The New Congress: How Will Gridlock Affect the Economy?

Welcome to gridlock. The Republicans have gained 58 seats to win control of the House of Representatives, but the Democrats are still running things in the Senate. How will this division of power affect U.S. economic policy in the next couple of years?

"I think uncertainty is holding the economy back, and that's why businesses are sitting on so much cash and not spending it," says Karen Dynan, co-director of the Economic Studies program at the left-leaning Brookings Institution in Washington, D.C. "It's a challenge for Congress to try to reduce that uncertainty in an environment that's going to be so prone to gridlock."

John Makin, a resident scholar at the conservative-leaning American Enterprise Institute, says the Republicans will likely use their new power to block any new spending. "This is a smaller government mandate, and the Republicans are certainly in a position to see that there are no new initiatives," Makin says. "All of the burden now goes on to the Fed."

"Kumbaya" Moments Aren't Likely

As widely expected, the Federal Reserve's rate setting committee decided today to embark on another program of asset purchases -- this time to the tune of $600 billion in bond purchases -- in an effort to drive down interest rates and get loans flowing in the system.

Rep. John Boehner (R-Ohio), the man likely to become Speaker of the House in the power shift, said today the Republicans will use their new majority in the House to promote a "smaller, less costly and more accountable government."

With the two houses divided, the parties will have to compromise to get legislation passed. But will they? "While party strategy is still being developed, we find it highly unlikely that Democrats and Republicans will quickly come together in a 'kumbaya' type moment in the first quarter of 2011 or even the second quarter," say analysts at broker Morgan Stanley in a client note.

Pushing Back on the State Level?

Brian Gardner, the Washington analyst for investment bank Keefe, Bruyette & Woods says the fact that the Democrats retained the Senate means Republican campaign promises to repeal health care and the Dodd-Frank financial regulatory reform law aren't likely to materialize.

But he said the GOP has been given a veto over any new anti-business or anti-bank legislation. "For example, the bank tax is now, in our view, off the table," Gardner said in an analysis of the election results.

While not being able to repeal health care reform or Dodd-Frank, the Republicans "will be able to put pressure on the regulatory environment, the instructions to bureaucrats," Makin says. "The fact that Republicans have gained a lot of governors means there may be some ability to push back at the state level."

The Battle Over the Bush Tax Cuts

The first area where compromise will be necessary is tax reform. The Bush tax cuts are due to expire at the end of this year. If no action is taken, the top tax rate will rise from 35% to 39.6%, capital gains will be taxed at 20% instead of 10% or 15%, and the tax on dividends will go up.

Dynan says she now expects the tax cuts to be extended on Republican terms. The GOP has been demanding that all the tax cuts be extended, while the Obama administration wanted to keep all the cuts except for taxes on individuals earning more than $250,000.

"The Bush tax cuts are much less likely to expire with the Republicans having more power," Dynan says. "From the administration's perspective, it may not be their proposal, but allowing [the cuts] to go through is still going to be positive in terms of growth, and that's good for them."

Handcuffed on Stimulus Measures

Dynan is concerned, however, that the lame-duck Congress that returns for the remainder of this year may not pass the emergency unemployment benefits package that expires at the end of November because the Republicans oppose any new spending that raises the deficit.

She also thinks it's much less likely that the two houses will be able to agree on deficit-reduction proposals contained in a report from a bipartisan commission Obama appointed to explore ways to cut the deficit. The report is due to be issued Dec. 1.

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Both Dynan and Makin think any new stimulus measures from Congress will have to be limited to tax-cutting proposals, including a plan for a possible $650 billion tax holiday for workers.

"If they can find the money for it, it would be good policy," Makin says. "But the stimulus impact would be somewhat mitigated if they feel they have to pay for it by cutting elsewhere, which seems to be the perceived mandate of the Republican side in the House, and they're in control."

A lot is riding on whether Fed Chairman Ben Bernanke's plans to stimulate the economy by pushing money out into the market will have the intended effect of creating more jobs. If unemployment is still high six months from now, the Republican majority may feel the need to join with the Democrats to do more to stimulate the economy, including spending money, however much of an anathema that might be to the voters who elected Tea Party candidates on Tuesday.

They'll all face reelection in 2012.