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By Jason Stipp and Robert Johnson, CFA | 02-28-2013 01:00 PM

What Does the Sequester Mean for the Economy?

Morningstar's Bob Johnson puts the $85 billion of spending cuts into short- and long-term perspective.

Jason Stipp: I'm Jason Stipp for Morningstar.

The so-called sequester is set to go into effect on Friday. This is potentially $85 billion of spending cuts over time. Here to offer his take on the potential impact of the sequester is Morningstar's Bob Johnson, our director of economic analysis.

Thanks for joining me, Bob.

Bob Johnson: Great to be here.

Stipp: They call it a "sequester." It's really spending cuts. Can you just give us a quick background on what exactly is the sequester?

Johnson: Sure. We started in 2011 with the fight on the deficit ceiling, and what happened is that they couldn't agree on the full program. They did agree that we need about $4 trillion worth of cuts over 10 years in the budget to make all the numbers come out right, and that seems to be relatively reasonable.

And so far through various programs that have been implemented, we've gotten maybe $2.6-$2.7 trillion of those [cuts], and that left about $1.2 trillion. And since they couldn't agree, they said fine, we'll just automatically do it as of "such and such" date, and we'll take half of it off social programs and half of it off defense.

Stipp: So they couldn't reach a [full] agreement back then. They did do some cuts in the meantime, but these are automatic cuts set to take care of the rest of those debt and deficit issues that they couldn't agree on yet, so it's the automatic spending cuts.

But there are a couple of interesting things going on here. So, this deadline officially starts on Friday, but it doesn't mean, first of all, that all the cuts will happen on that one day, and there are also some other upcoming deadlines that are important to keep in mind in relation to the budget issues.

Johnson: The $85 billion is for this year, and then every year after that--not an additional--but the budget will be about $110 billion lower than what it would be, and that over multiple years gets you to the cuts that we really need to bring our budget deficit down to about 2%-3% of GDP. And so that's the goal of all of this, and it does happen, as you said, over time.

Now, again, the sequester is a relatively small number at $85 billion, but it's not even going to be all that, because some of that's not going to be cash. It's going to change the budget authority. It means you can't contract for a school or an aircraft carrier or something that's got a multiyear life, but it doesn't change cash flows, because that wasn't meant to be spent this year anyway. So, the Congressional Budget Office says that out of the $85 billion, really $42 billion will be cash not spent.

And then to go further with the Congressional Budget Office analysis--which I've got no particular reason to disagree with--it is a bipartisan group, they've been relatively accurate, and they've handicapped a lot of the budget cuts and things that have been made so far. And their projection is that the sequester would take off six-tenths of a percent from overall GDP growth for this year, fourth quarter to fourth quarter, and it maybe would affect about 750,000 jobs potentially by the end of the year. And, again, keep in mind that we've got about 135 million people in the economy working right now.

Stipp: So the $85 billion, which is the top line number, but then only part of that is actual cash that will be taken out of the economy because of these cuts.

And you said that you have to put that number in context. We've already seen some cuts that have happened before or some tax hikes that have happened already. What does this number look like compared to what we've already seen the economy have to deal with so far?

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