Economic News & Analysis—February 25, 2013
The sequester and the continuing resolutionBy Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist
March could come in like a lion and out like a lamb; or, is it the other way around? Politicians will need to work on both the sequester, which refers to the federal budget cuts scheduled to take effect on March 1, and the expiration of the continuing resolution currently funding federal government programs and agencies on March 27. The sequester is the product of the Budget Control Act of 2011 (BCA), which raised the federal debt ceiling. The BCA required the deficit be cut by $1.2 trillion over 10 years and created a Joint Select Committee on Deficit Reduction (which the media labeled the Super Committee) to identify how to cut the deficit another $1.2 trillion over 10 years. Failure to come to an agreement would trigger automatic spending cuts of $1.2 trillion over 10 years. As we predicted in August 2011, the Super Committee failed. As a result, those automatic spending cuts were scheduled to start January 1, 2013.
I emphasize “over 10 years” in the previous paragraph to better put these cuts into context. If you work it out, the deficit cuts are approximately $120 billion a year. Politicians, however, seem to like big numbers, so they always talk about the 10-year forecast of revenue and spending numbers. For those of us with a background in finance, this is a little silly because there’s something called the time value of money where a dollar today is worth more than a dollar in 10 years. So, it’s somewhat misleading to just add up all those numbers. It makes the cuts to spending or increases in revenue seem bigger than they really are. There’s also the whole issue that one congress cannot bind another congress, so it’s entirely possible, if not quite likely, that what a congress today says it will do in 10 years is nowhere close to what will actually happen in 10 years.
Democrats and Republicans can both want and refuse tax increases, respectively.At the time the BCA was signed into law, it was done so under the assumption that the Bush-era tax cuts—many of which have been made permanent as a result of the 2013 New Year’s agreement between the White House and Congress—would expire, as would the payroll tax cut. I think that was a strategic error on the Republicans’ part because it made it difficult to actually negotiate for a continuation of the tax cuts. Maintaining the tax policies of the previous 10 years would have required identifying spending cuts or offsetting revenue increases to pay for continuing the tax cuts. This is why, I think, even though there has been a $60 billion tax increase as a result of the New Year’s compromise, the president can still say, with a straight face, that he wants more revenue. The BCA originally contemplated nearly $400 billion in new taxes because it assumed the entire expiration of the Bush-era tax cuts and the payroll tax cut. In a way, the White House made a $340 billion concession on revenues with the New Year’s agreement. With all these negotiations going on in D.C., many people seem to forget that they are effectively renegotiating the terms of the August 2011 agreement!
How the sequester worksWhile the New Year’s agreement postponed the implementation of the spending cuts to March 1, that really isn’t the deadline for the sequester. The president’s Office of Management and Budget (OMB) can probably delay the effects of the sequester for a few weeks until a new agreement is negotiated. A sequester caps the budget authority for a particular set of accounts for the fiscal year. In this case, it reduces the budget authority of certain defense and discretionary nondefense accounts. By capping the budget authority of certain accounts, the sequester doesn’t entail an immediate reduction in spending.
It’s important to note that the cuts are not to Social Security or Medicaid. While there are some cuts to Medicare, amounting to 2% of its budget, they are supposed to be targeted on provider reimbursements, so the actual benefits received by Medicare enrollees shouldn’t be affected, unless a provider decides to stop taking Medicare patients because of the reduction in reimbursements.
Different programs will be affected in different ways depending on how many accounts fund those programs. Some programs fall under a single account, giving that program some latitude when implementing the budget cuts. Other programs funded by multiple accounts will have limited ability to shuffle the cuts around. Some agencies have lumpy spending patterns. For instance, payments from the U.S. Department of Education mainly occur in July. So, if the sequester is implemented but gets reversed before July, that spending shouldn’t be affected. There are also agencies that have surplus funds from previous fiscal years, which can be used as a cushion for the current fiscal year. Some spending, common in the U.S. Department of Defense and the U.S. Department of Transportation, is authorized to span multiple years. Depending on the contracts, what has been authorized in the past will count against the budget in the year the contract was entered into not in the year the spending is done. So, a sequester wouldn’t likely affect an agency’s existing contracts but rather its ability to enter into new contracts.
