We subscribe to research from ISI Group Inc, and in their latest political report, they feel there will be a good chance that the GOP will take a house or both in the November election. The Iowa Electronic Markets recently had contracts on Democrats maintaining control of both houses trading a little less than 50 cents on the dollar, indicating an even-money chance that Republicans could take control.
We feel it would require a major landslide for Republicans to take control of the Senate. Some estimates show that Democrats will hold 52 seats, Republicans 47 and one Independent. With a split this close, Republicans in the Senate should have sufficient power to stop anything they feel is too egregious. However, we feel there is about a 55% chance Republicans will win the House.
In our opinion, if the GOP wins in November, many of the new Democrats who will be up for reelection in 2012—especially those in the Senate—will start voting more conservatively. We suspect big spending and huge stimulus packages will disappear. We may see more fiscal responsibility simply because when Congress is split, each party has different priorities, making it harder to come together to grow government spending.
Additionally, because government spending has been center stage in the media and the markets for so long, Republicans will have to follow through with what they have been promising for the last six months. Our large federal debt is financed with treasury bonds and notes at very low interest rates. Once the Fed executes a strategy to bring interest rates up, the cost to finance the existing debt will go up very fast. Of course the implications are that if you raise taxes too much that will discourage growth, which is a concern for us. We wonder when the Bush tax cuts expire at the end of the year, what else will come?
While there has been some talk about moderate democrats looking to extend the tax cuts through 2012, we do not think Speaker of the House Nancy Pelosi (D-Ca.) or Senate Majority Leader Harry Reid (D-Nev.) would allow it. The talk could also merely be election hype versus a long-term momentum.
If you believe tax rate increases will discourage economic growth then it has negative consequences for tax revenues as well. If the tax cuts sunset, it will have a dampening effect on some part of the economy; however, we do not think this would make 2% impact on gross domestic product. The real worry for us is higher tax rates on dividends and capital gains. The cost of capital on a pre tax basis will be higher because you will have to compensate investors for their higher tax burden.
We also see a little double-talk from Federal Reserve Chairman Ben Bernanke where he admits that unemployment is a problem and therefore we cannot tighten too fast, yet we cannot let the deficit grow forever. We feel the time to show fiscal maturity is when the economy is in good shape. When the economy is growing and tax revenue is up, then you can talk about cutting government spending. When unemployment is hovering at 10% it is seen by some as dangerous to remove stimulus. We feel the infrastructure spending in the last stimulus was needed, but we are against more stimulus spending and would not have likely voted for the latest unemployment benefits extension.
Additionally, we feel it would make sense to not pay interest on the extra reserves for financial institutions, as that may make the banks start lending the money they are hoarding. There was speculation that banks would pay an increased rate for having the excess reserves as a component of the Fed’s exit strategy. The Fed pumped considerable amounts of liquidity into the economy, but the Fed increased its balance sheets and inflated the reserve position of banks. Until the banks start lending, it is not increasing money supply.
The concern about unemployment is understandable as the economy has been working under the assumption that the 4% unemployment rate we had for several years is normal. In the mid to late 1990s, most economists would agree that 5% to 6% unemployment was a reasonable, healthy level. We were spoiled when in 2000 unemployment went down to 3%, so in our eyes, 4% unemployment is not an attainable goal. We think 7% to 7.5% unemployment would be more reasonable. Our economy would have to add 300,000 to 500,000 jobs a month to truly see a change in unemployment rates as the labor force is consistently growing. We are just not at that level of job creation in the private sector.
The economy is still expanding. Those who expected it to go from recession to strong overnight are the ones who are frustrated at the rate of expansion. We feel it will be sluggish growth for the next couple of quarters to the next couple of years.
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