The US Sequester

The Australian financial press has recently been filled with articles on the “US Sequester”. Most articles have focused on political finger pointing and fears that the US government would stop paying its employees and effectively shut down. However few people are aware of what the Sequester is, how it was actually created, and the effects the cuts are likely to have on the US economy. This article aims to shed some light on these issues.

What is a Sequester?

The Congressional Research Service defines Sequestration this way:

“In general, sequestration entails the permanent cancellation of budgetary resources by a uniform percentage. Moreover, this uniform percentage reduction is applied to all programs, projects, and activities within a budget account.”

In more general terms, it is across the board budget cuts that are automatically enacted through legislation upon a predetermined budget outcome being achieved or, as in this case, not being achieved.

How did it come about?

The Sequester was originally passed as part of the Budget Control Act of 2011. It was intended to serve as an incentive for the Joint Select Committee on Deficit Reduction (aka the “Supercommittee”) to reach a deal to cut $1.2 trillion from the national debt over 10 years.

If the Supercommittee, which is made up of a select group of 12 members of both the U.S. House of Representatives and U.S. Senate, failed to come to come up with a deal by 31 December 2012, then the automatic budget cuts outlined in the Sequester would come into effect.

The whole point of the Sequester was to force the politicians to come up with a better way to work towards a balanced federal budget, the idea being that the impact of the Sequester would be so undesirable that politicians would be forced to make a deal. In the event a deal was not reached the cuts to discretionary spending outlined in the Sequester would bring about the reduction in public debt anyway. No deal has been made thus far and as a result the cuts began automatically on 1 March 2013.

Which spending is being cut?

The cuts to spending in 2013 are represented in the below graph. The 2013 Sequester totals $85.4 million and include:

• • $42.7 billion in defence cuts (a 7.9 percent cut)
• • $28.7 billion in domestic discretionary cuts (a 5.3 percent cut)
• • $9.9 billion in Medicare cuts (a 2 percent cut) and
• • $4 billion in other mandatory cuts.

The cuts are evenly split between US domestic and defence programs, with half affecting defence discretionary spending (weapons purchases, base operations, construction work etc) and the rest affecting both mandatory (which generally means regular payouts like Social Security or Medicaid) and discretionary domestic spending. Some programs are exempt from being cut, including congressional pay, refundable tax credits to individuals, and low-income programs such as the Children’s Health Insurance Program, Supplemental Nutrition Assistance Program, Temporary Assistance for Needy Families, and Supplemental Security Income. 

Some of the largest programs being cut are:

• • Military research is cut by $6.3 billion.
• • Aircraft purchases by the Air Force and Navy are cut by $3.5 billion.
• • Public housing support is cut by about $1.94 billion.
• • The National Institutes of Health get cut by $1.6 billion.
• • NASA gets cut by $970 million.
• • Special education is cut by $840 million.
• • State Department diplomatic functions are cut by $650 million.
• • The Energy Department’s program for securing nuclear weapons is cut by $650 million.
• • Border security is cut by about $581 million.
• • The FBI gets cut by $480 million.
• • The federal prison system gets cut by $355 million.

It is estimated that direct jobs losses from the cuts will add 0.25% to the US unemployment rate, however the effect of indirect job losses could be as high as 1%.  US States most affected by these job losses are outlined below:

How long will it last?

The Sequester program extends beyond 2013, and cuts discretionary spending across-the-board by $1.1 trillion between 2013-2021.  No government programs are actually eliminated, but the effect is to reduce the scale and scope of a very wide range of existing programs.

What does the Sequester mean for the US economy?

An analysis by advisory firm Macroeconomic Advisors LLC layered the Sequester spending cuts on top of baseline assumptions to show the outcome of the cuts on the US economy.  The results for growth and unemployment are summarized in the charts below:

The effect of the sequestration is to slow real GDP growth over 2013 from 2.6% to 2.0%. The largest impact occurs in the second quarter, when growth is reduced by roughly 1.25%. By the end of the year, the civilian unemployment rate is 0.25% higher.

As early as the first quarter of 2014, GDP growth exceeds the baseline path, albeit slightly. The reason growth rebounds so quickly is that while, relative to the baseline, spending does continue falling modestly in 2014 and 2015, slower economic growth and higher unemployment lead financial markets to expect a later (2016:Q1 instead of 2015:H2) tightening of monetary policy. This lowers long-term yields roughly enough to just offset additional fiscal drag in 2014. However, because GDP growth does not exceed the baseline by much in 2014, the increase in unemployment lingers for several years.

Concluding remarks

Although the Sequester is gathering a lot of media attention, and was certainly intended to be a result so unpalatable that it would encourage both sides of US politics to reach agreement on budget controls, the forecasts are not as dire as predicted.

Prior to the Sequester US GDP growth was expected to be 2.6% in 2013 and 3.3% in 2014.  The sequestration is expected to reduce those forecasts of growth during 2013 by 0.6% (to 2.0%) but then, assuming investors expect the Federal Open Market Committee (FOMC) to delay raising the federal funds rate, boost growth by 0.1% (to 3.4%) in 2014.

By the end of 2014, the sequestration would cost roughly 700,000 jobs (including reductions in armed forces), pushing the civilian unemployment rate up 0.25%, to 7.4%. The higher unemployment would linger for several years.

The macroeconomic impact of the sequestration is not catastrophic. Nevertheless, the indiscriminate fiscal restraint would come on the heels of tax increases in the first quarter that total nearly $200 billion, with the US economy still struggling to overcome the legacy of the Great Recession, and when the FOMC is constrained in its ability to offset the additional fiscal drag with a more accommodative monetary policy. By far the preferable policy is a credible long-term plan to shrink the deficit more slowly through some combination of revenue increases within broad tax reform, more carefully considered cuts in discretionary spending, and fundamental reform of entitlement programs.