. Imports from China have acted as a safety-valve on US inflation. A trade war would have increased US inflation via higher import prices. Furthermore, there was no guarantee that the trade war would not have spread. The re-election of President Obama significantly reduces the chances of protectionism against China.

There is a perception that Democratic Administrations are more inclined to be protectionist than their Republican counterparts, presumably due their stronger links with labour unions. This perception is, however, misleading: Democratic Administrations are not averse to free trade agreements. The first Obama Administration was keen to explore the possibility of a free trade agreement between the US and the European Union (EU). The implications for both regions would have been huge, particularly in the realm of job creation.

The second Obama Administration may pursue the idea of a US-EU free trade agreement with more vigour. It makes perfect sense for both parties: there would be an immediate boost to economic activity and job creation from more vibrant trade flows. The European Commission is also now calling for the creation of a free trade agreement. It could be a very significant development, particularly if Congress grants President Obama so-called “fast track” negotiating authority. Stay tuned!

Summary and Conclusions

Prior to the Presidential election, US equities were behaving agnostically about the potential winner, choosing instead to focus on other factors. US equities have now, upon conclusion of the election, shifted their attention back to the potential fiscal cliff.

There are numerous future scenarios about the conduct of fiscal policy, but the CBO believes that a full fiscal cliff would result in recession and higher unemployment. An alternative fiscal scenario where the proposed tightening measures are deferred for 2 years would be supportive for growth in 2013.

The task of avoiding the fiscal cliff will require bipartisanship. Various outcomes are possible as negotiations proceed. The CBO estimates that spending cuts have a more direct impact on growth than tax increases. Some form of fiscal tightening is likely in 2013.

The US will reach its debt ceiling limit at the end of 2012, raising the spectre of another round of Congressional brinkmanship. Another increase in the debt ceiling is likely in 2013, but, once again, it will be linked to budget deficit reduction.

The re-election of President Obama reduces future political pressure on the Fed. This should have bullish implications for risky assets. Chairman Bernanke will be offered another term in 2014, but there is no guarantee that he will accept the offer. The current Vice Chairman, Janet Yellen, would be the favourite to succeed the present Chairman.

There is less chance of US protectionism against China under President Obama. Pursuing a free trade agreement with the European Union could well be one of the major policy goals of the next Obama Administration.

About Said Desaque

I'm a professional economist in financial services, with a keen interest in international relations, along with their implications for economic development.

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