Sequester Studies

Capitol building at night

The failure of Congress to prevent the budget sequester—the automatic cuts in government spending that were put in place as part of the Budget Control Act of 2011 deal—means that approximately $85 billion in planned spending will be removed from the federal budget beginning this month. With Congress at an impasse over how to resolve long-term issues such as reforms to the nation’s tax code, entitlement spending, debt, and deficit reduction, the spending cuts enacted by the sequester could remain in place indefinitely. 

While the cuts officially took effect on March 1, it could be many weeks until the full consequences of sequestration are realized. With little known about the immediate impact of the cuts there is an ongoing debate about how much hardship they will actually bring. Some point to a stock market that has performed well thus far in 2013 as a sign that the long-term financial outlook looks strong despite the cuts, while others argue that reducing spending now in the face of a fragile economic recovery could imperil any gains that have been made. And while most the debate has focused on the markets and larger-scale economics, there is even less clarity on the impact the cuts will have on individual Americans.

In this month’s feature, Sellinger School faculty members Frank D’Souza, Ph.D., assistant professor of finance, and Jeremy Schwartz, Ph.D, assistant professor of economics, consider the impact of the sequester.

Frank D’Souza

Having passed the March 1 deadline for the sequester to begin taking effect, financial markets have not skipped a beat and continue to move forward buoyed by anticipated positive jobs numbers. Chairman Ben Bernanke’s commitment to keeping interest rates low for the foreseeable future has also helped the stock market surge and pushed the Dow to new highs.

The sequester is different from the fiscal cliff that was avoided at the start of the year, which is why we don’t see much panic in financial markets after the missed deadline. With the sequester, there is still a possibility that a more reasonable solution may be hammered out this month. If not, then we will see the first of these gradual cuts begin in April and the adverse impact of these cuts will be reflected in Q2 2013 economic data. 

For now though, the market does not seem overly concerned. The Sellinger Applied Portfolio run by our finance students has also had a great run since the start of the year.

As one deadline passes, however, a much bigger deadline looms on the horizon—March 27, the day that the continuing resolution appropriations legislation to fund government expires. If this deadline passes without any action, markets are likely to react much more negatively.

Jeremy Schwartz

The automatic cuts to federal spending, known as the sequester, are the latest example of poor economic and fiscal management from Washington. While the U.S. faces a serious long-term fiscal challenge, the timing of spending reductions is critical. Worker furloughs and reductions in government contracting reduce demand in the economy at a time when unemployment is still high. This reduction in demand, which will impact our region disproportionately, is compounded by the recent expiration of the payroll tax holiday. Together lower demand will reduce firms’ hiring plans from what they would have been had we avoided the sequester.

One needs only to look at Europe’s recent poor economic performance to see the consequences of such policies. In contrast to Europe, where austerity was forced upon nations facing unsustainable interest rates on their sovereign debt, U.S. rates are at historic lows. This gives U.S. policymakers the opportunity to make critical investments in the economy now and form a credible plan to deal with deficits to be implemented when the labor market has healed. 

Further, the spending reductions will have very little impact on our long-term fiscal challenges, which are the result of an aging population and exploding health care costs. The sequester excludes all programs related to these issues, while cutting infrastructure, scientific research, and education spending, all of which are relatively inexpensive and critical for future economic growth. The sequester’s adverse impact on growth and distraction from the true drivers of government spending will make it harder to reach a sustainable budget in the future.