Special Reports / The Most Important Election in the World

Pragmatic Obama and unpredictable Romney

Martin Wolf in conversation with Łukasz Pawłowski · 6 November 2012
Martin Wolf, chief economic correspondent at the Financial Times, on the impact of the presidential election on American economy, disappointment with Obama’s stimulus and irresponsibility of Mitt Romney’s proposals.

Łukasz Pawłowski: What will be the economic consequences of the American presidential election? In what kind of shape will the the American economy be in 2017 under four more years of Barack Obama, or four years of Mitt Romney? 

Martin Wolf: It is an incredibly difficult question to answer, because there are many things we cannot possibly predict. Let’s start, however, with what I think will be happening to the American economy regardless of the election outcome and policy choices that will be made. Even if we leave aside the elections and politics, the economy is still there.

It seems plausible to argue that the majority of the post-crisis adjustment is now completed: there has been a very substantial amount of deleveraging in the financial sector and the household sector; the non-financial corporate sector is in reasonable shape; the monetary policy is very expansionary and will most likely remain so; the budgets of local and state governments have been already slashed enough, which is important because the reduction in fiscal deficits of state and local governments has been a very big drag on economic activity over the last two years. If all that is in place and GDP starts moving at about 3 per cent, then you might see quite a lot of investment. That, in turn, could lead to a virtuous circle and strong cyclical recovery.

What difference does the outcome of the election make? 

There is an immediate challenge, the so-called ‘fiscal cliff’ [1]. I assume that if Romney is elected and the Republicans hold the House of Representatives, they will agree to slash taxes and spending while maintaining all tax breaks. Their only problem will be to get that proposition through the Senate, where they probably won’t have the necessary majority. If Obama is re-elected but the Republicans hold the House of Representatives, then reaching a deal may be even more difficult, because the GOP will not accept any tax increases. Either way there is a serious risk of a great fiscal contraction, which would throw the economy back into recession. 

Despite all the favourable trends you described before?

Yes, because fiscal contraction is about 4 per cent of GDP. It’s so large that it’s very difficult to imagine that it would not put the economy into recession. 

How does it affect Mitt Romney’s promise that as a president he would balance the American budget?

I don’t believe he would. Romney’s fiscal policy would be more expansionary and produce larger deficits. He would cut taxes dramatically and then would not be able to offset those with reductions in tax expenditures, for this is impossible without cutting expenditures which are immensely popular. He also wouldn’t be able to reduce governmental spending as much as he promised. Spending on health care and social security cannot be changed rapidly. Along with debt interest and defence spending – which Romney promised to increase by a trillion dollars – they constitute roughly 72 percent of the US federal budget. The other 28 percent would have to be largely eliminated in order to balance those expenses. 

How would Obama’s policy be different?

If Obama is elected facing the Republican Congress, he won’t get his tax cuts through and he will resist massive spending cuts. Thus, there will not be much change in the fiscal path towards contraction. With Romney, however, fiscal policy might move towards loosening, which will probably have immediate beneficial effects for growth but will worsen the fiscal position in the longer run. During the next four years the economy might do better under Romney, but it is simply because his fiscal policy would be more irresponsible. Obviously, if the Democrats take the House of Representatives and Obama wins the presidency, then we are in a different world. This, however, is rather unlikely. 

To all your reservations about Mitt Romney’s plans, he or his supporters could reply more or less as follows: ‘Our plan is to reduce taxes. That will leave more money in people’s pockets, which in turn will boost both demand – because average people will be able to buy more – and supply, because people with more money will invest it. The economy stimulated by these resources will begin to grow quickly, people will earn more, and as a consequence state revenues will increase, despite lower tax rates’. Why do you think this plan is not going to work?

There are two separate elements in it – the incentive side and the demand side. They are related but they are not quite the same thing so let’s analyse them separately. As to the demand side, it all depends on who benefits from these policies. In this case, more affluent people would benefit from tax breaks, while the poorer would lose their social benefits, which are to be reduced to offset the cost of tax cuts. If you take into account that the marginal propensity to save for rich people is higher than that for poor people, then it is possible that, even if the net impact of Romney’s budget would increase the deficit, the spending reductions by poor people would be larger than the spending increases by rich people. We went through that in the early 2000’s – the Bush tax cuts did stimulate the demand a bit, but they did not do very much. On the incentive side – and it goes a bit against my point about stimulating demand – one of the surprising effects of the Bush tax cuts was how little they did to raise savings, even amongst the rich. 

But that may be precisely because the rich invested that money in the economy.

It’s not true. American investment in the pre-crisis years was financed to a large extent with savings from abroad, not through domestic savings. It’s not clear how much the reduction in taxes for the rich would raise their investible resources. They might as well use this money to buy another yacht, not to invest. A more interesting argument says that lowering taxes will encourage innovation. The crucial innovation comes from entrepreneurs and they are predominantly rewarded not by income but by capital gains. However, capital gains taxes in the United Sates are already at a very low level – only 15 percent. It’s therefore difficult to believe that any further reductions would greatly increase the desire to create new businesses and capital. 

Why then are we so often told that lowering taxes helps the economy?

Let’s be clear, economists don’t really understand growth. We don’t fully understand the links between incentives, innovation, scientific developments etc. and we certainly can’t say for sure what will and what will not deliver better outcomes. Still, there is very little evidence from economic history that lowering the already low marginal tax rates – as the Republicans propose to do – would have significant effects on the economy. I think the link that people like Romney make between taxes and economic performance is gigantically oversold. 

