Hamish McRae: Midterm defeats for Democrats could spell out economic recovery for Obama

Washington DC – Maybe gridlock will be good for the economy. The midterm elections on Tuesday seem likely to deliver a Republican majority in the House of Representatives and maybe even a majority in the Senate. Either way President Obama will be gravely wounded and the results will be painted as a disaster for the Democrats – as indeed they will be.

The reason for the hostility is largely the state of the economy, with unemployment stuck at 9.6 per cent, consumers fearful, house prices stagnant and growth only creeping forward. It is monstrously unfair because the President inherited the recession and, more particularly, the legacy of an economy puffed-up by excessive borrowing. And the economy has turned round and jobs are – slowly – being created. But given the unrealistic expectations he generated, the disappointment is at least understandable. Who thinks politics are supposed to be fair?

Come to why gridlock might be good in a moment. First, two snapshots of this unfairness.

One was the mass rally on the Mall on Saturday. This was the turn of the "liberals" to show support for the Democrats, or at least sympathy for their general direction. It was organised by two political comedy chat show hosts (a breed we do not yet have in the UK), Jon Stewart and Stephen Colbert and was called the "Rally to Restore Sanity and/or Fear". Something close to a quarter of a million people showed up to listen to Stewart's plea for more civility in politics – the stated reason for the rally – but maybe were more interested in being entertained by the likes of Ozzy Osbourne and Sheryl Crow. But – and this is the key point – while the purpose of the rally was supposedly to restore balance, it did not feel like that at all.

Walking in the crowds it all seemed to me to be cheerful and good-natured, but to judge by most the banners it was the left griping that Obama was not left enough. With friends like these ...

The other snapshot is a television advert which, if you are interested, you can pull up on YouTube. It purports to show a Chinese professor lecturing students in 2030 about the decline of America: how like other powers – the Greeks, the Romans and the British – the country had turned its back on the values that made it great. The aim is to attack the high borrowing and spending of Obama's economic stimulus. The professor explains that the money was borrowed from China and the punchline, to the amusement of the students, is "so now they work for us".

Clever, but totally unfair. The main policy error was the borrowing from China in the boom years under the previous administration, not the stimulus now. You can quarrel with the scale and design of the stimulus and it is attacked on both sides for being too big or too small. But the problem was entirely inherited.

You can see the sequence in the graphs. The recession bottomed out just as he was elected and ended in the middle of last year. Since then growth has been scruffy but no more so than after the dip in 2001. The latest figures, showing growth at an annual rate of 2 per cent for the third quarter, are disappointing but not dreadful. What is dreadful is the mood of consumers, as you can see in the other graph. Confidence has recovered a little but is still as low as it was at the bottom of the early 1990s recession.

So what happens next and why might political gridlock in Washington turn out be a good thing for the economy?

As far as the "what next?" question goes the conventional view is probably the right one. This view is that there will be a muted and uneven recovery, with the dangers of a double dip back into recession receding. The stimulus from public spending will fade and the private sector will have to take over the responsibility for boosting demand. The good news is that this is beginning to happen. Consumers will be in no shape to ramp up their spending but that may be no bad thing. At least they are still saving something – and the savings rate is still over 5 per cent.

What is really encouraging, though, is that business is increasing investment. Those latest third-quarter figures show investment running up at an annualised 10 per cent, with hi-tech investment particularly strong. That must be good for productivity, and profits, in the future. Indeed, companies in general are actually very profitable by past standards. As Ian Harwood at Evolution Securities points out in a recent note, US GDP is now only 0.8 per cent below its previous peak in the fourth quarter of 2007. And just as important, many of the imbalances then – the housing bubble, high consumer borrowing, heavy company debts – have now been corrected.

There is however one imbalance that has not been corrected: the Federal deficit. The cacophony of advice being given by some economists to the President that he has to borrow yet more may sound a bit rum to anyone from the UK, where the government deficit is being tackled. Of course the US, with the dollar as the principal reserve currency, has options that European nations do not have. But even the US has borrowing limits, as anyone who recalls the collapse of the dollar and the surge in interest rates in the early 1980s will know. That is not to criticise the new bout of quantitative easing that the Federal Reserve is expected to launch this week, for it does make sense to keep that project going. Rather it is to point out that even the US cannot borrow indefinitely from the rest of the world, nor is it in its self-interest to do so.

That is why it is so interesting to hear the President say that having turned round the economy the next big task is to tackle the deficit. He is making the same point, though in a totally different way, as the people who made the Chinese professor film.

And finally to the case for thinking that gridlock may not be too bad. The RBC capital markets group recently pointed out that in the past having a President and a Congress from opposing parties tended to be good both for the economy and for financial markets. It will be a world where Washington will step back a bit from economic intervention but one that no longer needs it to be so closely involved. It will be a world where the economy is, so to speak, on its own but supported by a positive monetary policy. And it will be one where the deficit is tackled because there is no alternative but to do so.