• Action. The EMU states have resolved surprisingly quickly to implement sweeping, individual rescue plans with uniform guidelines. The focus is on guarantees and capital injections for the banking sector. In the US, the concrete measures as part of the rescue program are now also heading in this direction.

  • Patience. With this concerted action, governments are pledging their full support to the financial system. As a result, the foundation has likely been laid to stabilize the banks. Rapid relief should not, however, be expected, as highlighted by the renewed slump on the equity markets and the still tight situation on the money market (cf. chart).

  • Concerns. Alongside the lack of details and doubts whether the rescue plans will succeed, the heightened growth concerns were primarily responsible for the setback. The latest very weak data from the US point to a recession (page 15). And in the eurozone, the trend reversal on the important labor market has only just begun (page 8).

  • Weakness. The leading indicators continue to point south and suggest a pronounced global economic slowdown. A rapid recovery is out of the question, despite the massive correction in commodity prices. Downside risks also remain high. Hence, the export world champion, Germany, is now also feeling the pinch. The slide into a recession in the third quarter appears virtually certain (page 5).

  • Further topics:

    – US election campaigns: The Government’s comeback (page 2).

    – Data outlook: EMU: Business confidence falls further (page 10).

    – Market outlook: EUR remains under pressure; T-Bills in demand (page 16).


US election economics: It's all about re-regulation

  • Senator Obama enjoys a widening lead over Senator McCain, according to the latest public opinion polls. Wednesday's debate broke no new ground and may have solidified his support.

  • Although the race may tighten over the last few days of the campaign, there is no doubt that the economy and ongoing financial crisis, will stay at the top of the list of issues that voters say is most important.

  • To a startling percentage of voters, inadequate regulation of business and finance is responsible for the nation's economic problems. Other important issues, including taxes, international trade policy, energy, and even the fiscal deficit, have receded as immediate concerns.

  • To financial markets, the message is that the era of deregulation is probably over in the US and that leverage will be more tightly constrained for all types of institutions, with fewer extremes of risk-taking but commensurately lower returns.


US political parties: unruly coalitions

Politics in the United States revolves around the two major political parties, the Democrats and the Republicans. Minor parties exist but infrequently have much influence – and never any success – in national elections. But this does not mean that the two main parties are homogeneous in their philosophies or in policy preferences. Instead, both are essentially made up of broad coalitions that often are at odds with each other. This was vividly demonstrated when the initial Paulson compromise bank rescue legislation was overwhelmingly rejected by fellow Republicans. Hence, what is the make up of these two coalitions?

For the Democrats, there are three major elements: 1. minorities, encompassing racial, ethnic, and social; 2. elites, including academic, Wall Street, Hollywood, main-stream media, and the legal and medical professions; 3. labor unions.

For the Republicans, four main strands are distinguishable: 1. Main Street, especially small business owners; 2. big business, including the top management of the largest corporations and a portion of Wall Street; 3. free-market conservatives; 4. evangelical Christians.

Internal cohesion is hard for either political party to attain in a number of controversial policy areas, including economic and financial policies. (The parties sometimes split among themselves on certain foreign policy and national security issues, notably support for the Iraq war among Democrats, or engagement with adversaries such as Iran or Cuba, among Republicans. But this Research Note focuses only on the economic and financial issues.)

Here are two timely examples: Among Democrats, elites tend to be internationalists and supportive of an open trading system, while unions have been increasingly critical of free trade and are willing to embrace protectionist policies on occasion. Thus, international trade is an uncomfortable policy playing field for Democrats, as demonstrated by the failure of Congress to ratify the free trade agreement with Colombia earlier this year.

For Republicans, the Paulson plan raised even more fundamental problems for its coalition. The Republican Party platform adopted at the Minneapolis convention in early September included the following policy statement: "We do not support government bailouts of private institutions." Barely three weeks later, a huge majority of Republican members of Congress voted against the initial Paulson rescue package, killing the bill and triggering a terrifying sell-off on equity markets. They voted the way they did it because it offended their principles, not because they sought an electoral advantage in the November elections. (Indeed, in the recent LA Times/Bloomberg poll, of which more below, fewer than 15% said that they would vote against a member of Congress who voted in favor of the bill, showing that hardly any were in danger of losing if they voted in favor of the bill.)

On some touchy issues, for example immigration policy, both parties face internal divisions. Among Democrats, minorities and elites favor relatively liberal rules, while union members and other low and middle income workers want tougher law enforcement to keep out illegal immigrants. Among Republicans, McCain has been a leader in sponsoring liberal immigration reform, backed by most business groups and freemarket conservatives. But rank-and-file party members, including most evangelical Christians, are strongly opposed.

What these internal divisions mean in practice is that it is virtually impossible to determine in advance how a newlyelected president will govern, even when his party also enjoys a majority in the Congress. No one would have predicted when George W. Bush was re-elected four years ago that his administration would sponsor the greatest US government direct intrusion in the private sector since the presidency of Franklin D. Roosevelt 75 years ago. The realities of crisis management can trump political ideology, as they have during the past two months.


