Terra Firma

When we think of large-scale state intervention in a domestic economy, it’s usually China, Russia, India or some other emerging market that we have in mind.

Historically, these are the states in which political considerations often trump economic fundamentals as a driver of market performance. Yet, the still-unfolding global financial crisis has invited rich-world policymakers to inject politics into economic decision-making on a scale we haven’t seen in decades.

All over the world, lawmakers and state officials are haggling over the details of stimulus packages filled with subsidies, protections and large-scale public investments meant to revive commerce, consumption and production. They’re also preparing to rewrite the rules that govern international financial flows. This will generate substantial risk this year because whether the governments they serve are democratic, authoritarian or some mix of the two, most political leaders and legislators make policy choices that are meant to satisfy the demands of their constituents, clients and patrons – not the needs of the global economy.

Given the importance of the economy for global trade and investment flows, the eye of this financial storm is centred in Washington, where lawmakers are now injecting political calculation into decisions on which companies and financial institutions must have a seat in the lifeboat, which should be left to drown and how to spend hundreds of billions of dollars to refloat the entire economy.

The risk is that all these politicians are going to over-regulate, creating obstacles to the free flow of capital that will weigh on foreign investment and global growth for years to come.

Newly Assertive Lawmakers

Lawmakers have complained in recent years that Congress ceded too much of its authority to the executive branch during the Bush presidency. Members of both parties want those powers back. Republicans are not the only ones who will fight the Obama White House for control of the policy agenda. A Democratic leadership, sensitive to charges of inaction over the past two years, is ready with plenty of ideas about how taxpayer dollars can and should be used to stimulate the US economy.

Start with the stimulus. Weeks before his inauguration, Barack Obama began calling for an ambitious spending package meant to jumpstart the economy and create jobs. Given the need for quick action, the new President’s team provided a broad outline for the deal and left the details to Congress. When, for example, Obama ally Senator John Kerry (D-MA) targeted the new President’s signature $3,000 job creation tax credit and called for its removal from the final package, Obama offered little resistance.

The White House could afford a hands-off approach on the stimulus package because there are many different ways to spur economic activity through public spending. Stimulating the economy is the policy equivalent of a doctor pounding a patient’s chest to restore his heartbeat. Rewriting the rules and regulations that govern financial flows is a much more delicate process – the equivalent of microsurgery. If the details are subject to large-scale political horse-trading, the result will likely be ineffective in creating the proper balance between the free flow of capital and the need for responsible oversight. It is the details that will determine whether and when confidence is restored to financial institutions. This is where arguments between the legislative and executive branches are likely to generate real friction – and risks for markets and investors.

The White House can move swiftly with solutions. At the height of last year’s financial crisis, then-Treasury Secretary Henry Paulson went to Congress with a three-page memo asking for broad authority to spend up to $700 billion to stabilise the financial sector. That memo was developed quickly and had solid executive branch support. Yet, even as markets plunged into turmoil, the package fell victim to congressional politics, delaying its passage while few significant changes were made.

The current received wisdom is that the first half of the so-called Troubled Assets Relief Programme (TARP) was spent irresponsibly and that monitoring of its implementation was lax. As a result, Congress will face intense public pressure to take greater responsibility for how the next round of funds is tracked and spent. The White House got much of what it wanted from the battle that led to the release of the second half of these funds, but Obama suffered a symbolic ‘no’ vote in the House and a narrow win in the Senate before the remaining $350 billion could be tapped.

Political Horse-Trading Undermines Policy Effectiveness Even if the Obama team could design a quick and efficient comprehensive solution to the problem of how best to manage toxic bank assets, one that drew universal praise from the financial and economic communities, it might well cost as much as $4 trillion, according to Senator Charles Schumer (D-NY). The White House would be fortunate to persuade Congress to authorise even a small fraction of that amount without accepting the sorts of compromises and add-ons that can undermine the effectiveness of legislative remedies.

Members of both houses and both parties will have their say in what is certain to be a politically-charged debate over whether each competing version of the financial reform plan properly balances the needs of Wall Street with those of taxpayers, whether Congress will have the oversight powers it wants and whether the government has a credible exit strategy from the assets it acquires once economic conditions have normalised. All these questions will spark intensive public and behind-the-scenes negotiations among legislators and political bureaucrats. A mix of good faith debate, multilateral bargaining and political posturing will influence the construction of key aspects of the proposal, as haggling over details delays passage of a final bill. Consider how much more contentious all these processes will prove if, as is virtually certain, the White House proposal does not win the universal acclaim described above.

The global economic slowdown and liquidity crunch have exposed the need for a new financial regulatory framework. But the crisis that has added a sense of urgency to these changes has also generated a surge of populist policy proposals which suggest that the new rules will err on the side of protecting consumers at the expense of producers. That choice will create risks of a spike in regulatory and transaction costs, as well as restrictions on certain types of products and investments. Congress over-regulated in 2002 by responding to the Enron crisis with the Sarbanes-Oxley Act. Given the apparent severity of the global financial slowdown, another such overreach will likely have more far-reaching consequences.

Trade Flows Are Also At Risk The risks extend to trade. President Obama is not a protectionist. The pro-trade credentials of those he has tapped for senior economic advisory positions speak louder and more clearly than his campaign rhetoric. But whatever the inclinations of the White House, hopes that Congress will restore leadership on the liberalisation of global trade may soon be dashed.

Consider the ‘Buy American’ provision proposed by Representative Peter Visclosky (D-IN) that emerged with unanimous support from the committee that produced the House version of the stimulus package. Under the plan, iron and steel producers would have preferences in all stimulus-funded infrastructure projects. The Senate version of the bill includes a more sweeping proposal.

Senator Byron Dorgan (D-ND) reportedly argues that all material and equipment used in infrastructure projects funded by the package should be made in America. Both versions of the bill include a waiver for any project in which buying American-made products increased costs by at least 25 per cent.

As at the time of writing, President Obama has not moved to eliminate the ‘Buy American’ proposal, despite widespread condemnation from the business community and trading partners like the European Union and Canada – which sell 40 per cent of their steel to buyers. Advocates of the plan argue that laws favouring the use of steel in federally-funded transportation projects have been on the books for more than a quarter of a century – without producing a trade war. But the current international climate leaves foreign governments more vulnerable to risks of a slowdown in trade volumes – and more susceptible to protectionist pressures from within their own countries.

Lawmakers who support the ‘Buy American’ provision know it will provide them with political capital – even if the provision is crafted with enough loopholes to make it virtually inoperable. But they are providing cover for other governments to enact similar protectionist proposals of their own, creating new risks for American companies doing business abroad. The plan would also substantially raise the cost of certain goods and services for American consumers.

Ultimately, careful wording of the package will ensure that ‘Buy American’ has limited market impact on trading partners – though that won’t necessarily prevent trade tensions. It could even be scrapped altogether. But there are plenty of other economic issues on which lawmakers could force Obama into a political corner – on enforcement of trade rules, China’s currency valuation or distortive subsidies for industry.

The Congress has taken on problems of exceptional importance for the global economy at a moment when governments around the world are searching for consensus on how best to craft new rules of the road for trade, investment and financial flows. A growing number of critics argue that the global slowdown began in America before metastasising across the planet. The risk is that new restrictions on trade and financial flows will follow much the same path. That’s why politics will drive market outcomes more directly (and less efficiently) in 2009 than in any year since the end of World War II.