The Georgia Bifurcation

By Philip Marey of Rabobank

Summary

• If the Democrats win both run-off elections in Georgia this would open the door to a large fiscal stimulus package and more expansive fiscal policy in the coming years. Part of this will likely be financed by higher taxes somewhere down the road. However, it would take only one centrist Democratic senator to derail the more ambitious plans of the left. Nevertheless, with more room for fiscal policy, there will be less pressure on the Fed to increase its asset purchases or extend their maturity. However, there may be more pressure on the Fed to use its special lending facilities to support local governments. In fact, a Democratic majority may push for a more socially activist Fed.

• If the Republicans win at least one of the two run-off elections in Georgia, the Senate Republicans are likely to block further fiscal stimulus, and the Democrats can forget about the spending spree they have in mind after Biden takes office. Consequently, there will be more pressure on the Fed to provide monetary stimulus during the course of 2021 if the economic recovery falters. Since the Fed does not want to take policy rates into negative territory, this would mean more asset purchases or extending their maturity. However, there will be less pressure on the Fed to use its special lending facilities to support local governments or to become more socially activist.

Introduction

Although Election Day was November 3, the January 5 Georgia Senate run-off elections may be equally important to the US political landscape in the coming years. President-Elect Biden has ambitious plans for expansive fiscal policy in the coming years. He wants to boost the economy by increasing government spending on education, R&D and infrastructure. The Democrats also want more fiscal stimulus in the near-term as Covid-19 relief. However, these plans will be difficult to carry out without a majority in both the House of Representatives and the Senate. While the Democrats kept their majority in the House – albeit reduced –, they have yet to gain control of the Senate. Therefore, the Georgia run-off election is a bifurcation point that will lead to one of two regimes: either a Biden administration supported by Congress (‘Democratic Control’) or a Biden administration reined in by a Republican Senate (‘Divided Government’). These two regimes do not only differ in their political dynamics and outcomes for fiscal policy, but they also have different implications for monetary policy.

Democratic majority in the Senate

If the Democrats win both run-off elections in Georgia, the Republicans would have 50 seats in the US Senate. Since the two independents, Bernie Sanders (Vermont) and Angus King (Maine), caucus with the Democrats, this would give the Democrats effectively 50 seats as well. In this case, the next Vice President would be the tie-breaker. Assuming that Biden will be inaugurated on January 20, the Democrats will then have the upper hand in the Senate through Vice President Harris. This would open the door to a large fiscal stimulus package and more expansive fiscal policy in the coming years. Part of this will likely be financed by higher taxes somewhere down the road. However, the more left-leaning Democratic plans are likely to meet with resistance from centrist Democratic senators. In a 50-50 Senate, one dissident Democrat can block his own party. Therefore, we should not expect the whole Democratic agenda to become reality. However, there will be more scope for fiscal policy than in a Senate with a Republican majority. Consequently, there will be less pressure on the Fed to increase its asset purchases or extend their maturity.

However, there may be more pressure on the Fed to use its special lending facilities to support local governments. As we explained in Billions, Republicans had earlier indicated they were worried that the Municipal Lending Facility and the Main Street Lending Program could be used by the Democrats to bypass Congress if Republicans were to block additional fiscal stimulus, in particular for blue states. Therefore, Republican Senator Toomey attempted to insert a measure in the recent Covid-19 relief bill that would prevent the Fed from reviving the special lending facilities that Treasury Secretary Mnuchin requested to be closed down. The compromise that was reached is the Fed will not be allowed to launch identical special lending programs without congressional approval. The compromise deleted language from Toomey’s proposal banning ‘similar’ programs from being launched without congressional approval. However, Democratic Representative Maxine Waters has already said that if the Democrats win both run-off elections in Georgia, Congress should rewrite this language and give the Fed more discretion. In practice, this would mean that the Democrats would want the Fed to use its special lending facilities to support local governments.

In fact, why stop there? A Democratic majority may push for a more socially activist Fed more generally. Nevertheless, the 50-50 ‘majority’ (with the Vice President as a tie breaker), may not be sufficient to push through the most extravagant demands from the left. At some point, centrist Democratic senators like Manchin are likely to defect. And it only takes one dissident Democratic senator to derail the plans of the left.

Republican majority in the Senate

In contrast, if the Republicans manage to hold on to at least one of these two Georgia seats, they will keep their majority1 in the Senate (either 51-49 or 52-48). In this case, the Senate Republicans are likely to shoot down the ambitious spending plans of the Democrats. This means that we should not expect major fiscal policy measures, at least until the 2022 midterms. Only in case of major economic downturns are we then going to see the two parties come together and repeat the joint effort that we saw with the CARES Act. The negotiations on the recent Covid-19 relief bill could be indicative of what we can expect in the next two years. As we explained in Billions, the size of the final package – and its funding – suggested that the Republicans won the negotiations.

If further fiscal policy measures remain absent or insufficient, it would be up to the Fed to provide monetary stimulus during the course of 2021 if the economic recovery falters. This comes at a time when the central bank’s arsenal is almost depleted. The FOMC has already cut the target range for the federal funds rate to the zero bound, promised to keep it there through at least 2023 and announced a strategy of average inflation targeting that would keep rates at zero long enough to make up for past undershoots of the inflation target. And the Fed does not want to take its policy rate into negative territory. This means that options are limited. The easiest option is to make adjustments to the Fed’s asset purchases. A more difficult option is yield curve control, which would still require a lengthy debate in the FOMC. Given the low levels of rates, the impact may also be limited. However, this can also be said about asset purchases. The reality is that the Fed is near the end of the road. This comes at a time that the economic data show a loss of momentum. Despite the improving outlook for Covid-19 vaccines the virus is resurging and we still have to bridge the period until vaccination has been rolled out.

While a Republican Senate would indirectly put more pressure on monetary policy to support the economy, there would be less pressure on the Fed to use its special lending facilities to prop up local governments. Ironically, in this regime the Democrats would need this bypass the most, but they have the least chance of overturning the compromise made in the recent Covd-19 relief bill. However, this compromise will not prevent the Fed from starting similar programs, with the approval from the Treasury Secretary, which will be a Democrat (Janet Yellen if approved by the Senate), This will be a key topic in the upcoming confirmation hearings.

Probabilities

Georgia’s emergence as a battleground state is the result of immigration from the North and abroad that has boosted the progressive vote. This is also reflected in the two Democratic candidates, with Warnock considered more progressive than Ossoff. In contrast, Perdue and Loeffler are Trumpists. We showed that after the Georgia bifurcation point we enter one of two regimes that will be very different in political dynamics, fiscal policy outcomes and pressure on the various Fed policies. If we look at recent polls the probabilities of the two regimes are close to fifty-fifty, although there appears to be a slight advantage for both Democratic candidates.

We should note that opinion polling at the state level tends to be more challenging than national polling. What’s more, the rapid demographic changes in Georgia – which made it a battleground state in the first place – make it even more difficult to calibrate the statistical methods. So the actual outcome may be very close and this also means that it could take some time before we know the final results. What’s more, they are likely to be contested.