Sequestration: What it really means

The real problem with the sequestration for both politicians and investors is that the cuts will be phased in over time without an immediate impact. No one is really sure what its effect will be. It is doubtful that either party will feel the need to compromise until there is a consequence either from the markets or from the voters

Three months ago as most Americans were getting ready for the annual holiday insanity, the news outlets were adding to the hysteria with threats of a fiscal Armageddon. The fiscal cliff was coming! The fiscal cliff was coming! As of 1 January 2013 taxes for all US taxpayers would rise and government spending would be drastically cut. This would result in an immediate recession. Markets would crash. Corporate and consumer spending would cease. But a funny thing happened. Nothing! Nothing happened.


After a number of dramatic late night telephone calls, all-night meetings and even a rare session on New Year’s Day, a holiday in the US, at the last minute the US Congress got together and passed a Bill that raised taxes on a very small percentage of Americans and reinstated pension charges on everyone else. The spending cuts were delayed for two months until Friday 1st March. Markets seemed to anticipate this and continued to rise throughout December and have been flirting with multi-years highs ever since. What is interesting is that the markets do not seem to have priced in the second part of the fiscal cliff, the cut in government spending known as the sequester.


In contrast to the fiscal cliff, sequestration has been met with a universal yawn. Compared with the disaster of the Italian election, it seems that nothing much has happened. But if you listen to president Obama, disaster is just around the corner. For the last two weeks the White House has been listing the effects of sequestration. These include the loss of nutrition support for 600,000 poor women and children, cascading flight delays, and a hit to the US military readiness as up to 800,000 civilian employees of the military will go without pay for a short period. Still the American public is almost unanimously apathetic.  Polls have shown that although more voters blame the Republicans rather than the president, only half the population has a clue that there is something going on. They dislike the way the government is going about the spending cuts, but the cuts themselves are generally popular, unless the cut is to your favourite programme.


Last December, before the fiscal cliff, there were all sorts of businessmen and CEOs lobbying to prevent it. But now most seem to believe that the cuts would do little harm. The fiscal cliff entailed something all businesses hate with a passion: higher taxes. The sequester is something much more benign: cuts in government spending. Even better those cuts phase in gradually over time. So, unlike a tax hike which would affect people immediately, the cuts may or may not be noticeable.


The sequester started as a compromise in the summer of 2011. It was a compromise to insure that the US could continue to borrow money and stand behind its obligations. It was basically a bet by both parties that they would come out with the upper hand at the next election. Sadly the electorate again split down the middle and neither party gained any advantage.


The two aspects of it were unequal though in their repugnance to a particular constituency. The idea was to find a solution to America’s $16 trillion deficit, which is approaching 100% of GDP. The Republicans wanted to solve America’s growing deficit with spending cuts. The Democrats wanted to solve it with higher taxes on the rich. The fiscal cliff contained both cuts and taxes, but the Republicans outmanoeuvred the Democrats. They came up with a deal at the last minute that raised a few taxes on a very small number people earning over $450,000 a year, a very small number of individuals. But they delayed the cuts until 1st March. With the taxes out of the way, the Republicans felt no need to compromise on spending cuts. There are Republicans who dislike the military cuts especially in districts with military installations. For every one of those, there are Democrats who like the idea of taming a bloated military.  Still the vast majority of citizens will probably not notice at all. President Obama basically admitted this on Friday. He toned down the scare tactics and said that sequestration would not result in a collapse.


The economic effects of the cuts in government spending are hotly debated. Some Democratic tinged economists feel that the cuts of $85 billion this year and $1.2 trillion over 10 years will result in a loss of almost 1% of GDP. In December the US economy grew at only 0.1% and the forecasts are for not more than 2%. The Republican economists are more benign. They point out that the cuts account for only 2.3% of total spending and that the government should easily be able to cut this amount since government agency budgets have been growing by an average of 17% in the previous five years. Their projections are for an impact on the economy of as little as 0.3% although unemployment could tick up from the present 7.9% to 8%.


