A sequestration of federal spending, scheduled to take effect on March 1, is now less than two weeks away.  Little progress has been made in negotiating a bargain that avoids or delays the automatic spending cuts implied by the sequestration.[1] Accordingly, we now put the odds of a sequestration at close to 50%, and rising.
  • Our baseline forecast, which shows GDP growth of 2.6% in 2013 and 3.3% in 2014, does not include the sequestration.
  • The sequestration would reduce our forecast of growth during 2013 by 0.6 percentage point (to 2.0%) but then, assuming investors expect the Federal Open Market Committee (FOMC) to delay raising the federal funds rate, boost growth by 0.1 percentage point (to 3.4%) in 2014.
  • By the end of 2014, the sequestration would cost roughly 700,000 jobs (including reductions in armed forces), pushing the civilian unemployment rate up ¼ percentage point, to 7.4%.  The higher unemployment would linger for several years.
The macroeconomic impact of the sequestration is not catastrophic.  Nevertheless, the indiscriminate fiscal restraint would come on the heels of tax increases in the first quarter that total nearly $200 billion, with the economy still struggling to overcome the legacy of the Great Recession, and when the FOMC is constrained in its ability to offset the additional fiscal drag with a more accommodative monetary policy.  By far the preferable policy is a credible long-term plan to shrink the deficit more slowly through some combination of revenue increases within broad tax reform, more carefully considered cuts in discretionary spending, and fundamental reform of entitlement programs.

The Budget Control Act of 2011 (BCA) established separate caps on defense and nondefense spending for fiscal years 2012-2021, while also creating the Joint Select Committee on Deficit Reduction charged with proposing an additional $1.2 trillion of deficit reduction relative to budget projections based on the cap that was to be enacted, by January 15, 2012.
[2] Failure of the Committee was to trigger, effective January 1, 2013, “automatic” cuts in spending of roughly $110 billion per year relative

to the caps, with the cuts split equally between defense and nondefense outlays.  For 2013, the reductions were to be implemented by cancelling budget authority in a process called “sequestration.”  For subsequent years, the cuts were to be achieved by adjusting downward the original caps.  The Committee did in fact fail, starting a year-long countdown to the sequestration.  The recently enacted American Tax Relief Act of 2012 (ATRA) made slight adjustments to the original spending caps enacted under BCA, reduced the size of the sequestration in 2013 by $24 billion (from $109 billion to $85 billion), and delayed its implementation until  March 1.  That day is now imminent.

Sizing the Sequestration
Table 1 and Chart 1, which are based on estimates prepared by the Congressional Budget Office, show the effect of the sequestration on both federal budget authority and federal outlays for fiscal years 2013-2023 relative to projections based on the spending caps.
[3] For purposes of assessing the impact of the sequestration on the economic outlook, our focus is on outlays as opposed to authority.  Note that the full impact of the sequestration on the level of outlays—roughly $110 billion—is not reached for several years, because the sequestration for 2013 was reduced and cuts in outlays lag behind cuts in budget authority.

Designing the Alternative Scenario
MA’s current baseline forecast does not include the sequestration.
[4] Rather, it assumes the sequestration is avoided and replaced with a long and gradual squeeze on spending that is less damaging to near-term economic growth and delays a significant part of the fiscal contraction until later in the decade when the FOMC is better positioned to offset the fiscal drag with accommodative monetary policy.

To use our macro model (MA/US) to simulate the potential effects of the sequestration on our forecast, it is first necessary to convert and interpolate the spending cuts shown in Table 1 from fiscal years to calendar quarters and then allocate those spending cuts across the components of federal expenditures in the National Income and Product Accounts (NIPAs) that are the basis for the government sector in MA/US.

This allocation does affect the results because cuts in different components of the federal budget affect the economy differently.  For example, a reduction in federal purchases of goods reduces GDP directly but (private) employment only indirectly, while a cut in federal employment reduces GDP and public employment directly and then private employment indirectly.  In addition, the fiscal “multiplier” is higher for direct purchases than it is for payments such as subsidies or foreign aid.

The results of this allocation through 2015 are shown in Table 2.  Cuts in NIPA consumption and gross investment account for roughly two-thirds of the savings, with transfers and grants comprising the rest.  About one-third of the cuts in transfers and grants are in Medicare benefits.

Simulation Results
We layered these spending cuts on top of our baseline assumptions and re-simulated MA/US allowing the model’s endogenous response of monetary policy.  The results for growth and unemployment are summarized in Charts 2 and 3; details of the baseline and alternative simulations are shown in the tables at the back of the report. 

The effect of the sequestration is to slow real GDP growth over 2013 from 2.6% to 2.0%.  The largest impact occurs in the second quarter, when growth is reduced by roughly 1¼ percentage points.  By the end of the year, the civilian unemployment rate is ¼ percentage point higher than in the baseline.  As early as the first quarter of 2014, GDP growth exceeds the baseline path, albeit slightly.  The reason growth rebounds so quickly is that while, relative to the baseline, spending does continue falling modestly in 2014 and 2015, slower economic growth and higher unemployment lead financial markets to expect a later (2016:Q1 instead of 2015:H2) tightening of monetary policy.  This lowers long-term yields roughly enough to just offset additional fiscal drag in 2014.  However, because GDP growth does not exceed the baseline by much in 2014, the increase in unemployment lingers for several years.  

Concluding Remarks
The impact of the sequestration would not be a macroeconomic catastrophe.  Nevertheless, the indiscriminate fiscal restraint would occur on the heels of tax increases that total nearly $200 billion in the first quarter, with the economy still struggling to overcome the legacy of the Great Recession, and when the FOMC is constrained in its ability to offset the additional fiscal restraint.  Furthermore, spending cuts that are so arbitrary in their allocation and timing can’t possibly be optimal from a public policy perspective. The preferable policy is a credible long-term plan to shrink the deficit more slowly through some combination of tax increases within broad tax reform, more carefully considered cuts in discretionary spending, and fundamental reform of entitlement programs.

[1] Democrats have proposed replacing the first 10 months of the sequestration with a combination of tax increases and spending cuts that would accumulate to roughly $110 billion over ten years.  The proposal would raise revenue by imposing the so-called “Buffet rule,” limiting tax breaks for oil companies, and penalizing companies that outsource jobs.  It would cut both defense spending and nondefense domestic outlays by $27.5 billion over 10 years.  Republicans appear unimpressed by the proposal and, at least for now, many in the GOP seem content to let the sequestration play out.
[2] The caps applied to spending other than outlays related to operations, both military (defense) and diplomatic (nondefense), in Afghanistan and also allowed “carve-outs” for spending on emergencies and disaster relief.  In addition, cuts to Medicare benefits were limited to 2%. 
[3] Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2013 to 2023 (February 2013).
[4] Please see Macroeconomic Advisers’ Outlook Commentary (Volume 31, Number 1; February 15, 2013).

[5] The sequester does not apply to the benefits of either the Social Security or the Medicaid programs, and cuts in Medicare benefits are capped at 2% of the baseline level. We allocated the defense sequester proportionately across all components of  NIPA defense expenditures and the nondefense sequester proportionately across all components of NIPA nondefense expenditures except Social Security benefits and Medicaid transfers to states, while observing the limit on cuts to Medicare benefits.  In addition, we assumed that reductions in grants to states are matched by reductions in state and local expenditures on goods and services other than compensation.

This is from a commentary that was published on February 19, 2013.

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