The Dollar If McCain Wins

August 26, 2008

It’s hard to pick up a newspaper these days without finding an article on Obama’s vulnerability in the November election.  That’s a bad sign for the Democrats, especially since articles about McCain’s vulnerability are not so prevalent.  Press hype is often grounded in fact but nonetheless has a way of magnifying the momentum.  With Labor Day just six days away, the Democrats should listen to Yogi: “It gets late awfully early out here.”  Within 3 weeks, opinion polls will have to be taken very seriously.  I can’t say I am totally surprised that the Democrats do not seem headed for a landslide win despite the mishaps of Bush43.  My posting on April 23rd, Democratic Party Follies, foretold that an easy rout would not be in the cards.

This piece is not intended as a political prognostication, however.  My interest here is to say, okay McCain wins.  Then what happens to the dollar?  The major assumption that I make at this stage is that McCain has short coattails. The election is turning into an assessment of Obama’s fitness for the presidency at this stage of his life.  While surveys that pit McCain against Obama are close, voters continue to have a preference for policies espoused by the Democrats, according to other polls, and that suggests that the Democrats will extend their leads in both the House and Senate whether or not Obama wins the presidency.  So I assume that McCain governs with a hostile Congress.  It will be a throwback to 1995-6 only with a reversal of roles.  Stalemate is not necessarily a bad thing, but neither is it necessarily good.  It was often beneficial for the U.S. economy and for the dollar when Clinton was president.  Stalemate in the Carter years, on the other hand, was toxic.  Investors and analysts have to ask what will stalemate prevent, and what will it keep?  How stalemate is perceived boils down to the economic context in which it occurs.

McCain wants freer trade and deeper tax cuts.  He’s right on globalization, and the dollar would perform better if Washington accepted freer trade but also promoted U.S. competitiveness.  However, the Congress will not go along with McCain’s vision on trade policy, even if he uses the bully pulpit to make his case.  Tax policy will be even more contentious between the White House and Congress.  McCain probably will get some of his agenda but not virtually all of it as Reagan and Bush43 managed to do.  Reagan’s policy increased the Federal deficit and real interest rates, which were also lifted by the countervailing weight of a much tighter monetary policy than we will see next year.  Bush43’s tax cuts led to weaker economic growth than Reagan achieved.  More importantly, Bush43 oversaw weaker growth than Clinton, who engineered higher taxes.  When McCain assumes power, America will already have a deficit problem that is getting worse.  Tellingly, the tax cuts made in Bush’s first term when there was a Federal surplus had a much better effect on growth than this year’s rebates as the economy was teetering and with a big deficit.  I suspect the economy will be only moderately responsive to tax cuts next year.

Stalemate inevitably begets compromise and concessions. A monumental shift in 2009 as occurred in 1981 or 2001 is doubtful.  The policy side of fiscal changes will have less impact on the dollar than what the Fed does.  Monetary officials have acknowledged the need to be aggressive in normalizing interest rates once downside growth risks are manageable.  But so far, rhetoric has been far, far more hawkish than action by the Bernanke Fed.  Unless inflation persistently surpasses what officials expect, a repeat of 1994-5 when the funds rate was doubled to 6% in 12 months is unlikely.  The acid test will be if the central bank is willing to move rates upward in increments greater than 25 basis points. Ironically, the dollar probably does better if U.S. inflation proves stickier in receding.  That would force the Fed to move forcefully.

One of the most important elements to the dollar’s performance early in a McCain Presidency would be the attitude of the new administration toward the dollar.  We know the Treasury Secretary will not be Henry Paulson, but we do not know who that person will be.  Would Robert Rubin reprise his role from the Clinton Presidency?  That would be a brilliant appointment, avoiding rookie mistakes and demonstrating McCain’s willingness to work with a Democratic Party-controlled Congress.  But is this thoughtful wishing or just wishful thinking?   The fact is the identity of the Treasury Secretary will not be known until late this year at the earliest, and dollar policy will be learned only over many months when markets have a chance to hear what is said and see what is done.  A risk exists that this whole area of governance will bore McCain and simply get neglected.  By his own admission, foreign policy and national defense are McCain’s preferred cups of tea.  It’s hard to get terribly excited about dollar prospects in 2009 unless the Fed takes full aim on restoring credibility and sub-2% inflation.

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