This week in his testimony the Federal Reserve chairman, Ben Bernanke promised continued monetary stimulus in the form of QE3. But he admitted that the stimulus would not be sufficient to overcome the effects of the budget cuts. Bernanke’s promise may not be sufficient, because there are rising doubts about the risks of his programme both in Congress and more importantly among his own Committee. In the minutes recently released ‘many’ of the 19 officials who attend the rate-setting Federal Open Market Committee “expressed some concerns about potential costs and risks arising from further asset purchases”.


The sequestration is not the only budget issue. Congress has not been able to pass a budget due to the continuing polarization. To keep the government running, they use a device called “a continuing resolution” that funds programs at prior levels less the sequester cuts. It there is no budget by 27th March, the government shuts down. Finally the debt ceiling ran out in the beginning of February. To avoid the really harsh and immediate economic impact it was extended, but only until May. No doubt these deadlines will be an excuse for more sniping and possible delay, but to go past either deadline has an immediate effect which is probably untenable for either party.


The real problem with the sequestration for both politicians and investors is that the cuts will be phased in over time without an immediate impact. So no one is really sure what its effect will be. It is doubtful that either party will feel the need to compromise until there is a consequence either from the markets or from the voters. Right now neither seems to be interested. So nothing will be done.


What is clear is that the period of unlimited monetary and fiscal stimulus in the US is coming to an end. This will be difficult for both politicians and central bankers. It is far more fun and popular to hand out money than to take it back. The problem for investors though is not the US tightening. The American economy has recently shown signs of resilience especially in the housing market. It appears that the employment situation is getting better, which will change with sequestration. Recent numbers from manufacturers are hopeful. So there will probably not be a US recession, but neither will there be anything but marginal growth.


The problem is that tightening in the US appears to be part of the global tightening. The best thing that can be said about the European numbers is that they are not as bad as they were. The EU remains in recession and the political turmoil in Italy and other countries will not help the situation with the Euro.


China has been floating on a flood of cash from the unleashing of its shadow banking system since last year. This will end. The People’s Bank of China recently announced new regulations aimed at controlling these off balance sheet transactions. The state council has announced further restrictions on real estate. The experiments with real estate taxes will be continued and expanded, which will increase carrying costs for the millions of empty apartments. The real estate issue is so bad that even Rui Chenggang, the patriotic anchor of a prime-time business news programme on China Central Television, the state-run broadcaster, opined that “There is a huge real estate bubble in third and fourth-tier cities in China. Sales of homes have slowed significantly, to the point that supply seriously exceeds demand.” Only Japan seems interested in more free money.


The combination of a more optimistic outlook in all the major economies and loose fiscal and monetary policy has encouraged speculators around the world to increase their risk exposure and look for yield in every possible place. Markets have been driven to all-time highs in many countries. After a recession a certain amount of stimulus is good, but after four years there may be distortions in the global economy that central bankers did not predict, government policy makers did not foresee and investors may find more painful than any effects of the sequestration.


Other stories from William Gamble


(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)

Vinay Joshi
1 decade ago
Hello William,

History shows the second term Prez in US rarely bothers, not many have bothered, Obama bothers for Dems reputation.

The sequester is going to hurt but when else the US will summon the seriousness to cut?

Will it be a hatchet or a scalpel?
What about defences?

What is the reason for US debt?
Per capita debt of $ 52,812 [16.6 trn, GDP 15.7 trn], globally 700+Bn$ assets & operations sold by commercial banks, overseas operation are about 350+Bn.

Will Obama decide to his [Dems] political advantage? 41% GDP government spending.

Italy STARK 'eye opener'. High taxes, VAT 22%, 47% wages of employees fund social protection schemes, employers no better off, unions grip, high taxes.

US wants to follow the path?


Free Helpline
Legal Credit