Expert View, Mark Cliffe: The known unknowns of American regime change

In all the debate about the consequences of the US Democrats' election victory on the markets, the real significance lies in its impact on economic policy.

On the basis of "stick to what you know", market commentators have, as usual, focused narrowly on the economic effects. Many have reacted positively to the Democrats' triumph, suggesting that cohabitation with President Bush will lead to "gridlock", which will prevent either side from pushing through any harmful initiatives on economic policy.

Others argue that this "gridlock is good" thesis is misplaced: it's simply a non-event. Divided government has been the norm, not the exception. The previous Congress had in any case produced little of macro-economic significance, and the markets had at least partly discounted a Democratic victory.

To support their cases, both sides have tried to draw historical parallels. But these don't get us very far, since the change of power in Washington has often coincided with very different economic circumstances.

The usefulness of precedents is even more dubious now. The decisive issue in the elections was, after all, the Iraq war, not the economy. The problem, to use the phrase of Donald Rumsfeld, the Defense Secretary ousted in the wake of the Republicans' defeat, is that the consequences of a new Iraq policy are a "known unknown".

Although the President retains ultimate control of foreign policy, the scale of the Demo- crats' electoral success promises bigger changes on this front than on economic policy. These could well be more important for the financial markets too, since bonds have been benefiting from the geopolitical risk at the expense of stocks due to their "safe haven" status.

The initial signs are that Mr Bush may take a more conciliatory line. The replacement of Mr Rumsfeld with former CIA director Robert Gates may make aggressive military action, not least in Iran, less likely.

The imminent publication of a strategy document by the Iraq Study Group, which is co-chaired by former secretary of state James Baker and of which Mr Gates is a former member, may allow the President to adopt a less hawkish, bipartisan line. Neither the current strategy nor the immediate withdrawal of US and coalition troops are serious options. It is expected that a phased withdrawal and redeployment of troops will be proposed, as will the possibility of direct talks with Iran and Syria, something to which Mr Gates is thought to be more open to.

There is a common assumption that a more conciliatory approach from the US may ease tensions. But Iraq's militias, insurgents and neighbours may have other ideas. Whatever options Mr Bush chooses, the consequences are unpredictable.

The announcement of a phased troop withdrawal will meet one of the insurgents' key demands, but there is clearly no agreement among the Iraqis, let alone their neighbours, over how to govern the country. Meanwhile, the Sunni militants, some of whom have been enraged by Saddam Hussein's death sentence, will not take kindly to US concessions to Iran, the key sponsor of the Shia militias. Moreover, Iran and Syria, previously demonised by Mr Bush, may be emboldened by his obvious weakness. This will make Iraq's neighbours to the south even more nervous.

For the moment, the financial markets seem to be ignoring these "known unknowns", but just because they can't be measured should not detract from their importance.

I claim no particular insight into geopolitics, but it is worth noting how many commentators are hoping for an easing in political tensions. To the extent that this is already factored into the markets' thinking, any resurgence in tensions would be bad news for stocks and good news for bonds.

In any case, events in Iraq are set to have a bigger impact on the markets than any of the fiscal tinkering that is likely to take place over the remaining two years of Mr Bush's presidency.