What the voters think is important

According to this week's LA Times/Bloomberg poll, which is the most comprehensive on economic and financial topics among the major opinion surveys, fully 90% of prospective US voters now believe that the US economy is doing badly. A mere 10% say it is doing well. Just a year ago, about the time McCain and Obama were both launching their presidential candidacies, the replies were the opposite: 70% said the economy was doing well while only 30% answered "doing badly." This unprecedented reversal in perceptions is one result of the worsening housing slump, the collapse of the subprime mortgage sector, and a broadening banking crisis, which has culminated in a stunning stock market crash. As a result, over USD 2 trillion of wealth has vanished from household balance sheets. This has reordered not only public perceptions of the economy but also the relative importance of the key economic policy issues that have formed the backdrop of the presidential campaign. In particular, as shown in the following table, doubts about the adequacy of regulation have climbed to the top of voter concerns. The topic was almost invisible before the chaotic events in financial markets of the past two months. Perhaps just as surprising, the issue of the federal government's growing budget deficit did not make it to the top five list.

What is the most important issue for Senators Obama and McCain to address while campaigning?

Three out of four Americans attribute all or part of the financial crisis to a lack of regulation. This reflects a sea-change from the public's disenchantment with regulation at the beginning of the era, when President Reagan was inaugurated in 1981. Interestingly, Republicans were slightly more likely to mention the issue than either Democrats or Independents.

In general, do you think there is too much, too little, or about the right amount of government regulation of business?

What were the candidates saying about this topic before it burst onto the scene? In the case of the McCain official website and its extensive elaboration of "The McCain Economic Plan", the topic of strengthening regulation of business and finance is not mentioned at all, either to support or to oppose it. As for the Obama campaign, its extensive briefing materials didn't mention it either. Nor did the topic come up in his standard "stump" speech, either. Obama's frequent criticisms of the failure of deregulation only entered his public statements after the dramatic failure of Fannie Mae and Freddie Mac, the even more dramatic bankruptcy of Lehman Brothers that was accepted by the US government, the rescue of AIG, which exposes the US taxpayer to over USD 100 bn of potential losses, and the frantic efforts by the Treasury Secretary and Fed Chairman to gain support for a controversial bailout of the entire financial system. Thus, it was events that thrust the issue into the public's consciousness, not a deliberate effort by one or both of the candidates to highlight the issue in their campaigns.


What the candidates are proposing as the financial crisis flares up again

Proposals to deal with the associated problems of housing, the financial crisis, and the economic downturn have come fast and furious from the candidates as election day approaches. Here are the key elements of their latest plans:

Obama published this past Monday an "economic rescue plan for the middle class." It envisages a USD 60 bn expansion in his previous proposal for up to USD 115 bn in tax cuts to households earning under USD 250k per year. The new measures would include temporary tax credits for firms that create jobs within the US; a 90-day moratorium on foreclosure for debt-burdened homeowners who are making "good faith efforts" to keep up their mortgage payments; temporary suspension of taxes on unemployment benefits; an initiative to lend to state and municipal governments that can't raise funds in the credit markets to fund operations; penalty-free withdrawals of up to USD 10,000 from retirement savings plans to help offset lost income. The emphasis is on aiding low and middle income families and their communities.

McCain followed up with a plan of his own the next day. It also supplements previous proposals, specifically his plan to have the government step in to refinance mortgages on which the current values of the homes are below the outstanding mortgage amounts. That would cost an estimated USD 300 bn that he would fund out of the USD 700 bn already approved by Congress for the Paulson plan. The new proposals include a lower 10% federal tax rate on income from private pensions in 2009 and 2010; an expanded tax deduction for investment losses realized in 2008 and 2009, plus a 50% increase in capital gains allowances; tax-free unemployment benefits for two years (essentially identical to the provision in the Obama plan); and authorization for retirees to postpone mandatory withdrawals from retirement accounts until equity markets improve. The emphasis is on aiding senior citizens, especially those who own substantial amounts of stocks in their taxable portfolios and in taxfavored retirement funds.


What isn't resonating

What is genuinely remarkable is that many of the economic policy issues that have been fixtures in the political debate over recent years – and which dominated the party platforms at this summer's Democratic and Republican conventions – have been barely touched on during the campaign itself. They include: The budget deficit; trade policy; labor laws and rules governing union organizing; education; technology. Even the discussion of energy policy has tended to wane as a decisive issue for voters.

To be sure, healthcare reform remains a critical, even a decisive, issue for millions of voters. McCain and Obama traded charges during the final debate about the adverse consequences of each other's proposals. Experts noted that both candidates distorted what those effects would be. But most voters tend to perceive the topic as a social rather than an economic issue. They see it as having to do with whether access to health insurance should be treated as a right (the Democrats' view) or a privilege (the Republicans' position). Obama himself was forced to admit during the debates that the financial crisis and the burden remedial programs will place on the federal budget will force him to scale back his aspirations for moving fast toward a national health program for all citizens.


A long campaign nears the finish line

In the end, the national elections will largely be a referendum on which candidate and political party is best able to steer the US economy and financial system through one of the most difficult periods in recent history. The average voter intuitively understands, without having to master the technical details, that Treasury Secretary Paulson was right months ago when he unveiled his department's blueprint for regulatory reform: The US system of financial regulation had become dysfunctional, to the point that institutions were permitted to take enormous risks in the pursuit of extraordinary earnings. When market conditions suddenly changed, many firms were caught unprepared for a process of deleveraging that would take an ordinary market correction and turn it into a financial catastrophe, requiring unprecedented government involvement to protect the entire system from potential collapse. "Business as usual" was abandoned, and with it the traditional economic policy debate that both political parties were prepared to engage in, but that the public obviously believes is irrelevant to the crisis at hand. Their choice of navinavigators, whether it will be Obama or less likely McCain, will be made on November 4.