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What Does the Sequester Mean for the Economy?

Jason Stipp
Robert Johnson, CFA

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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Johnson: Well, when we went over the fiscal cliff and actually implemented part of the things that were in the fiscal cliff, it did some deficit cutting of about $235 billion. Now the sequester is about an $85 billion number. So it's about a third of what we've already seen. So, again, it's not helpful in a slow economy, but on the other hand, we've gone through a lot worse.

[Consider] the payroll tax alone, which was immediately implemented, no hiding, no escaping. It hits consumers today--none of this, "well, it may happen next week; it may depend on whether we take aircraft carriers or TSA or whatever in the cuts." The payroll tax was a much bigger number, and [the sequester] is smaller--painful--I hate to deal with it, but it is small.

Stipp: So the other issue that I've heard people talking about are knock-on effects. So, for example, if TSA layoffs have to happen, travel gets bottlenecked, that could potentially affect commerce. It's just harder to get business done, because some of the things that government does help to facilitate that. Is some of that getting captured or not captured in that $85 billion number?

Johnson: That is not at all captured in that number, and I don't really think it's actually in the Congressional Budget Office number impact, either. I think [the CBO number is looking at] how many people, and how many agencies, and then how many people are subcontractors to that, and then doing multiplier effects to figure it out.

I'm thinking nobody is thinking that the government shutdown is going to be so bad that it actually does impinge on the economy, but it could, as you mentioned, if people stopped flying because of the TSA backups at airports, or the meat inspectors can't inspect meat anymore, and slows the commerce in meat or the import and export of meats. There could be some effects. I don't think anybody is really talking or thinking a heck of a lot about that, but obviously it could be an effect.

Stipp: And the other thing that you've already mentioned is that some of these things will happen over time. So, even though we are going to hit that automatic start on Friday, it's not like everything goes into effect immediately.

The other thing that's coming up is the government funding and the government budget by the end of the month. Do you expect that we will see a lot of these cuts and sequester issues potentially change in this month's time between the automatic start of the sequester and when the rest of the budget discussions are going to happen.

Johnson: Well, right now, the sequester, they may just let it happen. And I … by the end of the month, they have to get together to do something or government completely shuts down, and that just can't happen. And I think they will be talking to each other by the end of the month.

But in prelude to that, they may just forget about what's happening in the sequester and say let's watch the big picture, or maybe everybody doesn't cut the first day anyway, let's let that sit. But we really do have to talk by the end of the month, and then there's no messing around or else the government shuts down.

And then you've got the debt ceiling issue, which comes up again--remember they kicked the can down the road on that one until the middle of May. And so the sequester is probably the least important of all those events, but certainly the way we are dealing with that isn't particularly helpful.

Stipp: So, a lot of things that need to be on investors' radars that could potentially have an impact, and the sequester is just one of them.

Let's just talk about that $85 billion. You mentioned that they had calculated that it could take 0.6% off of GDP. Do you think this is something that the economy could handle over the time period that you're expecting these cuts would take place without a really negative impact? It's obviously going to have an impact, but is it going to sink us?

Johnson: I don't think so at all. I think it will be a little bit further into the year when the rubber hits the road, so to speak. I think that's when they'll have to deal with that. By then I think the economy may be just a little bit stronger, may have recovered from some of the payroll tax issues that we've hit upon, and this little soft spot with the weather-related issues in a couple of the government statistics.

So, I don't think it's going to sink us this year at all. Again, keep in mind we've got a $15 trillion economy, and this is maybe $85 billion worth of cuts. So, it's not a massive number. It shouldn't be enough to sink us, but that doesn't mean it might not make our lives miserable, because even though it's a small number in the economy and it's actually relatively small relative to the total government spending, it's a very large percentage of discretionary spending. It's like 7% or 8% of defense spending and maybe 5% to 6% of social spending that's going to be cut in one year, because you can't touch Social Security, you can't touch food stamps, you can't touch a lot of government entitlement programs under the terms of the sequester. So, that's going to force cuts in a lot of discretionary programs, and those numbers are actually pretty big there, even though the whole cut is about 2% of government spending, which sounds like, heck, who can't cut spending 2%.

Stipp: This is obviously a very politically contentious issue, how much cutting we should do, where we should do it. As you mentioned, the sequester is not touching some of those entitlement programs, but over the longer term, a lot of the cuts we're talking about now will get us so far, but we have lots of other issues, as you've mentioned, 10 or 15 years down the road that we'll eventually have to address. So, in your mind, is the amount of cutting we're doing now appropriate and will we have to do bigger cuts in the future to keep the boat steady?

Johnson: I think they're doing it right by trying to take care of the next 10-year deficit problem first, but I think we need to get on the entitlements case relatively soon, because if you fix it now, it's relatively easy. You [raise] the retirement age a couple years, and you've cured an awful lot of the problem. If you wait until 10 years from now to fix it, well, now the retirement age has to be 72, 74, 75--I don't know the year--but it becomes a draconian number.

So, again, let's get this wrapped up and get a plan of action, but the longer-term entitlements issue still has to be solved.

Here are some numbers: the whole government spending in the year is about $3.3 trillion; $2.2 trillion of that is entitlements and mandatory spending. Only $1.1 trillion of that, or about a third of it, is discretionary things. And even there you could argue, how much more can you cut meat inspectors and the little programs that are involved there? Not a lot. They have to go after the big banana eventually.

Stipp: So, a lot of work to come in the future. Unfortunately we'll be talking about these issues, I think, for a long time.

Johnson: We will.

Stipp: Thanks for giving us an update and being here today, Bob.

Johnson: Thank you.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.