For what is generally described as an impending political earthquake, the much anticipated US midterm elections today seem to have left financial markets strangely unmoved.

With Democrats poised to end 12 years of Republican control of Congress and, perhaps, to bring to a close the era of conservative domination of the American political landscape, you might have thought that markets would be registering some unease, or at least volatility, to reflect the uncertainty of the new era that could be born today.

Yet so far the more likely a Democrat victory seems, the less investors appear fazed. Even the sudden possibility — dismissed until a few weeks ago — that the Opposition could take control of both chambers of Congress — the Senate and the House of Representatives — has had little effect. Markets are supposed not to like uncertainty, but the clouds of doubt over the direction of US policy have not deflected stocks from their impressive upward flight path. Volatility indices have also declined in the past month, further suggesting that the uncertainty is not intruding on investors’ attitudes.

It is possible that markets simply believe that changes in the composition of Congress will not change anything substantive for the American economy — but history suggests that that is shortsighted. A better explanation is that markets may actually welcome a period of divided government in Washington, where one party holds the White House and the other Congress. Politicians fear gridlock — it stops them getting their ideological agendas and pet projects into law — but recent evidence suggests that, for investors, that enforced inaction might be very good news. One of the best periods that US financial markets have enjoyed in the past century happened when Washington was supposedly in the grip of gridlock from 1995 to 2000, when Bill Clinton was forced to cohabit, as it were, with a Republican-controlled Senate and House of Representatives.

That immobilising conflict famously reached its nadir when Mr Clinton was impeached by the House over his alleged perjury in the Monica Lewinsky case. This could mean that the more politicians focus on fighting each other, and the less they come up with meddlesome policies that muck up the functioning of the economy, the better. Gridlock? Bring it on.

But this is a misreading of the Clinton-Republican years, and it would be wrong to assume that the elections today — if they do result in triumph for the Democrats — will lead to glorious inaction in Washington. The 1990s era of supposed gridlock actually produced some real legislative achievements. A Republican Congress drove American economic policy in a pro-market direction. Bill Clinton’s Democrats had the good sense to realise that this not only made for good economics, but made political sense, too.

Between them, they passed a radical reform of welfare, they balanced budgets and they promoted free trade. It was a period, in other words, in which government did what it should do — get out of the way of efficient markets.

It is not at all clear that divided government this time will produce such benefits in the next two years. If Democrats emerge from these elections with the kind of momentum that the Republicans had when they swept to power in 1994, that may well not be good news for markets.

They will press immediately for a big increase in the minimum wage. They have pledged to intervene more aggressively in all kinds of markets — drugs and oil, for example — in ways that will surely divert companies from pursuing efficient outcomes. Prospects for much-needed reform of the Sarbanes-Oxley accounting and regulatory regime, which most Republicans acknowledge overreached and harmed US competitiveness, will dim. The Democrats’ rhetoric on trade borders on the protectionist and the climate for international investment in the United States will almost certainly get harsher.

As for fiscal policy, Democrats at least say that they want to balance the budget. They point to the deficits of the Bush-Republican years and contrast them with the surpluses achieved by President Clinton and the Congress in the late 1990s. They promise to reverse course.

Now, some of the gloom about the US fiscal position so common among international financial commentators is overdone. The budget deficit in the fiscal year just ended dropped to 1.9 per cent of gross domestic product, hardly massive by historic standards. And even that is half what it was two years ago. Solid economic growth after the recession of 2001 restored some fiscal balance. But, clearly, some further fiscal consolidation would be welcome.

Although they have tried to avoid talking about it on the campaign trail, Democrats seem likely to try to raise taxes in the next few years — at least in the form of not renewing the tax cuts passed by Congress over the past few years, many of which expire in 2010.

Republicans, and a veto-wielding President Bush, will oppose that and, one assumes, given the general unpopularity of raising taxes, will succeed. A classic Washington compromise, then, may have to be found in which both parties get what they want — for Democrats (and a depressing number of Republicans), spending increases; for Republicans (and electorally vulnerable Democrats), tax cuts.

More spending and lower taxes — not exactly a recipe for fiscal stability. And that is before Democrats start floating their plans for reforming social security, America’s liability- laden public pensions system. Those plans are likely to involve yet more spending.

All in all, good reason to watch the results tonight and sweat a little as the Democrat numbers inch higher.

gerard.baker@thetimes.co.uk

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