The economic effects of US political change

published 17 January 2007

Do not underestimate the significance of the political shift that has just taken place in the US Congress. Not only have the Democrats taken back control of both houses of the US legislature for the first time since 1993, but this is also the first instance in over half a century when they have recaptured both the Senate and the House of Representatives simultaneously. The potential impacts on the economy and financial markets should not be minimized.

Political shift comes at a unique point in the economic cycle

This shift in political power is occurring at a unique juncture in the US economic cycle. The profits share of national income currently stands at a 50-year high of 12.4% (see accompanying figure). At the same time, the portion going to labour compensation is just 56.3% - the lowest a newly elected Congress has faced since 1965. In other words, the Democrats are assuming power at a point in time when the returns to capital are at historical highs and the rewards to labour are at more than 40-year lows. This underscores the most profound economic implication of all: Just as the pendulum of political power has swung to the left in the United States, I think there is a very good chance that the pendulum of economic power could swing from capital back to labour in the years ahead.

Don't look to the modern history of the American political cycle in attempting to discern the outcome. The shift in congressional control that has just occurred - with the Democrats retaking the leadership of both houses of Congress simultaneously - last occurred back in 1955. In the 25 years that followed, the Democrats maintained control of both the House and the Senate. It wasn't until the election of 1980 - Ronald Reagan's first term - when the Senate went Republican for the first time since 1953. And it wasn't until the election of 1994 - a stunning mid-term defeat for Bill Clinton - when the House of Representatives went Republican for the first time since 1953. Long the resident party in power insofar as Congressional control was concerned, it has been fully 54 years since the Democrats did what they did last November. By simultaneously seizing control of both houses of the US legislature - albeit with the narrowest of possible margins in the Senate - modern-day Democrats find themselves essentially in uncharted waters.

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Democrat gains could mean a pro-labour shift

That's not to say politics haven't mattered in shaping recent economic cycles in the US. In looking at the past 40 years, the tug-of-war between capital and labour does appear to have been influenced by the party affiliation of the President. Three of the most recent upsurges in the labour share of US national income occurred in Democratic Administrations: LBJ's Great Society Program was key in pushing up the labour share in the late 1960s and early 1970s. Similarly, there was a significant increase in the compensation share of national income in the final years of the Carter Administration in the late 1970s. And the last time there was a meaningful gain in the labour share was in the late 1990s during the second Clinton term - albeit in that case, the increase stopped well short of that which occurred in the Johnson and Carter Administrations.

In this context, a White House that remains in Republican control appears to argue against a shift from capital to labour. But it should be pointed out that in none of those earlier instances of Democratic leadership was the ascendancy of labour instantaneous - typically there were lags of around 2-3 years. Moreover, at no point in those earlier political cycles had the pendulum swung as far in a pro-capital direction as is the case at present. In the end, it may well be that a weakened Bush presidency is in no position to stand in the way of forceful pro-labour initiatives from the new Democratically-controlled Congress.

We'll know soon enough. Confirmation of a pro-labour shift should be evident in the early months of 2007. Look for the new Congress to push ahead on several fronts: The first hike in the minimum wage in 10 years is a "done deal" - a two-year 40% increase from the current $5.15 per hour to $7.25. Imminent tax hikes on the oil industry are also on the radar screen, as is focus on the excesses of executive compensation. Moreover, an intensification of protectionist pressures is a distinct possibility, as the newly elected Congress views America's gaping trade deficit as a threat to the job and income security of middle-class workers. Despite Republican control of the White House, most of these initiatives could well be veto-proof in the current political climate. And, most likely, they are just a down-payment on what is likely to be a multi-year pro-labour agenda of newly empowered Democrats.

Risks of increased Protectionism

Of all these possible developments, the one that worries me the most is the mounting risks of protectionism - especially the scapegoating of China. Over the past couple of years, the so-called Schumer-Graham approach - a proposed 27.5% tariff on all Chinese goods sold in the US - has been the lightning rod in US-Sino trade tensions. At the request of newly-appointed US Treasury Secretary Hank Paulson, the two senators withdrew their bill last fall; they were mindful that the draconian tariff proposal could not only deal a lethal blow to global trade but that it was probably not even WTO compliant. Yet far from having given up, both Schumer and Graham appear more determined than ever to craft a different measure - this time, joining forces with Senators Baucus and Grassley, the two leading members of the Senate Finance Committee. Look for a new and important bipartisan proposal on trade coming jointly from these four senators in the first half of 2007.

The intensification of anti-China sentiment in the Congress was fueled by three major developments in the aftermath of last November's election - a disappointing outcome of the mid-December US-Sino strategic dialogue in Beijing, inflammatory and mis-directed statements by Fed Chairman Ben Bernanke (see my 18 December dispatch, "Who's Subsidizing Whom?"), and the latest foreign exchange report of the US Treasury, which disappointed congressional hard-liners by once again failing to charge China with currency manipulation. Collectively, these developments seem to have instilled a newly-elected Congress with an even greater sense of determination to get tough on China. An equally significant development on the protectionist front is that political leadership in the anti-China campaign could swing from the Senate to the House. In fact, it is hard to identify a free-trade advocate in the House who is in a position to derail this increasingly fast-moving train.

I have personally presented the counter case to the China blaming to so many politicians, I have lost count. As a saving-short nation, America is biased toward chronically large deficits - I remain convinced that our large bilateral imbalance with China is an outgrowth of a serious and worrisome saving deficiency. A Congress that closes down trade with China - or materially alters the terms on which this cross-border commerce is occurring - runs the real risk of simply transferring the China piece of a gaping multilateral US trade deficit to another trading partner, imposing the functional equivalent of a tax hike on American consumers. This is a lose-lose response to Congress's growing frustrations with the win-win rubric of the globalisation debate. Logical or not, the point is that no one in the US Congress is listening to the other side of the debate. That could well put Washington in the increasingly dangerous position of veering ever closer to the slippery slope of protectionism. A move by China - especially on the all-important intellectual property rights issue - could go a long a way in defusing this tension. But my latest discussions in Beijing do little to encourage me that anything is in the offing on this side of the debate either.

Courtesy of this sea change in the US political landscape, important changes are likely in the US economy and financial markets. The stock market could be adversely affected by the negative earnings implications of a shift from a pro-capital to a pro-labour political climate. The bond market could be hurt by perceived risks to inflation brought about by new pressures on labour costs in conjunction with the potential inflationary fall-out of mounting protectionist risks. The US dollar could be hit by China's diminished appetite for dollar-denominated assets - a painfully logical response to Congressional intensification of China blaming.

Nothing is forever. The political and economic climate has been amazingly hospitable for financial markets for a long time. But with this climate have come tensions and consequences that have sparked a powerful response from America's body politic. Therein lies the change agent: As is always the case when the pendulum of political power swings too far to one end of the spectrum, it is now starting to swing back the other way. That puts the US Congress on a very different path than has been the case in a long time. And it also suggests that the pendulum of economic power could well be starting to swing from capital back to labour. Courtesy of this power shift, it's as if the movie of the past six years is about to run in reverse.

By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley's Global Economic Forum