The Independent Market Observer

2/25/13 – What Would the Sequester Mean?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Feb 25, 2013 6:48:49 AM

and tagged Politics and the Economy

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The headlines today seem to imply that the sequester will hit, as the Republicans have very little incentive to back down.

With the tax increases at the end of the year, Republicans faced a core issue—keeping taxes low—and the default option was a huge tax increase. In that case, they had an incentive to negotiate, because the alternative was far worse than any deal they could cut.

This time around, that’s not the case. Spending cuts, another core Republican priority, are on the table—but this time, if they do nothing, they get a big part of what they want. They now have an incentive to hang tough.

The problem, from a Republican point of view, is that many of these cuts come from national defense, historically a top priority for the party. Perhaps, when the sequester was proposed, the thinking was that defense cuts would be absolutely unacceptable to the Republicans, forcing them back to the table. That thinking seems to have been wrong.

Not that the assumption was unreasonable—far from it. But, for the first time, the Republicans as a party appear to be prioritizing government spending control over defense. As a result, it seems likely that we’ll see the spending cuts hit.

What does that mean for the economy? Unlike the tax increases, the impact should be relatively muted. Not zero, for certain, but the best estimates at this point suggest a drag on growth of about 0.5 percent of GDP. With current growth rates estimated at around 1.5 percent to 2.5 percent for the year, that would take a big chunk out of growth but still wouldn’t tip us into a recession.

Moreover, even with the spending cuts, the extent of the damage would depend on how exactly they’re done. The current cuts were deliberately set up to be as ham-handed as possible, in the belief they’d never hit. While Congress is unlikely to call off the cuts, an agreement to make them more targeted and less damaging, while keeping the absolute amount, is quite possible. If so, the damage might be less than anticipated.

Finally, while the spending cuts would undoubtedly have an initial impact, they would be a one-time event. The economy would take a hit in the first quarter and possibly the second, as it did from the tax hikes at the start of the year, but then carry on. Plus, even as federal spending declines, state and government spending is expected to start to recover, which could offset much of the damage.

The bottom line is that, unlike at the end of last year, the political incentives favor letting the sequester hit. Fortunately, also unlike last year, the damage is likely to be moderate rather than severe.

Cuts like these have to happen, and the developing consensus that we should let them happen now is actually a long-term positive for the economy, despite the short-term pain. While I can’t say it’s encouraging that the sequester will hit, in the end, we’ll be doing the right things for the wrong reasons, which is still better than doing the wrong things.

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