Some entertaining observations from BofA's Ethan Harris, who describes in detail why there are 500 billion reasons why gridlock would cripple the economy, and asks whether Obama is (or should be) more like Clinton or Bush in dealing with the approaching deadlines that will result in the first openly negative GDP print as soon as Q3 (good luck justifying thoat 10% EPS growth when the economy is about to decline). And just to confirm how bad it is, Jan Hatzius chimes in to explain why the economy will face a nearly 2% point headwind from inventory liquidation and negative fiscal catch up (think Cash For Clunkers gone viral) nearly every quarter in the coming year.
Gridlock is not Goldilocks
With the election looming and huge decisions facing President Obama and the Congress, clearly politics will play a big role in the economic outlook. Republicans are likely to take over the House, while Democrats are likely to retain the Senate. The Iowa electronic market puts the probability of a Republican victory in the House at 74%, but only at 20% in the Senate. Some analysts argue that split government and gridlock in Washington is good for growth: it prevents the government from interfering further in the private sector. Others argue that a Republican victory is good because it means more business-friendly policies. The reality is a bit more complicated.
In the short term gridlock is very bad for the economy. If Democrats and Republicans can’t reach a compromise, there will be a major tax shock at the start of next year. Gridlock also means awkwardly drafted regulatory legislation adopted in the past two years will move forward without retroactive refitting.
Thus, in our view, the key to the economic outlook is not who wins, but whether the two parties can work together. Congressional Republicans will have to decide whether to block legislation with even small flaws or work to reach agreements. Presumably, a strong election result will make them less inclined to compromise.
We believe that the pressure to compromise will be greatest for President Obama. Both the Congress and the President Obama face declining popularity ratings (Chart 8), but rightly or wrongly the President is held accountable for the economy. As Table 2 shows, economic issues dominate all others. We’ve recalculated some economic models of elections and they suggest Obama will lose unless the economy gets several strong growth quarters in the run-up to the election (we will write more on this later).
From a Machiavellian perspective, President Obama has several choices about how to prepare for the next election. Should he be like Bill Clinton: moving to the center to attract independent voters and aid his re-election? Should he “triangulate” and adopt some of the Republican views? Hopefully this would reduce business uncertainty, spurring corporate hiring and investment. Or will he mimic George W. Bush, taking a more partisan approach to energize his base. A third option would be to “fake right, go left:” that is adopting business-friendly policies for the next year and a half, stimulating the economy, and then revert to the left, with populist rhetoric in front of the election.
Triangulation or strangulation?
On the margin, we think the Clinton scenario is more likely. If we advised the President, we would tell him that the unemployment rate will trump all other factors in the Presidential election and the way to get the unemployment rate down is to tack to the center, extend all the tax cuts and reduce regulatory uncertainty. That still leaves the option to shift back to the left in the months leading up to the election and energize his base. However, first things first: no amount of populist policy can overcome a bad economy. [oops]
So what should investors watch for? We do not expect any sign of compromise before the election. After the election, we think the Obama Administration would be more likely to move first than either party in Congress. Any hints that they are amenable to either a temporary extension of upper income rates or of raising the threshold for tax increases (say, from $250,000 to $500,000) would be a hopeful sign of compromise. A bad sign would be both sides emphatically restating their current position.
We will also watch for who Obama picks to replace outgoing members of his policy team. A recent Wall Street Journal piece (the main section, not the op ed page) argued that “White House Chief of Staff Rahm Emanuel is likely to resign in a matter of weeks, hastening a remake of the Obama White House that could lead to a lower-key, more cooperative approach after the November midterm elections.” The article also noted that by filling Larry Summer’s seat with a business executive and by offering tax credits the Obama Administration could show it can “make a course correction.”
Shocking tax math
How bad would it be for the economy if all of the Bush tax cuts expired? One scary calculation is to take the tax hike—say $250 bn—annualize it—$1 trillion— and assume a 50 cents on the dollar shock to spending – $500 bn. That would be a 3.3% hit to GDP growth and enough to easily push the economy into recession. Fortunately things are not quite this dire. The shock to the economy is mainly psychological rather than monetary. Even if the tax cuts are allowed to expire, we would expect most to be reinstated by late January when the new Congress gets down to work. So the direct shock to spending would be small. The bigger risk is that households and businesses go into wait-and-see mode as they watch dysfunction in Washington play out. This could mean a slowdown in hiring, capital spending and purchases of consumer durables starting in November and building the longer the dysfunction continues.
Quantifying such a potential shock is difficult to say the least. If all of the tax cuts are allowed to expire, then perhaps the economy will behave similar to the run-up to the War in Iraq in 2003. Then the worry was of either an oil shock or terrorism. Uncertainty rose sharply in the spring, causing payroll employment to drop in February, March and April. GDP was flat in Q4 2002, but rose 1.6% in Q1 and 3.2% in Q2 of 2003.
Alas, the tax "game theory" thing is not the only thing that will cripple the economy very, very soon. Oh no, pretty everything else will too. Here is Jan Hatzius explaining why Obama is screwed.
Among the many factors that will influence real GDP growth over the next 1-2 years, we can distinguish between two broad groups. The first consists of short-cycle impulses to growth, which can swing sharply from positive to negative and back within a few quarters. Two key examples are the inventory cycle and fiscal policy, but the short-cycle factors also include impulses from monetary policy, shifts in businesses’ willingness to hire and invest, “shocks” to financial conditions or energy prices, and exogenous factors such as the effects of natural disasters, wars, and terrorist acts. These factors are the staple diet of business forecasters.
Our forecast at the beginning of the year that real GDP growth would slow sharply through 2010 was based on a pessimistic outlook for the short-cycle factors, specifically a sharp decline in the impact from inventories and fiscal policy. Indeed, the chart below shows that this impact has gone from around +4 percentage points in late 2009/early 2010 to +1.2 points in the second quarter of 2010, and that it is likely to deteriorate further to around -1½ points in late 2010 and 2011.
It would be a mistake to argue that this 2.7-percentage-point deterioration will lead to a 2.7-percentage-point slowdown in real GDP growth compared with the second-quarter growth pace of 1.6%. First, as we argue below, there does seem to be some gradual “healing” in the economy underneath the surface, which should translate into a gradual pickup in underlying growth (excluding the fiscal/inventory impact). Second, the second-quarter GDP figure of 1.6% looks a bit “too weak” relative to other measures of economic activity during the quarter, including the business surveys, the labor market data, and indeed the GDP figures measured from the “income side” of the national accounts (the latter showed real GDP growth of 2.3%). One possible reason lies in a statistical overstatement of import growth, whose implausibly strong growth subtracted sharply from the conventional “expenditure side” measure of real GDP in the second quarter.
But despite these mitigating factors, the further deterioration in the “short cycle” factors does pose a significant downside risk to our forecast that real GDP will grow at a 1.5% rate in late 2010. Moreover, these risks remain large in early 2011. Under our baseline fiscal expectations—in which only the upper-income Bush tax cuts expire but all other cuts are extended—the fiscal/inventory effect remains around -1½ percentage points in 2011. But there is some risk that gridlock in Congress leads to a full expiration of all of the tax cuts passed under President Bush in 20101-2003 and President Obama in 2009. This would mean a much bigger tax increase and would imply an additional 1½-percentage-point hit in early 2011 relative to the baseline, i.e. a -3 perrcentage point impact (see Tuesday’s and Wednesday’s US Daily Comments on this issue). This would sharply increase the risk of recession. (It is also possible that all of the tax cuts get extended; this would imply a modestly smaller amount of restraint in early 2011 than in our baseline assumptions.)