America will choose more than just a new president

3-2-2012 | Economic news

American voters can break the deadlock on Capitol Hill in November, but the markets also have the power to force a solution to the imbalanced government finances.

The Republican primaries kicked off in Iowa on 3 January. The moderate Mitt Romney, the former governor of Massachusetts, is currently considered the favourite for taking on Barack Obama in November. But he will first have to beat more right-wing candidates including Newt Gingrich, Rick Santorum and Ron Paul. Republicans and Democrats in Washington seem to already be postponing all important decisions until the new balance of power is determined in November. This means very little will be done to tackle the country’s unhealthy government finances in 2012.

The trench war on government finances
While it has been known for many years that the American welfare state is unaffordable, the Great Recession has left an even greater hole in government finances. Politicians across the board now realise that reform measures are urgently needed. But there is one problem: the two parties fundamentally disagree on the solution. Democrats want to leave the current welfare state intact as much as possible and prefer a mix of (not overly deep) spending cuts and tax increases. Republicans, on the other hand, want to overhaul the welfare state and introduce sweeping spending cuts (but preferably not in the area of defence spending) and are not keen on tax increases. A compromise proved to be infeasible in 2011 and the resulting trench war on Capitol Hill led to the US losing its AAA status from credit rating agency S&P in August.

Voters could break the deadlock

It became clear last year that a political compromise is beyond reach. Under the current circumstances, it will only be possible to reach a solution if one party takes control of all the centres of power: the White House, the Senate and the House of Representatives. The Republicans hold a majority in the latter, while the Democrats are in control of the first two. Both the presidential election and the elections for the House of Representatives and a third of the Senate will take place in November. Given the slim majority held by the Democrats in the Senate, it too could see a change of power. This means voters could pave the way for a one-sided Republican or Democratic solution by providing a triple victory. But nothing will change if at least one of the centres of power remains in the hands of another party.

The markets could also force a solution

It remains to be seen whether a fast one-sided solution would be a good thing. A compromise proposal would more likely include simultaneous cuts in both parties’ unaffordable sacred cows, namely the welfare state for the Democrats and defence for the Republicans. Even though a voluntary compromise appears to be a long way off, it is not inconceivable that this could still be forced by the financial markets. After all, US government finances are unhealthier than those of the eurozone as a whole. The eurozone crisis will eventually end and at that point the US could then become an attractive target for the ‘bond market vigilantes’.

This article is written by Philip Marey.
Philip Marey is the senior US strategist at Rabobank’s Global Financial Markets Research Department.