Is a Sequestration Disaster Looming?
Here are some good thoughts via Macroeconomic Advisers on the sequestration and the overall impact. They’re calling for 700,000 jobs lost and -0.6 off of GDP if the cuts go into effect. Whew.
Of course, the equity market is whistling past the graveyard here as we reach a point where you can buy almost any dip and make money on the long side. Most of the time I feel like I understand what’s going on, but then the market reminds you that you can never understand Mr. Markets bi-polar disorder. Maybe the folks at MA can provide some guidance:
A sequestration of federal spending, scheduled to take effect on March 1, is now less than two weeks away. Little progress has been made in negotiating a bargain that avoids or delays the automatic spending cuts implied by the sequestration.[1] Accordingly, we now put the odds of a sequestration at close to 50%, and rising.
- Our baseline forecast, which shows GDP growth of 2.6% in 2013 and 3.3% in 2014, does not include the sequestration.
- The sequestration would reduce our forecast of growth during 2013 by 0.6 percentage point (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 percentage point (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 ¼ percentage point, 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 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.
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The impact of the sequestration would not be a macroeconomic catastrophe. Nevertheless, the indiscriminate fiscal restraint would occur on the heels of tax increases that total nearly $200 billion in the first quarter, with the 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 restraint. Furthermore, spending cuts that are so arbitrary in their allocation and timing can’t possibly be optimal from a public policy perspective. The preferable policy is a credible long-term plan to shrink the deficit more slowly through some combination of tax increases within broad tax reform, more carefully considered cuts in discretionary spending, and fundamental reform of entitlement programs.
Cullen Roche
Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.
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Republicans will cave due to Obama going on camera with firemen, first responders etc. Another “last minute deal” will be announced. Rand Paul may sum up why Republicans are finally fed up here, which is hilarious by the way : http://www.youtube.com/watch?v=svGDZOW-brA Pork has been an issue for both parties. But I think it has been elevated in the last couple years including stuffing the Hurricane Sandy bill full of non-emergency related discretionary spending etc. I worry about modern monetary theory in the sense that as the pork and entitlement spending continue to get worse, that politicians will succumb to the hyperinflation pundits and “America becoming Greece” rhetoric. I would probably be in this same camp if it weren’t for pragcap and Cullen’s modern monetary theory papers.
Note: I’m sure BHB meant to say “Monetary Realism..MR”…not MMT.
Good catch Rich R. Thank you.
“…the preferable policy is a credible long-term plan to shrink the deficit more slowly…”
CREDIBLE ?
This is the funny part.
The people and the Congress can change their mind. They can all swear oath that we will cut, starting the 5th year from now, for 10 trillion dollars. Because we will cut so much, we ought to spend 5 trillion today. Then on the 4th year, we start to talk about the pains again and “legislate” to cancel them all.
It’s all legal by the way. It’s also about democracy and maintaining people’s standard of living with good conscience.
That’s a brilliant idea! Cuts are always planned, but always in the future as well. Why hasn’t anyone in Washington thought of this?
Wait, what?
Some people are saying March isn’t the day for the cuts to kick in. It’s March 27, when the Continuing Funding of the government ends if we don’t come to a resolution.
I don’t know for sure. But seems odd to me. Obviously the market is not concerned.
Of course the market is not concerned… We’ve seen a few situations like this over the past few years and everyone has been “trained” to expect a certain outcome…
What will happen is a lot of bickering by politicians, name-calling etc. All will openly suggest a deal can’t be reached and blame the others. And then at the last minute there will be a grand bargain which kicks the issue down the road and everyone cheers…
What is this market you speak of? All I see is a centrally planned policy tool designed to distract popular attention from the true nature of our economic ills.
Why are the markets not worried?
Maybe because the actual cuts this year would be about $44 Billion, out of a $3.8 Trillion budget.
And considering the 2012 budget was $3.7 Trillion, the government will STILL spend more than they did last year.
But what will be the rate of growth of government spending? Will it be higher or lower than nominal GDP growth? If the growth rate of government spending decelerates below the nominal rate of GDP growth then it will be a drag on GDP growth.
But I do agree that the implementation of the sequestration is staggered and it doesn’t make two hoots difference if agreement is not reached until end March, maybe end April other than for a relatively small proportion of people who might be furloughed or take accrued holiday leave. There is no cliff, just a hill that is long and steepening. Any cyclist can tell you how they slowly grind you down!
watching this circus from europe i don´t know if i should be amused or confused?
stock market near all time highs, housing market has turned (prices up 6% yoy), jobless claims near multi year lows. both ISMs solidly above 50, no headwind from China and a broad consensus that the world economy is going to strenghten going forward.
and still the economy can´t take the slightest cuts?!
what where those leaders and what was mr. MARKET thinking when those measured where put in place 1 1/2 years ago, when economic conditions where WAY worse than they are now?
there will ALWAYS, AT ANY POINT be arguments why you can´t cut spending. the time will never be right. either you “harm the recovery” or you “intensify the downturn”.
and of course there is almost always an election that has to be won.
since the conservative led government took over here in Germany 8 years ago we have faced many spending cuts and tax increases. yet we are still alive and are on path towards a balanced budget.
if you are serious about balancing the budget, right now is the best time to start.
And why should be be “serious about balancing the budget”? Serious question…
Exactly. If anything MR has showed me that balancing the budget when you have a trade deficit would be unwise in most cases.
For as much good as this site does, it’s simplistic truths are taken much too far. And your question is proof of that fact.
