The polls are in our favor: they all say the electorate is sick of war, the country's general direction and Republicans in general.  The Lamont campaign scared the GOP establishment to death because it demonstrated a clearly an anti-incumbent mood.  However, assuming everything goes well and the Democrats win a majority in the House and Senate, it will be a short-lived victory.  Within 6 months of attaining majority status, the Democrats will have an economy is shambles thanks to 6 years of Republican mismanagement.  

A Crippled Federal Government

Increased government spending is the standard method of ameliorating an economic downturn.  However, the Republicans have seriously hampered this ability.  Although they are claiming they will halve the deficit by 2009, total debt issuance from the Bureau of Public Debt tells a far different story:

In 2002, the total deficit was $157 billion.  Yet total debt outstanding increased from $5.807 trillion to $6.228 trillion, or $421 billion.

In 2003, the total deficit was $377 billion, yet total debt outstanding increased from $6.228 trillion to $6.783 trillion, or $555 billion.

In 2004, the total deficit was $412 billion, yet total debt outstanding increased from $6.783 trillion to $7.379 trillion, or $596 billion.

In 2005, the total deficit was $318 billion, yet total debt outstanding increased from $7.379 trillion to $7.932 trillion or $553 billion.

The US has already issued $568 billion in new debt for fiscal 2006.

In other words, the amount of debt the US Treasury is issuing indicates THE DEFICIT IS NOT UNDER CONTROL IN ANY MEANINGFUL WAY.

Suppose a Democratic majority in the House wants to increase federal domestic spending to either stimulate the economy or mitigate the negative impact of an economic downturn.  There isn't any money to do this.    The debt/GDP ratio has increased from the upper 50s percent range to the lower 60's over the last 5 years.  Currently international interest rate arbitrage is the only major factor preventing the currency traders from selling dollars because of fiscal mismanagement.  However, the Federal Reserve is near the end of its interest rate increases while other central banks are increasing their respective rates (although the jury is still out on Japan's current policy direction).  These two factors - the US halting its interest rate increases plus other countries increasing their interest rates - will make the dollar vulnerable.  An increase in deficit spending will increase the possibility of a dollar sell-off because currency traders will wonder if the US will ever get its fiscal house in order.  A dollar sell-off will increase inflationary import pressures, forcing the Federal Reserve to raise interest rates to protect the dollar.  Increasing interest rates will slow the economy at a time while it needs economic stimulus.

Increasing the dollars vulnerability is the composition of international purchases of US Treasury debt.  Over the last few years, foreign individuals are responsible for the bulk of US Treasury purchases; foreign official institutions (such as central banks) have backed away from the US Treasury market.  Foreign central banks are less prone to sell assets in bulk; they are more likely to by "buy and hold" investors.  Not so with individuals.  If the investment isn't returning a certain amount each year, individuals will seek higher return elsewhere.  Considering China, India and Russia are all growing faster than the US and have a far better international account position, moving assets to these countries is a strong possibility.  In addition, all three of these countries will probably be willing to cut very beneficial deals for new foreign inflows.  In short, an increase in deficit spending may spook foreign private money away from the US market, sending US market-based interest rates higher, adding to downward economic pressure.

A Consumer Under Water

Consumer spending is responsible for 70% of US GDP growth.  However, the US consumer is in poor financial shape.  Inflation-adjusted non-supervisory wages have dropped for the duration of this expansion, dropping even after the economy hit "full employment" in December of 2005.  From the fourth quarter of 2001 to the first quarter of 2006, consumer debt as a percentage of GDP increased from 74% to 91%.  Establishment job growth is the weakest of the last 40 years, growing at a compound annual growth rate of .71%.  This means consumers can't find higher pay by switching jobs.  Finally, the negative US savings rate means people are not prepared for an economic slowdown.

In short, the US consumer has declining pay, high debt levels, poor job prospects and no savings.  An economic slowdown could place the consumer into an incredibly defensive position forcing him to withdraw from consumer purchases in a large way.  In other words, consumer spending based economic stimulus isn't a strong possibility.

A Business Sector Riding Out the Storm

The Business sector is the only economic area with strong financial fundamentals.  Their earnings have increased for the last 10+ quarters.  Their savings have increased.  They have cleaned up their respective balance sheets over the last few years paying down debt with their increased profits or refinancing their debt at lower rates.  In short, they are doing very well.

However, a slowing economy provides little incentive for increased investment, especially when other countries (India, China and Russia) have more attractive growth profiles.  Business owners are bright people; they see shaky US economic fundamentals and have decided to establish a war chest to help them ride out the coming problems.  They have no reason to invent in an economy during a downturn or recession, especially when other countries provide a far better rate of return.  So, don't count on a big boost from business spending.

International Capital Financing the US

In a recent newsletter, Nouriel Roubini sums up why this is unlikely to happen:

This year, instead, the structural gravitational forces pushing down the dollar are aligned with the cyclical factors that are now turning against the dollar: the Fed will soon pause and then ease while ECB and BoJ have just started to tighten; US growth is slowing down while - so far - Eurozone and Japanese growth are recovering; the HIA has expired; the US administration is in serious domestic and foreign affairs trouble and looks more lame duck by the day; US equities and housing are slumping. This is why the dollar started to fall in the spring as the reality of cyclical factors turning against the dollar started to sink in. But during the global market turmoil of May-June the dollar temporarily recovered because of transitory factors: Bernanke was flip-flopping by signaling that the Fed was not done yet, while the BoJ kept on postponing the timing of its phase-out of ZIRP; and panicky and risk-averse global investors rushing out of emerging markets sought the relative safety of US Treasuries.

There is nothing to add to his analysis, except to agree 100% with its conclusion.

 

In summation, it is imperative for Democrats to understand that if they return to power, they will be doing so at an economically disadvantageous time.  Most of their new found mandate will probably be invested in either stopping the pain caused by 5 years of Republican economic incompetence or undoing the damage caused by Republican policies.  The Democrats will have many difficult and politically unsavory decisions.  It will not be a return to power to enact a far-reaching agenda; instead, it will be an extremely difficult time to accomplish anything.