What effect will the sequester have on the economy?It all depends on what model of the economy you’re working with and the assumptions made about how the president will implement the cuts. While the president doesn’t have much leeway in how to implement the sequester, he does have some. The OMB can provide guidance to the affected agencies as to the pace of spending and which specific programs or areas should be affected. I believe the talk about the millions of jobs being lost as a result of the sequester is disingenuous at worst and misleading at best. It’s not entirely clear that people must lose their jobs as a result of the sequester. Often, other spending plans can be altered or workers can have their hours reduced. The extent of job losses depends not only on how the sequester is implemented, or if it is subsequently undone with a new budget agreement, but also on the assumptions made about multipliers.
Take all forecasts with a big grain of saltAll economic models are simplifications of reality. From these models, economists can estimate multipliers, which refer to how spending by one person or entity induces spending by other people or entities. For example, when the government reduces the pay of a government worker, that worker has less money to spend on other things. That spending is the income of other people who spend the money creating income for other people. Through these interactions, spending increases or decreases can have ripple effects throughout the economy. Some models posit that government spending multipliers are greater than one, meaning a one-dollar reduction in government spending results in more than one dollar in economic activity. Other models say it is less than one, meaning a reduction in government spending by one dollar reduces all economic activity by less than one dollar.
So what’s the right multiplier? It depends on the economic context (are there underused resources?), the time frame over which you measure economic activity (one day, one quarter, one year, one decade, etc.), and how that money is actually spent (not all spending is of the same quality). When it comes to estimating multipliers, I think it’s also important to recognize that government spending needs to be financed through taxes—whether those taxes are provided today or in the future—and those effects need to be considered as well. Increasing a government worker’s pay by one dollar is financed by reducing someone else’s disposable income (after-tax income) by one dollar.
Depending on how the sequester is implemented, I think it could result in the equivalent of 61,000 jobs being lost in terms of hours worked over the second quarter of 2013 or, stated another way, a reduction of approximately 2.5 million hours of work. That could come from furloughs or natural attrition where retiring or resigning workers aren’t replaced. Now, that estimate is based on an optimistic assumption that the president will try to minimize the effect on workers. Perhaps, for political purposes, he may not want to do that. Most polls suggest the majority of the public will blame Republicans for the sequester, so maybe there is an incentive to maximize the job losses instead of minimizing them. But that’s impossible to predict.
Don’t fear the sequesterThe face amount of the sequester equals a reduction in government spending by 0.5% of gross domestic product, which will almost certainly affect certain people and companies. While I don’t want to minimize that effect, I don’t think the near- or long-term effects will be earth-shattering for the economy or the markets. From an investing perspective, it pays to be aware of the exposure of the companies you invest in to federal contracts, but that has always been the case.
Some might argue that deficit reduction should be done now while others think we should wait. Both, I think, have valid points. One problem with the refrain that the government should provide short-term stimulus with a medium-term plan to lower the deficit is that there is little politicians can do to credibly commit to medium-term deficit reduction. Everything they agree to today can be undone if it seems politically expedient.
I think that’s why some say the sequester should take effect, not be reversed, and more should be done. Promising to do the right thing in the future is no substitute for doing the right thing today. But therein is the problem: There’s a lot of disagreement about what the right thing today is. Regardless, I think we’ll see the sequester deadline pass on March 1 and then the real arguing can begin on how to fund the federal government. Because a budget hasn’t been passed since 2009, the federal government has been funded through six-month continuing resolutions, with the most recent expiring on March 27. The old saying is that March comes in like a lion and goes out like a lamb. I think we’ll have a lot of roaring throughout the month from politicians. Markets may stay sheepish throughout.