Perhaps the answer is not simple though. For example, inflation might rise… a sign that taxes and interest rates should be increased and government spending decreased. That’s not the only factor… but why should we move in that direction (austerity) prior to there being a good reason to do so? I’m very skeptical of austerity for austerity’s sake. We’re being told my pundits on TV every day that “we need to get our financial house in order or we’ll end up like Greece” yet I doubt 1 in 1000 economists of any stripe seriously thinks we’re in danger of becoming like Greece! Greece is more akin to a state in the US rather than a sovereign country… and I have no problem seeing how California could become like Greece, but the analogy breaks when applied to the US government.
a deficit at the rate of the GDP growth rate is ok.
but if you run it above you steadily increase the debt-gdp ratio and will run into trouble at some point.
as the US can not run out of money MR has identified inflation as the only constraint. doing nothing would imply that current conditions (low inflation, low interest rates, low unemployment) will stick forever. how likely is that?
why do it now? because when those conditions change for the worse and the market demands actions it can´t be done in time.
GreenAB– Any inflation resulting from a fiscal deficit will hit at the time the deficit is incurred, not years later. That is because government “debt” is functionally equivalent to money. Similarly, there is nothing the market can do if the government decides, sometime in the future, that the deficit must be lowered by fiscal tightening.
The debt/GDP ratio, as popularized by Rogoff and Reinhart, is meaningless. They screwed up big time by mixing Greek-like apples with U.S.-like oranges…
there are numerous sources of inflation. in todays interconnected world economy it doesn´t have to start here to hit the US.
and i do think debt-gdp matters. lets say we get down to a 5-6% inflation rate, while running debt-gdp up.
with no slack in the labor market inflation has a chance to be sticky. lets say we get a modest inflation rate of 5-6% which leads to treasury yields rising also to the 5-6% range.
then the higher the debt-gdp ratio the more every single point rise in treasury yields will hurt the ability to spend because a larger piece of the pie has to be directed towards debt service.
last year the sky was falling because Spain and Italy could not possibly sustain yields north of 6%.
i could be wrong and this level won´t be a problem for the US. but i wouldn´t bet on that.
we can sit back and watch how Japan will handle it, once they get their desired inflation.
correction the second paragraph should be read: lets say we get down to a 5-6% UNEMPLOYMENT rate, while running debt-gdp up.
The interest on gov debt does not disappear into space right? It is a form of spending.
Also, inflation would of course lessen the burden of debt payments as a percentage of GDP.
Finally, the FED could simply cap yields on gov debt (as they did post WW2).
Well said, Happpy. Why would the U.S. raise interest rates to fight inflation, when — as GreenAB points out — that will be inflationary? Better to use fiscal policy to fight inflation when and if it hits and unemployment has fallen (as assumed by GreenAB).
The real problem with regard to potential inflation is the trade deficit…
I will give you some answers, why:
80% of new debt issuance is financed by the private sector according to Cullen. This means that deficit spending is not that inflationary, unless the Fed prints to cover it, which makes it inflationary in the eyes of banks at least, as these get to hold the reserves. Unfortunately the current path is of a rising stake of govt as part of GDP. And govt is less productive than the private sector, unless there are big infrastructure projects. In the US govt is about 40% of GDP now (from 20% 30-40 years ago) and in France it is 55%. And rising. This will destroy a lot of wealth on its way, but it may be not immediately evident by papering it over / printing QE. In that sense inflation will show when a lot of real wealth has been destroyed and the smoke and mirror shows cannot hide the facts. Then you would like to have a lower debt/GDP ratio. The Fed would raise IR to fight inflation / get market trust as Volcker did (and the Fed will be chasing the rates higher, which will move in front of it as always)
There’s a lot in your post that I disagree with, but the main issue is whether or not the Fed should list interest rates a la Volcker to crush inflation, should the time come.
My understanding is that Volcker didn’t really know what he was doing and plunged the economy into recession, and created the conditions for the S&L failures later in the 1980s. He thought he could control the money supply, but soon had to give up on that.
More significantly, in retrospect it’s clear that breaking the power of labor and globalization were key to the development in the 80s and 90s. U.S. wages have decreased as a percentage of national income, while profits have increased. Volcker’s interest rate blunders were a bit of a side show.
The historical correlation between lower interest rates and lower inflation is clear. Rates have decreased continuously since Volcker’s time, as has inflation. During the post-WWII period, both interest rates and inflation increased. This is obviously due to the fact that the Fed reacts to inflation rather than controlling inflation.
As far as the effects of fiscal policy being limited because most new debt issuance comes from the private sector, this is true up to a point. As we saw in the 1920s and 1990s, net private sector financial assets are key in the medium to long term. The private sector can create a lot of new debt, but that will collapse under its own weight, something that doesn’t happen with government debt.
When the private sector blows another bubble it will inevitably pop, whatever the level of interest rates…
Wow. Just wow.
Forbes says the $995 billion in cuts over ten years is actually a $110 billion INCREASE over ten years:
http://www.forbes.com/sites/paulroderickgregory/2013/02/19/the-995-billion-sequester-cut-is-actually-a-110-billion-spending-increase/
http://merrillovermatter.blogspot.com/2012/12/the-fiscal-cliff-of-1937.html
Macroeconomic Advisers writes: “The impact of the sequestration would not be a macroeconomic catastrophe.”
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What is sobering are the potentially catastrophic effects of perceived U.S. weakness in the minds of our enemies … and we do have some very serious minded enemies.
Weakness begets aggressiveness; aggressiveness begets violence … and people get killed, perhaps someone(s) you or I know and love.
All because of a bunch of Dearly Elected pinheads in Washington who are there because millions of electors are more concerned about party-think than fundamental human truths.