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Electoral Cycle Driving Debt Ceiling Debate

Debt ceiling negotiations are being driven by party politics, not ideology...

THERE SURELY can't be anyone left now who truly believes that the debt ceiling debate taking place in Washington is really about what's good for America, writes Martin Hutchinson, contributing editor to Money Morning.

The truth is it's about the 2012 election – and the party that wins the debt ceiling debate will be the party that comes out on top next year. 

It's politics – pure and simple.

Republicans and Democrats have their own respective agendas heading into the 2012 election. And with 16 months to go, there's just enough time for actions taken now to work their way through the system and swing the economy in one direction or the other. 

Now, I'm not a believer in conspiracy theories, but I am a firm believer in Public Choice Theory. That means I believe we can make clear statements about what economic conditions each party would like to see 16 months from now – considering their own selfish political points of view.

The Democrats would like to see rapid growth, with unemployment coming 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 figure they will sort out any problems after the fact – particularly if they can recapture the House. 

Conversely, the Republicans would like growth to be sluggish, with unemployment stubbornly high. They also would like to make the painful decisions that bring long-term growth now, so that they can benefit from the growth and not suffer the political cost of the pain if they capture the Presidency and ideally both Houses of Congress in November 2012. 

Both parties, of course, have strong beliefs about what policies work better, about what policies are better for the interest groups that support them, and about what policies are best suited to their ideology. But at this stage of the electoral cycle, they're pragmatists.

Here's how the election cycle breaks down:

  • The time for politicians to put their favorite ideas into effect is in the first year or two of the election cycle, after they've won a big majority. That's why President Obama and the Democratic Congress spent so much political capital on the "stimulus" and the healthcare bill in 2009-10, and tried to get a "cap-and-trade" carbon emissions program passed.
  • In the run-up to the election from next January onwards, the main effort will go into rewarding powerful interest groups that provide money and votes, and to electorally popular gimmicks.
  • After the election, there's a short period in which the winning party can do any unpopular, "root canal" stuff that appears necessary.
  • However, with the election still more than a year away, the natural impulse of both parties is to ensure that the economic picture faced by the electorate the following year will be as they wish. That's why President Nixon abandoned the Bretton Woods exchange rate system in August 1971; it's why President Kennedy advocated his supply-side tax cut in 1963 (it was passed early the following year) and it's why President George W. Bush pushed through capital gains and dividend tax cuts in 2003.

The Republicans currently have less power than the Democrats, but their objectives in the current negotiations are fairly clear. They want as big a spending cut as possible and as much progress towards reducing the deficit as possible. 

That's not just because they like spending cuts and deficit reduction. They also believe that spending cuts will result in public employee layoffs and may cause a short-term impediment to the economic recovery – even though they will improve long-term growth. 

Short-term pain for long-term gain suits the Republicans fine, as any economic slowdown and increase in unemployment will happen before November 2012. 

Conversely, the Republicans don't want marginal rate tax increases, which would affect long-term growth prospects, and for which they would be blamed by the electorate.

However, they don't mind tax code rationalization through the elimination of tax subsidies. Such reform would have mostly short-term effects, resulting in the closure of subsidized activities with accompanying job losses. 

Capping the home mortgage deduction for high earners, which would probably cause a further lurch downward in the housing market, is also fine. The Republicans also probably don't mind capping the charitable tax deduction for high earners. The vast majority of charities are natural Democrat constituencies, except for churches, whose donors are predominantly middle-income people rather than the wealthy.

The Republicans also have a clear self-interest on monetary policy, though they are less able to affect that directly other than by harassing Federal Reserve Chairman Ben Bernanke at Congressional hearings. 

A "QE3" program of bond purchases would make the federal deficit easier to finance in the short term and boost the stock market while increasing inflation in the longer term. It would thus be bad news for Republicans, and for older people living on savings, a natural Republican constituency. 

Conversely, higher interest rates would help savers and slow the economy, both natural Republican wishes going into an election year. 

Again, there are no conspiracies involved here – just the politicians' self-interest. 

So when scoring the debt ceiling debate and other economic policy moves this year, you can put a tick in the Republican column from all the policies on the above list. Needless to say, some of the wins will be accidental from Democrats failing to figure out where their true interests lie – and likewise Republican ineptitude may hand the Democrats a few freebies. 

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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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