The Midterm Elections: No Panacea for the U.S. Economy

[Editor's Note: When it comes to explaining the nexus of business and politics, Money Morning's Martin Hutchinson is unmatched. Months before the actual events, Hutchinson correctly predicted the outcomes - and the investment impact - of the U.S. presidential primaries and the general election. And he recently did the same for Great Britain. Now he turns his attention to the U.S. Congress.]

With many of the primaries past, and the November 2010 midterm elections less than five months away, it is worth taking a look at what policy changes we might expect from the next U.S. Congress. Both the political and economic worlds have changed one hell of a lot since the last elections, in 2008.

Thus, even though U.S. President Barack Obama is slated to remain in office until at least 2013, the Congress elected in November will be very different from the one that was elected in November 2008.

The Early Returns

The results of the primaries have already given us a lot of information about U.S. voter intentions. Voters have already rejected two sitting senators - Arlen Specter, D-PA, and Robert Bennett, R-UT - which suggests a general dislike for incumbents. On the other hand, moderate-Democrat Sen. Blanche Lincoln, D-AR, won her primary handily, defeating an opponent who'd enthusiastically backed the policies of the current Democrat-controlled Congress, the Obama administration, and the unions.

That suggests that the moderate-Democrat policies represented by the 1990s Clinton administration still have appeal with U.S. voters. As an overall entity, however, government is viewed with disdain - or even outright contempt.

For instance, taken together, the stunning January victory of little-known Scott Brown, R-MA, and the current 63% approval in opinion polls for repealing the new national healthcare plan, suggest that the rapid expansion of government attempted by President Obama and the current Congress is very unpopular.

There's other evidence, too. Take the proposed "cap-and-trade" environmental legislation: As drafted, it would give government huge new powers over the economy. The upshot: It's out of favor.

Handicapping the Midterms

All this doesn't mean that the Republicans will sweep the country. For one thing, memories of the inept Bush administration and the corrupt GOP Congress of 2004-2006 remain fairly fresh. Furthermore, while the "tea party" movement has aroused considerable enthusiasm, voters appear to be developing doubts about its radicalism and sometimes "nutty" views.

Thus, the likelihood is for considerable Republican gains - but not outright dominance.

In the U.S. Senate, it's almost impossible when only 17 Democratic Senate seats are up for re-election for the Republicans to go from 41 to 51, thereby giving the GOP the 10 additional seats it needs to get a majority (ties would be broken by Vice President Joe Biden - in favor of the Democrats).

Even if the popular mood favored Republicans strongly, enough of their candidates would have weaknesses that they would lose some apparently winnable races. For example, Sharron Angle, who won the Nevada primary to run against the apparently vulnerable Senate Majority Leader Harry Reid, D-NV, is a "tea-party" candidate whose views and past statements make her vulnerable to attack from the well-funded Reid.

Over in the House of Representatives, removing incumbents in large numbers is similarly quite difficult. The greatest turnover in a midterm election since World War II was 54 seats - which occurred in 1946 and again in 1994.

Thus, excited Republican calculations of a possible swing of 80 to 100 seats are just not realistic. For the Republicans to get the 270 seats that such a turnover would imply might be possible if they already had 210 to 220 seats. It is not realistic from the GOP's starting position of 179 seats (the Democrats have 255 seats, and two are vacant).

A Republican pickup of 39 seats - which would give it a bare majority - is certainly possible, although I place the odds at less than fifty-fifty.

It seems equally unlikely that the GOP will gain less than 25 seats or so. Thus, the 112 th Congress is most likely to be close to evenly divided, but partisan - with fewer "blue dog" moderate Democrats than there are right now, and very few floor-crossing Republicans. Either President Obama will control both chambers of Congress, albeit with small majorities, or Congress will be split, with a Republican House and a Democratic Senate, again with small majorities.

A Look at What To Expect

With President Obama remaining in office, the Republican "wish list" will not pass. But the Democrat wish list will also be in trouble. The U.S. budgetary position will be dire, so large new spending programs will be impossible. Taxes will increase, beyond the reversal of most of the 2001 tax cuts. However, whatever the Deficit Commission reports in December, it's very unlikely that the huge revenue-raising device of a value-added tax (VAT) will be granted to a Democrat president by a Congress where Republicans are strong.

However, it is possible that the two sides will compromise on a moderate carbon tax, which would have the dual virtues of combating global warming and raising revenue. To force the Republicans to agree to this, President Obama will be able to use the threat of EPA regulation of carbon emissions.

The recent healthcare legislation will remain in force, coming into effect on schedule, although very likely subject to partisan fights. The big battle here will arise in 2013, as the legislation's major changes take effect in 2014.

Since 2007, it has been impossible to get trade agreements through Congress; this will not change, so the Colombia and South Korea Free Trade Agreements will remain in limbo. Other protectionist actions are likely - in moderation.

The banking legislation passed this year will not be significantly amended, but there will be a massive partisan battle over what to do with Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE). These housing finance behemoths are each continuing to absorb about $100 billion in taxpayer money every year, and no significant reform has been attempted by the current Democrat-led Congress.

The Bottom Line for Investors

If anything, this discussion underscores that the U.S. budget deficit will remain intractable - with an annual shortfall in excess of $1 trillion that will refuse to budge, unless the U.S. economic recovery really takes off. And that's not likely to happen.

The massive financing needs of the federal government will "crowd out" the private sector in the bank and bond markets, so small business investment will be low, unemployment will remain high and economic growth limited.

Equally, the chance of an economic crisis will probably be lower than with the current Congress. Policies will be moderate and a consensus between the President, Congress and the Bernanke Fed will agree to postpone problems until after the 2012 Presidential election. Interest rates will remain low, resulting in rising inflation.

It's not a very pretty picture, but it involves less structural change in the U.S. economy than if the current Congress had been re-elected. There will be no "new" New Deal - a program that would result in additional sharp increases in government involvement in the economy.

For investors, the best haven is probably gold - and emerging market stocks.

[Editor's Note: Money Morning readers are often amazed by Martin Hutchinson's profit-focused instincts - as evidenced by his unerring ability to paint a picture of what's to come. He's able to show us the big profit opportunities that are still over the horizon - while also warning us about the potentially ruinous pitfalls hidden just around the corner.

So it's no surprise that Hutchinson has pulled off a string of forecasting successes in the face of the worst financial crisis since the Great Depression - a financial crisis that, not surprisingly, Hutchinson is widely credited for having predicted and warned about well ahead of time.

With his "Alpha Bulldog" investing strategy - the crux of his Permanent Wealth Investor advisory service - Hutchinson has managed to combine dividends, gold and growth into a winning, but low-risk formula that has generated some eye-popping returns for subscribers.

To take a moment to find out more about the opportunities related to dividends, gold, "Alpha-Bulldog" stocks and The Permanent Wealth Investor, please click here.

You'll find the time well spent.]

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