How Washington Will Mess with Your Money in 2010

In this era of growing government involvement, it's no surprise that Washington is poised to be the biggest economic wild card of the new year.

Indeed, investors who are trying to estimate the impact that politics will have on their portfolios in 2010 are likely finding this attempt at analysis to be an exercise in futility.

If that's been the case, read on: Political pundits - even those who claim to be impartial - spend a lot of time trying to score points for their side. But they aren't really that interested in the economic aspects of the endless battle. I certainly don't claim to be any more unbiased than the next person. However, I thought it worth trying to take an educated guess at what will actually happen, and what it will mean for our money.

Key Areas for Investors to Watch

There are four areas of legislation investors need to understand and watch for in the new year. There are key budget and tax issues to be aware of and important reasons to care about the results of next year's midterm elections. More than in most years, the midterm results will have a lot to say about the outcome of the presidential election that follows (in 2012).

Healthcare reform will almost certainly pass in the early months of the year. With Democratic majorities in both the U.S. House of Representatives and Senate, and a much-admired Democrat president, the political cost of not producing a signature achievement would be too great.

In terms of healthcare reform, then, here's what I am predicting…

The final plan will not include a formal "public option." Nor will it include much in the way of cost-cutting. Therefore, to produce a substantial expansion of coverage, it will cost a chunky amount of money - let's call it $150 billion to $200 billion a year - as well as including some taxes that will be modest in their economic importance but painful to those who have to pay them.

The modest taxes will be imposed almost immediately - maybe even in 2010 but certainly in 2011 - while the big changes won't appear until 2014 or so.

That structure is intentional. That way - with nine or 10 years of revenue and only six years worth of actual costs in the 10-year scoring time frame - healthcare reform will be presented as only moderately expensive.

The truth, of course, is very different.

Healthcare reform actually represents a big expansion of government. In fact, we could be talking about boosting gross domestic product (GDP) by as much as 1.5%.

However, most of that expansion won't occur until the changes kick in, down the road a little. For those opposing the new bill, the sad history of the Medicare Catastrophic Coverage Act of 1988, repealed in 1989 after huge protests, will be a comfort. They will have two elections - in 2010 and 2012 - to try to elect a Congress that will repeal or drastically modify the legislation before its major provisions kick in.

While healthcare reform looks like a win for the Obama administration and its congressional supporters, "cap-and-trade" legislation does not. One way or another - at a point of extreme economic difficulty - this legislation would impose huge new burdens on the economy. And the "Climategate" revelations about the allegedly nefarious methods of global warming scientists have - at the very least - undermined the credibility of the underlying science.

But here's the thing: U.S. President Barack Obama now has an alternative avenue to get carbon controls imposed. He can simply encourage the Environmental Protection Agency (EPA) to impose them. The bureaucratic process will be lengthy, businesses will undoubtedly sue, and court battles will be prolonged.

However, if President Obama serves two terms - thus remaining in control of the EPA -this pathway will allow him to establish carbon controls that are every bit rigorous and contain fewer wasteful loopholes than any legislation he is likely to obtain through Congress.

This is bad news for the U.S. economy: The controls will reduce growth much more than a simple carbon tax, which is the approach to controlling carbon emissions that economists prefer.

There are a number of other possible measures the Democratic congressional majority could pass in its remaining year before a new Congress takes over in January 2011. The two most contentious - each with considerable economic implications - would consist of:

  • The Employee Free Choice Act (EFCA), which would make unionization much easier (by abolishing the requirement for a secret ballot).
  • And immigration legislation, which would provide some kind of amnesty for illegal immigrants, and which, ultimately, could increase the flow of legal immigration.

The EFCA would probably reverse the decline in union membership that has continued since the 1950s. And it would almost certainly increase unionization in the public sector, raising costs.

Immigration amnesty would once again increase the flow of illegal immigrants into the United States, making it easier for the wealthy to get cheap maid service while depressing wages for the U.S. blue-collar work force.

Both pieces of legislation would be strongly opposed, but the Democratic congressional leadership may feel it worthwhile to take the chance, to pay back their supporters in the unions and the Hispanic caucus and, with the immigration measure, probably tip the long-term electoral balance somewhat in the Democrats' favor.

Whether either of these measures is attempted will depend on political developments over the next few months. If healthcare reform and President Obama's fiscal 2011 budget are well received, the Democratic leaders in Congress may conclude the worker and immigrant initiatives are well worth going for.

The Obama administration will proclaim its fiscal rectitude loudly, if only to reassure the bond markets. And it will probably include only modest additional spending items in its 2011 budget, which the administration is supposed to present in February.

Tax increases will occur in 2011 from the expiration of most of the Bush administration tax cuts, so the Obama administration will not propose many additional increases (beyond those in the healthcare bill). Those increases will be left for the fiscal 2012 budget, presented in February 2011. By that time, it will be clear from bond-market activity that the U.S. budget deficit must be attended to.

At that point, tax increases are likely to be substantial.

Handicapping the Elections

Finally, the major political change in 2010 will be the midterm elections in November. It's too early to prognosticate accurately on these. Arithmetically speaking, it is most unlikely that the Republicans will gain the 10 seats needed to recapture the Senate - there are simply not enough vulnerable Democrat-held seats. Besides, the 2010 Senate class was the one elected in 2004 - a good Republican year - so there are few opportunities for gains.

That means that Republican Senate hopes must be focused on the large Democrat classes of 2012 and 2014.

The Republicans should pick up several governorships to add to the Virginia and New Jersey posts that they gained last month. That's because the last gubernatorial cycles - in 2006 and 2008 - were both bad Republican years. As for the House, it is most unlikely that the Republicans will gain the 41 seats they need for control.

The bottom line: It's highly likely that the 2011-2012 House and Senate will each still have Democratic majorities. The majority will shrink a bit in the Senate and by a larger amount in the House.

The Republicans aiming for the White House in 2012 should be glad about this. Their only chance of beating an incumbent President Obama in 2012 is if the economy is rocky and his policies unpopular.

As was the case in 1995-96, Republican control of Congress would make a politically clever president's re-election much more likely - President Obama would undoubtedly find ways to share the blame for whatever went wrong.

However, with a nominal Democrat control in the two houses of Congress, that play wouldn't be an option. That would elevate the odds of an upset win in the 2012 presidential election.

All in all, 2010 is likely to be an eventful political year.

For investors, unfortunately, that will prove to be a most regrettable reality.

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