In a jam

America expects a swing to the right in the midterm elections and although markets favour stasis, lack of clarity and political gridlock would keep the economy at a standstill. Vanessa Drucker reports from New York.

To compound the stasis, those who assume a Republican Congress begin operating immediately in January are not taking into account how the system operates. For the House of Representatives to start functioning, committees and subcommittees must be organised, which requires locating people who are experienced at staffing them. “People are too hasty if they are expecting a new world order when they turn on the lights during the first week in January”, says Lykos.

Several key regulators have already left, or are leaving their posts. John Dugan, who had been controller of the currency since 2005, stepped down on August 14, replaced by John Walsh as acting head of the agency that oversees the largest American banks. Speculation is rampant that Sheila Bair, the head of the Federal Deposit Insurance Corporation (FDIC), will soon be leaving office. It is especially critical that key regulators be in place at a time when so much drafting will be required.

”If the Bush tax cuts are extended, there is no way the country can avoid incurring debt levels rising over 100% of GDP”

Obstruction in subcommittees could not loom at a less propitious juncture. Consider that the Dodd Frank financial legislation calls for about 240 rulemakings and over 60 further studies. In other words, the legislation spells out a mandate for regulators: go reform! A vast agenda awaits, covering bank capital levels, derivatives, reporting transparency, and accountability at the corporate board level. If Republicans dominate the House, they will be the ones who set the hearing agenda, chair the hearings and determine who testifies. As they call up the heads of the main regulatory bodies – the Commodities Futures Trading Commission, the SEC, the FDIC – they will be “paying back those special interests who gave them money,” Turner explains. The prospect for serious reform will be compromised, with banks less likely to be held accountable and a more laisser-faire context permitted. “Despite all the press noise, Basel III will turn out to be a farce,” Turner warns.

The immediate challenge to overcome is taxes. The nation is focused on the expiry, or sunset, of the tax cuts enacted under George W Bush in 2001, with reconciliation rules scheduled to kick in after 10 years (which is next month) reverting to their 2000 rates. Dividends and capital gains taxes, which could double from 15% to the previous level of 30%, bear keenly on financial market performance; a rescission of tax cuts could dampen investors’ enthusiasm for dividend paying stocks.

Obama is willing to extend the tax cuts for those labelled “middle class”, that is, families earning less than $250,000 (£160,000) a year, while he would end the relief for those earning more. Although the cut-off level has provoked heated controversy, the percentages involved are less than sensational. The higher earners would be taxed at 39.6%, instead of 35% on income over $250,000. Altogether, a Republican package for cuts would amount to $3.7 trillion over 10 years, according to Tierney. Obama’s own proposal, excluding those in the two highest brackets, costs the government almost as much, saving only $700 billion by upholding higher rates on the wealthy.

The tax battle “will turn into a game of chicken before year end,” Goldberg predicts. The Democrats do not want to raise taxes on the middle class, fearing an increase would hurt the economy, and might alienate their own base of voters. Most pundits expect the White House to blink, extending tax cuts at all levels, given the legislative difficulties of separating out the high earners. “But the more seats Republicans win, the broader the extensions will probably be,” says David Twibell, president of wealth management at Colorado Capital Bank, a Denver-based firm.

”People will think at first that lower tax rates will help, but in a year or two it will dawn on them that they have bankrupted the country”

Malpass is not so sure. He says that a full expiration is more likely than an extension, in the context of “a divided Congress, legislative procedures, the president’s view, and the big deficit impact under CBO [Congressional Budget Office] scoring rules.” Although he concedes that Congress may act in December, the legislative obstacles are high, requiring 60 sitting Senators to vote for a much bigger tax-cut-related fiscal deficit. Besides, he notes, expectations for quantitative easing from the Federal Reserve “give Congress a timely excuse for inaction.”

If taxpayers do get a reprieve, they may be celebrating too soon for their own good. Turner sketches a bleak scenario. “If the Bush tax cuts are extended, both the Congressional Budget Office and others have shown there is no way the country can avoid incurring debt levels rising over 100% of GDP. That would be the point of no return.” The CBO has mapped out estimates of national debt, escalating from $12,278 trillion in 2010 to $22,278 trillion in 2020. As of now, American intra-governmental holdings account for over $5 trillion of that sum, with Japan and China both major creditors at about $750 billion each.

Underlying this gloomy rationale, 60% of American debt is short term and must be refinanced in the next three years. The Chinese in particular are gunning for shorter maturities, that is, they are basically providing vendor financing. As the Chinese migrate from creative investment to ramping up their own internal consumer spending, they will have less need to export to the West or to provide that vendor financing. At that point, America may lose such a willing lender. Cutting spending programmes will not be enough to resolve fiscal imbalances. Turner says bluntly, “people will think at first that lower tax rates will help, but in a year or two it will dawn on them that they have bankrupted the country.”

A counter argument holds that extending the tax cuts will help the economy to revive. Some, like Malpass, would argue that the CBO scoring rules explicitly ignore the positive impact of lower tax rates on economic growth. The battle over tax cuts versus spending is flaring up. The previous administration ran up deficits on military spending, while chopping taxes. “Recently we have focused on Keynesian spending, but a robust debate is coming,” says Twibell. “If we try to do both, as the Bush administration did, we will take a horrible deficit problem and turn it into something our economy can’t shoulder.”

Unless the economy takes a vigorous new lease of life, voters will remain frustrated after this November’s results. It is true that since 1945, the Dow Jones Industrial Average has gained 17.1% on average during the year following a midterm election. The simple driver is that an incumbent administration usually throws all its weight into pumping the economy, ahead of its next presidential race. But the economy is still mired, after the credit crisis and recession. This time, housing and job markets have stubbornly resisted all priming efforts.

Whichever party comes out ahead of predictions, a ping-pong match will ensue, with angst redirected back at those in control in 2012. With all incumbents proving unpopular, it would be typical for a third party independent candidate to make inroads, possibly splitting votes. There is already some discussion that a prominent figure such as Michael Bloomberg, the mayor of New York City, might be preparing for a national campaign.

In the meantime, it is worth watching the narrow margin in the Senate. Be a little wary of traditional cynicism, which tends to cheer gridlock and paralysis. This time around, inactivity may not prove such a good friend to business and markets, when they crave clarity. And do not count on pollsters’ predictions. As Tierney says, “when citizens get into a voting box, they do all sorts of strange things.”

Correction – November 2. George Munoz was the president and chief executive officer of the Overseas Private Investment Corporation (Opic), a federal agency, rather than, as stated in the original article, the Export-Import Bank.