What gives? Does the market reaction to sequestration—or apparent lack thereof—give the lie to all the doomsaying in government, media and Wall Street circles over sequestration? Not necessarily. Before answering this question, let’s clarify exactly what the sequester (to use a shorter-hand term) does.
It cuts $1.2 trillion in budget authority over 10 years, starting with $85 billion this year, split about evenly between defense spending and discretionary spending (just about everything besides Medicaid, Social Security and, for the most part, Medicare). The law makes no distinction between desirable cuts and undesirable cuts—everything takes a hit. The design was intentionally blunt, since sequestration was supposed to be so unpalatable to both parties that they would be forced to make tough, but reasoned, choices about spending cuts. Unfortunately, they didn’t do so.
Should all the cuts take effect (and they are a “ramp,” not a “cliff”), we can expect a hit to GDP of roughly 0.5%, at a time when slowing government spending is already a drag on growth. Whether these cuts will all take effect is dubious, however, for several reasons.
When a cut is not a cut
First, the cuts are to budgetary authority—what departments are empowered by Congress to spend—but these may not equate to what they were planning to spend in the first place. A more accurate way to think of the size of cuts is that the dollar amounts reflect the value of substitute cuts Congress would have to come up with in order to replace those in the sequester.
Secondly, Congress will probably use either the budget debate coming up later this month or the next debt ceiling debate, due this summer, to try to find a way to avert, delay, reduce or otherwise mitigate the cuts deemed least desirable (politically, if not economically). Another opportunity may present itself when Congress has to tackle the 2014 federal budget toward the end of the year (the federal government’s fiscal year ends September 30). Beyond that, while sequestration caps budgetary authority, Congress can always waive the caps, if it wants to, and even retroactively reinstate 2013 spending authority. The bottom line is that while spending cuts will now begin to come into effect, the economy has some wiggle room before growth faces a major crimp.
Of course, just because Congress has the opportunity to refine the terms of the spending cuts doesn’t mean it’s going to do so. Until now, its recent modus operandi had been to impose self-inflicted fiscal crises, such as the debt ceiling debate and the fiscal cliff, and then reach a compromise at the 11th hour to avoid the worst outcomes. The tactic has been surprisingly effective, if aggravating to watch. For all its sturm und drang, Congress has managed to pare 10-year projected debt-to-GDP levels from 87% to 73% (including the full effects of the sequester). What’s more, for every dollar of increased revenue lawmakers have agreed to, they’ve cut three to four in spending—approximately the ratio “grand bargainers” like Simpson/Bowles have recommended.
Unfortunately, little has been done to address the biggest driver of long term fiscal trouble, the growth of entitlement spending. The sequester is no different. Its design causes undue pressure on economic growth in the short term (which Fed Chairman Ben Bernanke warned last week could actually worsen deficits by reducing growth), but won’t have much of an effect in the long run. Indeed, discretionary spending has fallen to its lowest level as a percentage of GDP since 1962. A wiser plan to address the country’s fiscal challenges would help support the economy now, while making meaningful strides to bring down the cost of entitlements later, once the economy is in better shape.
In the short run, if we start to see more real-life pain as a result of sequestration—longer lines at airports, material degradation of public services, big layoffs, etc.—the political pressure for Congress to rethink the timing and composition of spending cuts is likely to increase.
We shall see. For now, what I believe it means is that breakout growth remains out of reach. Not all is lost. As we expected, 1-2% real growth and 1-2% inflation keeps the Fed accommodative, fostering an environment that should continue to support equities.