November 7th and the Dollar

Well aware that the US holds midterm elections on November 7 and that most polls suggest the Democratic Party may garner a majority in the House of Representatives and could get control of the Senate as well, investors have nonetheless taken a favorable look at US assets. The equity market has rallied strongly, with new record highs being recorded in the Dow Jones Industrials and the S&P 500 is posting a double digit gain, with about a third of this year’s gain being scored over the past month, even as a Democrat victory looked more likely. While the US Treasury market has moved lower in recent weeks, it has held up better than the European and Canadian bond markets. The dollar has held its own. The euro has been mostly below its 100-day moving average since the start of October. The greenback recorded its high for the year against the Japanese yen on October 13th just below JPY120.

It makes perfect sense, unless you believe the pundits and partisans, who frequently are the same people. The political bias of most Wall Street commentaries seems clear. A Democratic victory, they tell us, would result in higher taxes, more regulation and insipid protectionism. It is almost as is the analysis is taken straight from a stump speech, like Vice President Dick Cheney’s, who warns that a Democratic victory would “sabotage” the economy.

The fact is that the US political parties are not ideologically distinct. This is readily grasped by most observers outside the United States. Just like a mountain is clearer from the plain than from the summit, much of the domestic analysis suffers from the hubris of small differences. What passes for political dialogue in the US would be little more than a hair-splitting debate, for example, within the right-wing of the UK’s Tory Party or right-wing of Germany’s Christian Democrat Party.

Indeed, if anything, the historical record shows that Democrats have done no worse and in some respects better than Republicans in delivering economic prosperity. But the point is not to counter conservative bias analysis with offering a liberal bias. Rather the purpose here is to show that the markets are correct to pay the US election little mind.

One of the most startling characteristic of the US electoral system is the power of incumbency. Over time, something like 90-95% of the incumbent national legislators who run get re-elected. This is a function of several confluent forces, including significance of money in financing campaigns, the power of office and the gerrymandering of the districts to minimize partisan challenges.

To appreciate the significance of this, consider by contrast the power of incumbency in undemocratic regimes like the Soviet Union and China. In a 1998 Foreign Affairs essay by the Chinese scholar Minxin Pei noted that at the prior to Glasnost, the re-election rate of full members of the central committee of the Communist Party hovered around the high 80% area in the late 1970s and early 1980s. The China, the power of incumbency was weaker, hardly ever moving above 50% since the death of Chairman Mao. In 1997, the last data that Pei included the re-election rate was 43%, less than half the US rate.

Regardless of the outcome of the election, important parts of macro-economic policy are unlikely to change. Surely this is especially true of monetary policy. Fiscal policy is also unlikely to fundamentally change. Most of the Bush Administration-pushed tax cuts including on capital gains and dividend expires in 2011 and thus appear relatively safe. Even the most optimistic scenarios do not call for the Democrats to achieve a veto-proof majority and even though President Bush has barely used his veto power in his first six years, the threat remains potent and real.

In addition, even if Republican candidates do unexpectedly well, the power of the executive branch that has grown markedly in recent years will be more checked. Due to the unpopularity of the war in Iraq and a high degree of economic anxiety, many Republican candidates have distanced themselves from the President. In addition, Bush’s trade promotion authority (fast-track) is set to expire next year and is unlikely to be renewed even if the Republican Party is able to maintain its majority in both chambers. The 2002 farm support program expires with the 2007 crop year. Both Republican and Democratic parties have consistently support farm subsidies and various support schemes and next year should prove no different regardless of the electoral outcome.

If the Democrats do achieve a majority in the House of Representatives, which would require a net gain of 15 seats, California Congresswomen Nancy Pelosi would most likely be the next Speaker of the House. The Democrat strategy calls three immediate legislative goals: Raise the minimum wage, lower interest rates on student loans guaranteed by the government and lower prescription prices for Medicare. These issues do not appear to the stuff that would derail a $12 trillion economy or presents creeping socialism.

The war in Iraq is a significant issue for Americans. The issue is clearly not simply a point of disagreement between the parties, but is dividing the parties themselves. Shortly after the election, a blue-ribbon commission headed up by former Secretary of State James Baker will issue a review of US policy and is widely expected to call for a fundamental shift in the US strategy. This and the passing of the election will likely create an opportunity for the political elites of both parties to hammer out a bipartisan approach. This will help de-politicize the issue and possible reduce its saliency for the 2008 presidential race.

All of the 435 seats in the House of Representatives and one third of the 100-seats in the Senate are theoretically up for grabs. The power of incumbency, however, in practice, means that very few seats are really contested. Control of the Senate, for example, seems to rest on only five races: Ohio, New Jersey, Virginia, Tennessee and Missouri. The Democrat candidates appear ahead in the first three, while the Republicans appear to have a slightly advantage in the latter two.

Ohio was a key state in the 2004 election and some Democrats still harbor suspicions that the results were marred by voting irregularities. It could be the single most important state in this midterm election. Ohio has been a Republican stronghold. It has had a Republican governor for 32 of the past 44 years. Both Senators are currently Republican as are 12 of the 18 members of the House of Representatives. The statge has lost 200k jobs over the past six years and the unemployment rate is a full percentage point above the national rate. Many Democrats are running well ahead in the polls and it is possible that the Democrats pick-up 5-6 House seats and a senate seat in Ohio alone.

The argument here is not that the election does not matter. It surely does, but not in terms of macro-economic policy, or the direction of the US dollar. Of the myriad of factors that move the foreign exchange market, which party enjoys a majority in Congress is not among them. Some commentators, usually who fear of being on the losing side of the election, praise the benefits of a divided government. This is little more than making a virtue of a necessity. It is an unintended consequence rather than a purposeful strategy on the part of voters. The most important point is not to confuse the partisan claims with analysis. One’s overall views on the direction of the US economy, interest rates, equity prices and the dollar should not be impacted by the electoral outcome.