With the presidential campaign now at high pitch, and most of the vitriol focused on the turmoil in Iraq and safety at home, there hasn’t been much focus lately on what the candidates’ policies might portend for the U.S. economy. And, even though President Bush and Senator Kerry would have you believe otherwise, the impact of their different approaches on the course of the economy is easily overstated. In our near $12 trillion economy, few fundamental trends are likely to change quickly. Still, we think several observations can be made that might help shed light on what is to come under each candidate and what it might mean for the financial markets.

Foremost, perhaps surprisingly, there is not much difference between the positions of Senator Kerry and President Bush at the aggregate level of fiscal policy. Both have set a goal of halving today’s massive federal deficit in five years. The President, however, pins much of his forecast for economic growth on the tax cuts already adopted, his proposal to make those cuts permanent, and his intent to hold down increases in federal spending. Kerry’s plan allows for considerably more government spending, especially on health care. He would offset these increases with a tax hike on high income households.

Some skepticism, of course, is required in assessing these forecasts. The candidates are naturally inclined to underestimate the costs of programs they propose, overestimate economic growth, and characterize their tax policy in the most favorable light. What outcomes are more plausible than the crystal balls used by the Kerry and Bush teams?

Neither candidate is likely to be as successful as promised in addressing the budget deficit. True, as the economy continues its recovery from the recent recession, progress will be made in the short run regardless of who resides at 1600 Pennsylvania Avenue. However, neither candidate has proposed a realistic strategy for addressing the giant deficits that will emerge in the long term due to our aging population and the ballooning costs of social security and healthcare. Indeed, the President’s plan to partially privatize social security would add hundreds of billions to the national debt over the next fifteen years. Senator Kerry has been mostly silent on these issues except to say that we must spend more to care for our elderly.

Judging from past experience and the statements of some of the advisors he relies on, we anticipate that the President, believing that lower taxes are the surest way to stimulate the economy, will be more willing than Senator Kerry to tolerate large deficits in the short run. Kerry, relying on the advice of Robert Rubin, Clinton’s Treasury Secretary, emphasizes that the deficit is intolerable and a major hindrance to growth. He has stated that he will delay or reduce spending initiatives if the deficit widens. We may suppose that he would also be ready to raise taxes further than he has currently proposed to achieve greater fiscal balance.

What can the experience of past administrations suggest about the likely impact of such disparate policies? From the point of view of spending and taxation, the Reagan years may be a guide to a Bush economy over the next four years; Clinton’s presidency provides some insight into a Kerry economy. Surely, either candidate would be pleased to achieve the economic growth, well over 3 percent in real terms, that their predecessors experienced. And, happily, it is our judgment that the economy will in fact grow briskly in the next few years. Beneath the aggregate numbers, however, the character of growth proved very different for the country under Reagan than under Clinton. The comparisons are revealing.

Reagan inherited a moderate deficit of 2.7 percent of GDP and an economy in recession. His policies, not unlike those of President Bush, kept government spending rising as he cut taxes. Federal tax receipts declined from 19 percent of GDP to 17 percent as the deficit widened to 6 percent of GDP in his first term. However, as the economy grew the deficit narrowed to 3.1 percent of GDP by the time Reagan left office. In contrast, Clinton, who fortuitously was inaugurated just as the economy was emerging from recession, but who not so fortuitously inherited a large deficit, held spending growth below the pace of economic growth (often with the help of a tight fisted Republican controlled Congress). Federal spending as a percent of GDP declined from 22 percent to 18 percent during his presidency. Taxes, on the other hand, rose substantially. Clinton thus left office with a rare budget surplus.

Importantly, the distribution of income in the U.S. changed markedly under both the Reagan and Clinton administrations. With marginal tax rates sharply reduced under Reagan, most of the benefits of the strong economy went to the highest income groups. In fact, households in the bottom two-fifths of income distribution actually saw their real (inflation adjusted) after tax incomes decline slightly. In contrast, households in the top fifth experienced substantial gains. Under Clinton, income distribution also widened as many of those in the top groups benefited not only from a strong economy but from a strong stock market as well. But during the Clinton years lower income households also experienced the benefits of an expanding economy. In other words, the rich got richer but the poor and middle income groups got richer too.

What does this mean for the next four years? Though it is naive to assume that either history or the candidates’ election season pronouncements will be a good guide, taken together they help us draw a picture of alternate futures. To put it simply, we have before us a choice between two classic approaches to fiscal policy, Kerry’s tax and spend versus Bush’s spend and borrow ideologies. We sum up our forecast this way: With Bush the economy would grow relatively rapidly but the deficit would shrink slowly as the growth in spending is barely controlled and tax cuts are continued. Most of the benefits would fall where most of the tax cuts do, with those at the top end of income distribution. A Kerry administration would preside over similar growth but a more rapidly declining deficit and more evenly dispersed progress across the range of U.S. household incomes.

Social and economic justice issues aside, an ever increasing disparity between the incomes of the rich and everyone else is a cause for concern for the long term health of the economy. America as a whole benefits with increased prosperity in low and middle income households because proportionately more of their income is spent on goods and services – the primary driver of our consumer driven economy.

As for the financial markets, we expect that stocks will do well with either administration as they track the growth of corporate profits. The bond market, however, bears greater risk in a Bush administration as a large federal deficit in a strong economy may push inflation and interest rates higher.

—B.Lincoln