Dr. Martin Regalia

Although the economy clearly was not the major factor in the November elections, I was nonetheless often asked by the "unbiased" media what Democratic control of the House and Senate would mean for the economy. Not only was that a theoretically difficult question to answer, but it was virtually impossible to answer correctly politically. So in the best traditions of the economics profession, I punted by refusing to deal in the hypothetical. Now with a new year upon us and a new Democratic-controlled Congress, the question is no longer hypothetical. What will the new Congress and divided government mean for the U.S. economy?

While we will have to wait a bit longer to see what proposals actually materialize, much rhetoric has centered on rolling back the tax cuts of the past few years; increasing taxes on corporate America, particularly sectors like oil; and redistributing the proceeds to the lower end of the income distribution. None of these proposals seem pro-growth in my opinion. In any event, it is unlikely that the current administration would sign such proposals even if they could get through the House (a definite possibility) and the Senate (a much more difficult proposition). Therefore, in the near term, it seems more likely that a partisan standoff, or dare I say gridlock, will characterize the political scene in the area of taxes, and this may not necessarily be a bad thing for the economy.

The federal budget is another area where gridlock may actually produce a positive result. The last time we had a political situation similar to today's was in the latter half of the 1990s when the Democrats controlled the administration and the Republicans held Congress. During the period from 1995 through 2000, nominal GDP grew at an average rate of 5.6%, inflation averaged 2.5%, and short-term interest rates averaged 5.3%. The combination of solid economic growth and political gridlock produced federal revenue growth of 8.3% and slowed the growth in federal spending to only 3.4%. The budget deficit plummeted, achieving a surplus in 1998 that lasted through 2001. Could divided government produce similar results this time around? While I am not projecting a rerun of the movement to a balanced budget, the economic and political prospects are eerily similar to the late 1990s.

As in the late 1990s, our economy today is strong, and that means we can expect continued revenue growth. Nominal economic growth over the last two years averaged 6.6%, inflation was 3.0%, and short-term interest rates were 3.1%. Federal revenues grew at a 13.1% average annual rate. And despite the fact that growth in federal spending was a healthy 7.6%, the budget deficit fell from $413 billion in FY 2004 to $248 billion in FY 2006. With the economy expected to grow in nominal terms at a 5.0% average rate over the next two years, inflation projected to run about 2.5%-3.0%, and short-term interest rates to remain relatively steady at about 5.0%, federal revenues should continue to grow nicely. It is easily conceivable, even plausible, that they could average 8.0% growth over the next two years.

Just how big a dent this revenue would put in the deficit depends, of course, on how well federal spending is controlled. Historically, a divided government has had a calming effect on spending growth. However, when one party controls both Congress and the White House, growth in spending traditionally accelerates. To illustrate, let's take a brief look at some of the major spending components in recent years.

Beginning with the mandatory spending side, average growth during the 1990s gridlock was 4.8%, significantly below the over 8.0% average that existed for a decade and a half before the age of gridlock and well below the 6.8% annual average during the last six years. For the sake of this exercise, let's assume that the current situation produces mandatory spending growth of 5.0% annually.

The next spending category is nondefense discretionary spending. The slowdown in the growth of this component during the highly partisan late 1990s was almost as sharp as that for mandatory spending, slowing from more than 5.0% in the decade prior to 1995 to only about 3.5% in the 1995-2000 period before ballooning to more than 8.0% in the last six years. Because this category is the most susceptible to partisan bickering, it would not surprise me to see its growth drop back to near the 3.5% rate that characterized the last period of divided government.

The final category of spending is discretionary defense spending. This category has exhibited the widest fluctuation over the last few decades, growing at more than 6.0% annually prior to the late 1990s before slowing to less than 1.0% during the divided government era and then expanding at almost 11.0% in the last six years as a land war in Afghanistan and Iraq and a worldwide war on terror dominated the political scene. With troops fighting overseas, I would be shocked to see outright cuts in defense. However, the war in Iraq was such a pivotal election issue that it is equally hard for me to envision a Democratic Congress authorizing and appropriating increases in defense expenditures at anywhere near the rate of the last few years. Thus, for the sake of this deficit exercise, let's assume growth in defense at the rate of inflation plus 1.0%.

So what would these revenue and spending assumptions do to the deficit? Revenue would grow to just over $2.8 trillion and spending would come in at around $2.95 trillion, leaving a deficit of about $150 billion or about 1.0% of GDP. This would be a significant reduction from 2.3% in 2006.

Remember, this is an exercise, not a forecast! But when I look for an economic pony in this pile of potential political gridlock, the possibility of deficit reduction is the best I can come up with.