How Big a Problem will the Sequester be for the U.S. Economy?

Having dodged the fiscal cliff and postponed the debt ceiling deadline, Congress decided to let the spending sequesters happen. Will the result be to throw the economy into recession or cause an economic catastrophe? We don’t think so, and neither does Congress.

A Brief Background

The sequesters are scheduled reductions in military and discretionary spending authority which were put in place as part of the 2011 debt ceiling agreement. After the failure of the Bowles-Simpson commission to craft a “grand bargain” deficit reduction package, congressional Republicans agreed to raise the debt ceiling—to let the government continue to run a trillion dollar deficit—only in return for the establishment of a “supercommittee” which was charged with finding a smaller deficit reduction agreement. If the super committee failed, sequesters would automatically begin reducing the military and discretionary spending over the next decade.

The intent of the sequesters was never to provide a pathway to deficit reduction. Rather, they were conceived of as a “stick”—a penalty for failing to agree on deficit reduction. Because the supercommittee failed, the sequesters are coming into effect.

The 2013 spending cuts were originally scheduled to take effect on January 1, but their implementation was delayed until March 1 as part of the “fiscal cliff” deal (the American Taxpayer Relief Act of 2012). March 1 has come and gone, and no deal to defer or eliminate the spending cuts has been reached, so they will now take effect.

What will be the Impact of Sequestration on 2013 Economic Growth and Unemployment?

Because $85 billion is roughly 0.5% of U.S. GDP, we can roughly estimate that this fiscal austerity is expected to reduce 2013 economic growth by roughly 0.5%.

Now that the elections are behind us, politicians in Washington have been warning that sequestration may lead to more than 500,000 layoff notices, but I am somewhat skeptical. Politicians (and the media) tend (love) to bring out scare stories whenever spending might be restrained—and often implement spending cuts in ways designed to make the public’s experience as painful as possible. We are warned that military readiness and public safety will be compromised and that TSA lines at the airport will be even longer, and so on. While no department head wants to be forced to cut their budget by 6%, and while those budget cuts will certainly be painful, I tend to believe that the scare stories are—as is typical in these sorts of cases—exaggerated.

It’s also important to understand the total federal spending for fiscal 2013 will still be up over 2012 levels due to “baseline growth” effects and the rise in entitlement sending. Sequestration isn’t really going to reduce GDP—it will just slow GDP growth. The CBO projects federal spending—after the sequestration—will still rise at a compound annual growth rate of 5% over the next decade.

Finally, it should be noted that the president’s suggestion that spending cuts be avoided by raising taxes would not directly increase GDP or GDP growth. It would simply divert $85 billion from the private sector (reducing consumption and investment there) to the government sector, where it would be spent.

In summation, we believe the spending sequesters will be a headwind for 2013 GDP but the underlying growth rate of the economy is high enough that they will only slow economic growth, not push the economy into recession.

Where does Congress Go From Here?

As noted above, the sequestration process was intended to be painful, to force Congress to come to grips with its budget deficits. The fact that Congress was unable to do so highlights the difficulty of the political problem it faces. It has long been said that “Social Security is the third rail of politics.” Politicians seek out the votes of retired voters, and these voters have been receiving a growing share of U.S. GDP in the form of transfer payments from the federal government. Proposals to reform Social Security and Medicare have been difficult to move through Congress. It is not happenstance that the sequesters did not cut into entitlement spending.

Still, the sequesters help highlight the fact that military and discretionary spending are not at the heart of the U.S. government’s budget problem—the aging of the baby boomers and the actuarial unsoundness of Social Security and Medicare are. Until Congress addresses the growth in entitlement spending, it will be virtually impossible to balance the budget. As a senior economist at the ECB lamented (when talking about European budget problems), “everybody knows what has to be done, but nobody knows how to get reelected after doing it.”

Perhaps the silver lining of the sequesters—the pain it imposes on both Democrats (by cutting discretionary spending) and Republicans (by cutting defense spending)—will help build a bipartisan agreement that the growth of entitlement spending must (finally) be addressed.

© Pioneer Investments

Read more commentaries by Pioneer Investments