Broker Check

Sequestration

| February 26, 2013
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Have you ever heard the saying, “Out of the frying pan, into the fire?” Basically, the phrase describes any situation where, after leaving one obstacle behind, you find yourself immediately confronted with another.

Such a situation is exactly what the United States Congress finds itself in. Less than two months after striking a deal to avert the fiscal cliff, Congress has a new problem to deal with … or rather, an old problem never properly dealt with in the first place. This problem is called sequestration. It could have a profound effect on our economy—and by extension, the markets—so as your financial advisor, I want to make sure you’re up-to-date on what’s going on.

Sequestration

Let’s rewind back to late 2012. Remember the fiscal cliff? It was the combination of automatic tax increases and budget cuts that, taken together, would probably have sent the economy into another recession. Thanks to an 11th hour deal, Democrats and Republicans agreed to a compromise that lessened the tax increases, while simultaneously postponing the automatic budget cuts. In effect, they patched over one problem, while punting on the second.

Unfortunately, their punt wasn’t a very long one. Per their agreement, the budget cuts (also known as sequestration) were to take place on March 1st if another deal wasn’t struck.

Now come back to the present. March 1st is right around the corner, and a deal isn’t looking very likely. The budget cuts are a real possibility. So what are these cuts, what will they do, and why do they have to happen in the first place?

Let’s take the last question first. The budget cuts are a response to an even bigger problem: the national debt. Currently, our country’s debt is over $16 trillion dollar, and for this year alone, we have a $0.9 trillion deficit. That means the government is expected to spend almost $1 trillion more than what it actually has. These numbers simply cannot continue, but Congress has been unable to take concrete steps to lower them. To give themselves extra incentive, Congress passed the 2011 Budget Control Act, which stipulated that if they could not lower the deficit, across-the-board spending cuts would be enacted to do it for them.

The problem with automatic, across-the-board cuts is that it’s like using a bomb when a scalpel will do. The cuts are large, broad, and fairly sudden. You just can’t make cuts like that without feeling negative effects. If you compare our debt to having a drug problem, these cuts are like quitting drugs cold-turkey. Sure, it will help your drug/debt problem … but the shock could be very painful. Here’s why. The cuts for 2013 total $85.3 billion, and are divided like this:

• $42.7 billion decrease in discretionary defense funds.
• $26.5 billion decrease in discretionary non-defense funds.
• $11.2 billion decrease in Medicare spending.
• $5.0 billion decrease in other areas.

These numbers are just the cuts that will take place within the next seven months. Much larger cuts, totaling almost $1.2 trillion, will ultimately occur over the next ten years, assuming the current plan remains in place. It would take up too much room to break down exactly what all of those cuts will do, but it’s enough to say that many jobs will be lost. The cuts would mean government departments will have to either furlough or layoff thousands of people. And decreased government spending means that even private companies will be affected. For instance, if the government spends less in defense, defense contractors could have less business. Less business means less revenue, which means fewer jobs. In fact, the Bipartisan Policy Center estimates that as many as 1 million jobs could be lost if the sequester occurs.

A few other effects:

• Unemployment benefits will go down by 9.4%.
• The price of some types of food will go up.
• Furloughed airport workers means there will be longer lines at airports.

Ultimately, the loss of so many jobs, combined with the belt-tightening that many Americans will have to face, means the economy could decline by 0.7% in 2013.6 Considering that our economy’s growth was already slow (projected to be just 2%), 0.7% is a big number. It’s impossible to say how the markets will react, but an economic slowdown usually doesn’t mean good things.

So What Happens Next?

That’s enough of the gory details. Now let’s look at what could happen next.

With a few individual exceptions, neither political party wants sequestration to take place. The problem is, neither party can agree on what the alternative should be. Both sides profess to want to decrease our debt, but have vastly different ideas on how to do it. Generally speaking, Republicans don’t want to cut from defense spending, and Democrats don’t want to cut from social programs. Democrats want to increase revenue to help pay down the debt, in the form of higher taxes on the wealthy. Republicans won’t hear of the idea.

Because of all this, it’s probable that sequestration will happen. It’s still possible the two parties could come to an agreement on how to make more targeted cuts, but it’s doubtful they can do it by March 1st. Instead, Congress’ best bet is to either waive the cuts altogether, or postpone them again.

If neither happens, the next thing Congress can try to do is make changes after sequestration starts but before the full effects are felt. Unfortunately, Congress has another major problem to deal with. They will soon run out of money to fund government operations for the rest of the 2013 fiscal year. If they do not come up with a new funding bill by March 27, the government will shut down. If that happens, it means even more furloughs and a greater loss of government services. On the other hand, if Congress can agree to a funding bill by that date, it’s possible they could reverse some of the automatic spending cuts at the same time.

Now the Good News

There’s no denying that Congress has become a legislative quagmire. But there’s one thing they’re still good at: avoiding the worst. Congress has a vested interest in ensuring the economy remains strong, and when their backs are against the wall, the most influential members of both parties have a history of abandoning their talking points in order to compromise.

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