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What the Democrats Want from the Debt Ceiling Debate

It certainly ISN'T spending cuts...

I WROTE on Thursday about how the Republican Party is making the most of its opportunity to affect the economy in the run up to the 2012 election, says Martin Hutchinson, contributing editor to Money Morning.

Well, the Democrats are doing the same thing – except whereas the Republicans are looking to make long-term fixes at the expense of short-term growth, Democrats are doing the opposite. 

And in this battle the Democrats would like to see rapid growth between now and November 2012. More than anything, they want to see unemployment come down sharply. 

They don't care so much about whether inflation is ticking up a bit, or whether an over-large budget deficit may cause trouble in the future. If they get elected in November 2012, they can try to sort out problems then – particularly if they can recapture the House of Representatives.

Furthermore, the wish to get US President Barack Obama re-elected is not confined to the president and his entourage. If Obama were to lose in 2012, after presiding for four years over a lackluster economy with high unemployment, this would seriously damage the Democrat brand. 

The Republicans would very likely preside over a recovering economy and be re-elected in 2016 on the strength of it. That would give them eight years to write the history of the preceding period and cast President Obama's Democratic policies as a failure. 

After all, President Carter would be remembered much more fondly if he had been re-elected in 1980 and had presided over the 1982-84 economic upturn; conversely FDR would be remembered as a one-term president who failed to cure a deep depression if he had lost in 1936.

Regardless of their ideological preferences, Democrats are thus very keen to see policies enacted now that will produce a more vigorous recovery in 2012 and lower unemployment. 

They don't much care if those policies cause inflation to surge, or leave the incoming president in 2013 with a dangerous budget position. If President Obama is re-elected, Democrats will have the first two years of his second term to take painful actions to control inflation and rein in the budget deficit. Even if those policies don't work exceptionally well, the Democrats would still have a chance in 2016 to blame any failures on the outgoing President Obama and campaign independently of his administration. 

So for Democrats – for public choice theory reasons – short-term benefits from policies implemented now are the only benefits that matter. 

In the current negotiations, the Democrats have more power. While their majority in the Senate is now too small to pass major legislation – which requires 60 Senators to the Democrats' current effective total of 53 – the Democrats still set the agenda and can both block Republican proposals and advance their own. 

Add to that the enormous advantage of the Presidency's bully pulpit and control of the executive branch, and you'd expect them to end up with most of the marbles at the end of this round of the game.

The Democrats don't want spending cuts for two reasons.

First, their ideological preference is for larger government. The government workforce has declined by over 1 million since April 2009, offsetting by more than one-third of the rise in private sector employment. 

Secondly, Democrats – being mostly Keynesians – believe that spending cuts have had a depressing effect on the economy as a whole, keeping the unemployment rate unexpectedly high. 

To the extent that tax increases would dampen economic growth, the Democrats don't want those, either. For example, temporary cuts in payroll taxes are attractive because they could stimulate economic activity among the modestly paid and would almost certainly stimulate middle-class spending. 

On the other hand, tax increases in the longer term – those that would take effect in 2013 or later – are favored, as they would push any pain (and much of the unpopularity) into the next administration while still encouraging the bond markets to believe that the deficit is being cut. 

Higher tax increases on the wealthy and on oil companies also are welcome. Democrats think the income of the wealthy tends not to be spent, resting useless in a bank. They don't believe tax rates have a supply-side effect. 

On monetary policy, the Democrats want more stimulus. They believe low interest rates stimulate economic activity and they want to make sure that Federal Reserve Chairman Ben Bernanke buys enough Treasury bonds to prevent the budget deficit from becoming a problem before November 2012. 

Democrats don't worry much about inflation. They believe it will arrive fairly gradually, and can be prevented from becoming a big worry before November 2012 with creative accounting at the US Bureau of Labor Statistics. 

The bottom line is that the Democrats are likely to get more of what they want in the current negotiations, but they are taking a big gamble. 

If Bernanke's monetary stimulus fails to create new jobs (and both theory and evidence suggest very low interest rates encourage companies to substitute capital for labor, thereby destroying jobs), then unemployment may still be high in November 2012, with inflation increasingly a problem. 

That would make it very difficult for President Obama to be re-elected – in which case the Democrats' only hope (but it's a substantial one) would be that the eccentric Republican primary system produces a flawed opponent.

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Now a contributing editor to both the Money Map Report and Money Morning, the much-respected free daily advisory service, Martin Hutchinson is an investment banker with more than 25 years’ experience. A graduate of Cambridge and Harvard universities, he moved from working on Wall Street and in the City, as well as in Spain and South Korea, to helping the governments of Bulgaria, Croatia and Macedonia establish their Treasury bond markets in the late '90s. Business and Economics Editor at United Press International from 2000-4, and a BreakingViews editor since 2006, Hutchinson is also author of the closely-followed Bear's Lair column at the Prudent Bear website.

See full archive of Martin Hutchinson.

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