22 Feb 2013 See-kwes-tra-shun

In one week less a day sequestration is set to go into effect and neither President Obama nor Congress seem willing or able to avert it. Left unchanged the policy mandates $85 billion in automatic, across-the-board government spending cuts to begin March 1st.

At first glance $85 billion seems a drop in the bucket when compared to a total federal budget of $3.5 trillion dollars – in fact it is only 2.4%. But its not the size that’s important, it is where the cuts are legally required by the policy.

Sequestration is focused primarily on the relatively small part of government spending that accounts for federal agencies and departments that include Defense, FAA, Homeland Security, Agriculture, etc. It exempts most of the entitlement side of government (the cause of growing deficits), such as Social Security, Medicare and Medicaid. In the words of John Boehner “should the sequester take effect, America’s military budget would be slashed nearly half a trillion dollars over the next 10 years. Border security, law enforcement, aviation safety and many other programs would all have diminished resources.”

Whether you believe as President Obama, and much of the popular media, that government spending must be increased in order to get the economy growing again, or alternatively that a big government and its commensurate debt are smothering an already anemic economy, really doesn’t matter so much at this point. The real possibility of gridlock and stalemate are increasing as the costs of budgetary inaction increase exponentially.

A Brief History of Sequestration

House Speaker John Boehner wrote a piece in the Wall Street Journal yesterday that provided a good summary. So far it has not been countered by the White House in terms of its accuracy.

In the summer of 2011, President Obama and Mr. Boehner came very close to an historic agreement to cut spending and increase taxes to get the federal budget deficits under control. In the words of Mr. Boehner “Unfortunately our deal fell apart at the last minute when the president demanded an extra $400 billion in new tax revenue—50% more than we had shaken hands on just days before.”

While the president and speaker were in negotiations, the Congress hammered out a deal to raise the federal debt limit. But when the president demanded that he not face another debt-limit deal before the election he effectively scuttled the bipartisan Congressional deal that was then on the table and he replaced it with the sequester known as the Budget Control Act of 2011. With the debt ceiling bearing down Congress had no time to do anything but pass it.

In November of 2011 the White House reinforced the president’s commitment to the plan by saying that the president “will not accept any measure [by Congress] that attempts to turn off part of the sequester.” At the same time Mr. Obama campaigned on a pledge for “balanced” deficit reduction consisting of $2.50 in spending cuts for every $1 of new revenue. Neither the president not the Democratic Senate has offered anything like it in proposals to counter the sequester so far.

Republicans in the House and Senate now find themselves between a rock and a hard place. Allowing sequestration will almost certainly damage the economy and indiscriminately hamper good government programs along with wasteful ones. They face an equally unattractive alternative of turning their backs on core beliefs; that excessive government, debt and taxes erode productivity and future standards of living.

With the ball now clearly in the Republicans’ court, it has become clear that doing nothing may weaken or endanger the security of the nation. They are faced with a conundrum in providing federal agencies the flexibility to adjust their budgets given the reality of sequester. In the words of Karl Rove, “Flexibility means giving the executive branch, e.g., President Obama, greater authority. Republicans are loath to do this, but many fear that without this authority the sequester will be especially damaging to military readiness.”

In order to minimize the ill-effects of sequester, Republicans must give direct authority to the president to cut where he sees cuts are needed. This opens up the real possibility he will cut programs they favor. Still, as suggested by Mr. Rove and others, it is the right thing to do in these circumstances.

Possible Economic Impact

Economists suggest that removing $85 billion in government spending this year will reduce GDP by 0.6% With an economy already weakened by the Great Recession, years of political uncertainty, and a troubled Europe, 0.6% is a big deal.

Compounding the impact of uncertainty and sequestration on the economy is a recently added drain on the largest component of the economy – the consumer. The recent expiration of the payroll tax cuts reduced consumers’ take-home pay by a full 2% and it is already having an impact, according to major retailers like WalMart. Citigroup says that a household with $65,000 in annual income will see a reduction of $1,300 this year, and shift $110 billion overall out of consumers’ hands. Consumers represent almost 75% of the US economy.

Between the government job cuts and reduced consumer spending from taxes and higher gas and food costs, our economy will experience pain as we begin to withdraw from decades of excessive spending. There is no escaping it.

Either we address today the results of a decades-long broken political process in which both parties have gained favor by leveraging future generation’s lifestyles, or we go over a cliff far more dangerous than that of Greece’s. According to estimates by the Congressional Budget Office, adjusted by Barron’s to account for recent tax increases and other factors, if the US doesn’t raise taxes further and cut spending dramatically, the national debt could easily reach 153% of economic output by 2035.

In a recent article entitled “Next Stop Greece” Barrons  says “this problem can’t be solved by asking the rich to pay a little more, despite what the president says. In fact, Barron’s calculates that immediately increasing the marginal tax rate to 50% on the top 1% of the country’s earners would bring in $500 billion over the next 10 years. This would barely dent the country’s debt load, which would then be $20 trillion, and do little to forestall a financial crisis.”

“Getting the national debt under control will require tax increases for everyone, as well as budget cuts, particularly in entitlement spending, which is beginning to run out of control as the baby boomers hit retirement age. Fixing that now is not an easy task, given that Congress can’t even reach a compromise on a budget.”

The current stalemate does not bode well for hopes of getting our county on a stronger path any time soon. Given the harsh realities of today and our future, investment strategy and sound planning are more important than ever.