Hamish McRae: Why Kerry lags behind Bush on the crucial issue of market confidence

Other people's elections are always puzzling - why do people get so worked up about such ordinary candidates? - and the US one is no exception. But the razzmatazz of the Democratic convention in Boston should remind us that there is a very real chance of a change of order in the US in four months.

Other people's elections are always puzzling - why do people get so worked up about such ordinary candidates? - and the US one is no exception. But the razzmatazz of the Democratic convention in Boston should remind us that there is a very real chance of a change of order in the US in four months.

The US election differs from all others in that it directly affects us in both political and economic terms. A huge amount has been written about the politics. What about the economics?

There are really two questions. One is what are the odds on a Kerry administration? The other, in what ways might that be different from a Bush one?

There is not much to be said on the first question. I was in Washington last weekend and the wisest comment I heard was that this election will be determined by events that have yet to happen. In other words, something will tip it in the coming weeks but we cannot predict what that might be.

The economy gives no clear signals either way. Don Straszheim, an independent economic consultant, has looked at the economic conditions in the run-up to all presidential elections since 1960, to see what the economic indicators have historically predicted. The best "fit" comes if you take real income growth and job growth six months ahead of the election and compare that with the average. Good economic conditions favour the incumbent; bad ones favour the challenger. Real income growth has given only one wrong signal in 40 years and seven accurate ones. Job growth has given only one wrong signal and eight accurate ones.

But this year there are no clear signals. Both indicators are neutral. So, as Mr Straszheim says: "No amount of political campaign happy-talk by President Bush will put the economy on his side. And no amount of downbeat economic talk by candidate Kerry will give him the economic issue. This year it is terrorism, Iraq and social issues."

So that is out of the way. Let's say it is evens. What might, in economic terms, be different, if there was a change of administration?

There is a conventional view that goes like this. Monetary policy is outside the presidential remit and in any case Alan Greenspan has served under presidents of both parties and would continue to do so. Fiscal policy is heavily influenced by Congress and the eventual make-up of the two houses would be as important as the choice of president: the president proposes but Congress disposes.

Nevertheless there are some differences. Kerry would rescind most of the tax cuts now made permanent by Bush, keeping only the middle-class element of it. So the rich would pay more tax. One the other hand, spending under Kerry, particularly on health, would be higher than under Bush, so the overall impact on the budget deficit would on paper not be very different. In both cases there is a huge problem and neither party has a credible programme for tackling it. Something will have to happen in the next few years but it is not possible to see now quite what that will be.

The graphs give some feeling for the scale of the problem. The top one focuses on the external deficit, showing the way the twin bouts of current account deficit have over two decades turned the world's biggest creditor into the world's biggest debtor. The middle one goes back to 1960 and shows how budget deficits are by no means a new problem. Indeed the push into surplus under President Clinton in 1992-2000 was something of an aberration. The budget deficit may look dreadful but it is no worse than it was during the 1980s.

But don't conclude from this that the external deficit is the key problem and the fiscal deficit is not. The two are linked. Look at the bottom graph, which is really just an expanded version of the middle one, focusing on the second half of the 1980s. During that period the current account deficit closed, moving to surplus in 1991. My contention would be that because the current account was coming under control it became much easier to finance the fiscal deficit. The budget balance (shown here adjusted for the economic cycle) did not matter because other things were coming right. This time around there is no improvement on either score, and that is dangerous.

Markets are driven not just by crude fiscal numbers. They are also driven by expectations, by mood, and by confidence. In the last few months share prices on Wall Street have been pretty weak and one of the effects of the Bush cut in tax on dividends will be to maintain confidence in shares. Kerry would end that - part of his stance that the rich, who do benefit most from dividends, should not have tax cuts directed towards them.

You can see the political logic of this but were he to get in, there might be unforeseen consequences. Confidence in US economic management is pretty fragile - witness the weakness of the dollar. Were Wall Street to tank, expect it to weaken still further. In other words, on paper there may not be much difference between Kerry and Bush but if you allow for swings in confidence a Kerry presidency might be rather less stable.

The graphs come from a study by the economics team at ABN Amro. The view there is that in the medium term a narrowing of the current account deficit will require a weaker dollar, tighter US policy and slower growth. "This," the bank points out, "would have profound implications for Europe and Japan."

Not 'arf, it would. The rest of us would see export demand weakening. Europe and Japan would have to find ways of boosting domestic demand to take up the slack, something that they have not been very good at in recent years. The bank says that if the dollar were to fall sharply, Japan has little opportunity to loosen monetary policy and so would continue to support the dollar by intervening on the exchanges. That would shift the burden to Europe and could potentially derail Europe's recovery.

To some extent the UK is insulated from all this, for we have consumers who are happy to borrow. The latest figures suggest that both consumption and borrowing are still climbing here. But obviously there would be some knock-on effects were the rest of the world to slow sharply next year.

So the significance of the election seems to me to be what it does to confidence. Do US consumers remain confident? Does Wall Street recover some of its nerve or does it tank? Does the US go more protectionist, echoing statements by Kerry and his running mate?

The bottom line is that the US needs to make a big economic adjustment, akin to that of the late 1980s, but it is in all our self-interests that it should do so gently. Question: is it more likely to make that transition gently under Bush or Kerry? There can be no definitive answer, of course, but fairly or unfairly, it would seem that Bush is more likely to carry the confidence of the markets in the months ahead.