On the other hand, it is often said the Democrats were not particularly successful either. Mitt Romney accuses president Obama of failing to get the American economy out of recession through his stimulus plan. Obama replies that had it not be introduced, the consequences for the economy would have been disastrous, but it is difficult to prove such a counterfactual statement.

This is true of any policy you can possibly imagine – no one actually knows what life would be without it. The stimulus was roughly 5.7 per cent of GDP over 3 years, which makes it about 2 per cent of GDP each year. It was never large enough to give the economy a great kick-start. It slowed the contraction in 2009 and slightly strengthened the recovery. That’s the most it could do. Many Americans hoped for a huge recovery after a huge recession, but the stimulus was too small to meet their expectations. They were disappointed, so they blamed the stimulus. 

During the campaign Romney presented his own 5-point plan to get America out of the crisis. Apart from lowering tax rates and cutting spending, which come under the single point of deficit reduction, another major proposition is to make the United States energy independent. Do you think this would have positive economic consequences?

Every president since Richard Nixon has promised energy independence, so taken at its face value this promise doesn’t mean anything. Energy independence in itself is not important. What is important is the price of energy, and there are some reasons to believe that electricity can become considerably cheaper in the United States than in other developed countries. Recent technological innovations that make it possible to use shale gas resources may dramatically change the energy position of the country. Electricity is generated by gas, and gas is not a very easily tradable commodity. Its prices can therefore be significantly lower in America than in Europe – as is the case now – which could give the American economy a big advantage. These changes, however, have nothing to do with Romney or Obama and can happen under either of them. 

Governor Romney has also put a great emphasis on changing American trade relations by fostering expansion to Latin and South America.

George W. Bush also wanted to create a free trade area in America but he got nowhere. There is no chance whatsoever that the South Americans would sign a free trade agreement with the United States because above all Brazil would not agree to it. And actually I don’t think that the U.S. Congress would agree either, for if there was a free trade agreement with Brazil or Argentina, then it would need to include free trade in agriculture, which in turn would hurt American farmers very badly. 

And what do you think about Mr. Romney’s promise to crack down on Chinese unfair trade practices, so that American and Chinese companies can “play by the same rules”.

I don’t know what Mr. Romney could do about this issue, but the Chinese would undoubtedly rebuff him. He would then find himself in a very difficult position, because he would not be able to impose sanctions on China without facing a fierce opposition from a huge part of American industry. You have to remember that a very large percentage of the exports from China to America that Romney is complaining about come from plants which are either directly owned by American companies or by subcontractors to American companies.   

The condition of American and global economy to a considerable extent depends on financial institutions such as the Federal Reserve, IMF and European Central Bank. What is the dominant frame of mind of these institutions as to how to deal with the crisis, and which of the two candidates will find it easier to cooperate with them? 

With Obama it will be business as usual. He’s a pragmatic centrist and these institutions are run by exactly these kinds of people. He’s not a radical reformer and is therefore predictable. Obama to my mind is a realist with a very few ideological commitments, who does the best he can to handle the problems that confront him. He’s not in the business of changing the world and right now that’s exactly the kind of leader the world desires. Nobody wants to be bothered by America engaged in a crusade to transform the planet. You can say this is a terrible mistake – and many of my American friends think it is – but from the point of view of the world’s leaders it’s convenient. They can deal with this guy. 

And Romney?

Romney is an unknowable and an unpredictable figure. He constantly changes his mind on many issues and we still don’t know who he would choose to work in his administration. One of the people in his team is Robert Zoellick, former President of the World Bank and a Deputy Secretary of State. If Romney chooses people like him, I know that we will see a perfectly sensible, traditional Republican policy. But if he chooses somebody from the so-called neoconservatives, then his policies will be entirely different. The instinct of this side of the Republican Party is aggressive and unilateralist, rather than multilateralist, and were they to shape American foreign and economic policy, they would try to reduce the importance of financial institutions such as the IMF. The truth is, however, we don’t really know Mitt Romney enough to say what his administration will be like. He might choose a group of pragmatic, rational Republicans. 

If you were American, would you then risk a vote for Mitt Romney?

No, I would vote for Obama. I have nothing against Romney as a person – apart from the fact that he has flip-flopped so much – but the party he leads… 

He does not lead it…

…the party he would be the titular head of, is full of people whom I regard as really terrifying in many different respects. If I was an American I would be looking at domestic policy, particularly religion, the cultural wars, equality, quality of public goods, and health care. With that in mind I could not possibly vote for Romney, because I don’t trust the Republicans on these issues. Furthermore, if he had a chance to nominate new, conservative judges to the Supreme Court it would only make matters worse. For that set of reasons it would be very hard for me as an American to support current Republicans. But I’ve not always had this view. Thirty years ago I was quite happy to see Ronald Reagan as president. I changed my mind on it because which policies are best for economy depends on circumstances. Apart from that, the great Republican figures of the 1980’s were completely different than what we see today.

[1] It is a set of problems American economy will face due to a cluster of laws which are scheduled to be automatically introduced on January 1st 2013. These regulations will bring an end to certain tax breaks and simultaneously cut public spending. As a result, they will significantly reduce the deficit but at the same time will probably send the U.S. economy into recession. To avoid this, American authorities must agree upon which cuts to delay and which tax breaks to maintain. Due to the lack of compromise between the Republicans, who hold the majority in the House of Representatives, and the Democrats, no decision has been made so far. What steps will eventually be taken depends not only on the result of the presidential election but also on the congressional elections which are held on the same day. Although most polls predict Barack Obama to win the presidential election, the Democratic Party is highly unlikely to win a majority in the House of Representatives, and in the Senate both parties will probably have a similar number of members.