Expect political trench warfare as the economy slows

By Edward Harrison On Nov 16, 2018

The right narrative here is that the Republicans will lose very badly. And so, expect gridlock, political trench warfare, in the US starting in 2019. That’s going to be a significant factor controlling how well the US government responds to crises, including a recession.

Re-read that post in its entirety. I think I made the right call regarding election turnout and the consequences of that turnout in terms of Democrats getting a big electoral victory. Having said that, crucially, the election did not go so far as giving the Democrats power in the Senate as I predicted on the eve of the election. But, folks, we’re still going to get political trench warfare here. Some thoughts below

The Presidential Cycle is dead

Here’s the FT on Jeremy Grantham’s Presidential Cycle investing thesis right before the 2016 Presidential election:

Jeremy Grantham, the revered investor who popularised the “presidential cycle” of stock market investing — in which gains during the third year of a president’s term were greater than the other three combined — now believes that the Federal Reserve has killed off the cycle.

The founder of the GMO fund management group in Boston told the Financial Times: “The presidential cycle owed everything to the Fed. The Federal Reserve, completely innocently, always decided to come to the aid of the party in power.”

This involved stimulating the economy in the third year of the term, so that the economic benefits would be feeding through as voters went to the polls in the fourth year. As stock markets attempt to pre-empt economic developments, the effect on share prices was felt in year three. They did not stimulate earlier in the cycle “or everyone would have forgotten about them by year four”…

But Mr Grantham said this was before “the age when the Fed became the dominant force in economics and finance and assumed enormous power”. Now, he said: “They are constantly looking for excuses to push down on interest rates and drive asset prices higher to get some wealth effect. I don’t trust them any more to play the easy presidential cycle.”

Interesting.

I have a different take though.

The impact of the Great Financial Crisis swamped the Presidential Cycle

Cyclical policy in the US economy is dominated by the Fed. We certainly got some fiscal stimulus under both Bush 43 and Obama when they worked against US downturns early in their respective presidencies. Nevertheless, in each case, it was the Fed, with near zero rates under Greenspan and zero rates and QE under Bernanke, that dominated cyclical policy. So, Grantham is right about the huge impact of Fed policy.

But, the last cyclical downturn was so severe that the Fed was still goosing the economy with QE some 4 years into the Obama presidency. Completely forget about 2011, the third year of Obama’s first term then. In his second term, tapering finally started under Yellen in 2013 and ended in 2014. So, 2015, the third year of Obama’s second term, was a year of monetary tightening, not easing. The Fed even started to raise rates in December 2015.

That’s the legacy of the financial crisis.

Donald Trump the Keynesian to the rescue

And, of course, that was to Hillary Clinton’s detriment as a candidate. And she ended up losing to Donald Trump. But, Trump had a big problem as he came into office. The Fed was actively tightening policy for the first time in almost a decade. That would almost certainly work against his party in 2018. What does one do in that situation?

What Trump and his party did was back a massive fiscal stimulus. Like Reagan, when he ushered in the the Economic Recovery Tax Act (ERTA) in August 1981 to bolster the economy ahead of his first midterm election, Trump was calling his fiscal policy ‘supply-side’ economics. But, I have argued that this is just Keynesian economics in disguise – straight-up stimulus to give a pre-election boost.

Here’s the thing, though. Supply-side is trickle down economics. Even David Stockman, who was first to implement it in 1981, admitted as much in an interview in 1981. And that’s a problem, as I outlined before Trump even took office:

Overall though, I see Trump as having been elected due to voters angry about declining income growth and job security, particularly in the rust belt states that had voted for Obama in 2008 and 2012. That means Trump needs to appeal to this group in some discernible way to be successful. He even said so himself on election night, talking of having only two years to make his mark. He might be able to appeal to them on cultural grounds the way Republicans have done in the past. I don’t see that being effective though given the angst still evident after seven years of recovery. But supply side isn’t going to do it either unless Trump can create enough growth that it reaches deep into the rust belt where all the manufacturing jobs have been lost.

My view: Supply-side didn’t go — and never will go — deep enough into the economy under Trump. Therefore, it can’t have enough positive impact on Trump’s base in the working class to overcome the disaffection that his ‘cultural warrior’ strategy creates among the Democrats’ base with minorities and women.

Trump’s base is still getting killed though

Look at these numbers, for example. Now, forget about the headline; I find it kind of inflammatory. Focus on the numbers.

First, here is the setup pre-Trump win:

Donald Trump carried 2,584 counties across the country, but calculations by scholars at the Brookings Institution showed that the 472 counties Hillary Clinton carried accounted for nearly two-thirds of U.S. economic output.

Here’s the visual.

What’s happened since the tax cut for Trump voters? Here’s one example from the same article:

the GOP’s small-government ethos constrains its ability to boost the struggling economic constituencies that Republicans represent. In 2016, for example, candidate Trump pledged to revive coal mining communities through deregulation rather than investment.

But coal mining employment has not reversed its long-term decline, and the government projects falling coal consumption this year and next. Owners of unprofitable coal-fired power plants have shuttered them at a record rate in 2018.

And remember, most voters still disapprove of Trump’s tax cuts. Republican voters say they helped. But independent voters say they didn’t by a margin of 53 to 35%. That’s what made running the midterms on tax cuts not viable for Republicans. So Trump focused on cultural issues. That got some voters to the polls. But, of course, in general, Republicans still got killed.

This is where the trench warfare comes into play

Now, the Democrats control the House of Representatives. House GOP leader Kevin McCarthy says he hopes House Democrats in pro-Trump districts will work with him in the next Congress on infrastructure and taxes. Good luck.

If you look at any analysis of top Democratic priorities, infrastructure is way down on the list. Tops on the list? More Investigations of Trump. That’s why I say expect political trench warfare.

Personally, I don’t expect any stimulus whatsoever. At the same time, I expect the Fed to be hiking rates almost to the point that it’s painful — and maybe beyond. So, as I opined yesterday, Trump’s goose is really cooked. The real question is what happens when we get a bump in the road. I think the Fed runs out of bullets and then the question will fall to fiscal policy.

Ignoring the ‘ability’ to deficit spend, look at ‘willingness’ to deficit spend. We have trillion dollar deficits already. And that’s during the peak expansionary part of the economic cycle. Given the massive deficit we already have, as well as the likely automatic fiscal stabilzer spending we will get in a downturn, Congress will be reluctant to expand the deficit even more. I would go as far as saying we won’t get any major stimulus until and unless the downturn metastizes into an economic crisis.

It’s all about the Fed (as usual)

So, we will be in a tough place. And the Fed knows it. That’s why they’re in a hurry to get rates up, hoping they can reload, while also avoiding a hard landing. That’s not a good place to be in.

But, as a reminder of the Fed’s role here, Gavyn Davies is saying “the major US recessionary risks stem from tighter financial conditions and from leveraged corporate debt, not from a housing meltdown.” And so, when the next downturn does come, the likelihood is that the Fed’s tightening will be a major contributor to it.

For me, one key to whether we can avoid or delay this outcome is whether the Fed recognizes how sensitive the expansion is at this time. To date, I’ve been alarmed at their lack of recognition of the sensitivity of the expansion to their rate hikes. Comments pooh-poohing an inverted yield curve speak to the potential for a certain wanton recklessness a la Bernanke 2006. Even Yellen made comments to that effect when she was Fed Chair, by the way.

At the same time, what are they supposed to do? I mean when would they raise rates, if not now? For me, this is the dilemma: you would like to see fiscal relief when the cycle turns down. But religious over-reliance on monetary policy and the existing pro-cyclical fiscal policy of Trump says that’s not going to happen.

We better hope Powell can pull off a soft landing… because if he can’t we’re in for a world of hurt. And an environment of political trench warfare is going to make the hurt that much greater