Paul Ryan Says Sequester Likely To Take Place

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When the Republican party agreed last week to a push back on the debt ceiling discussion by three months to May 19, virtually without a fight in a move that may presage what is set to become a quarterly can kicking exercise on the US credit card max, some were curious what the quo to this particular quid may be. Earlier today on Meet the press Paul Ryan explained: the pound of spending flesh demanded by the GOP in exchange for caving on yet another key GOP hurdle is, as our readers have known for over two weeks, the Sequester, which is set to hit on March 1 and possibly the stop-gap government funding on March 27, after which various government agencies will start shutting down. Both programs are set to kick in automatically as incremental spending cuts, chopping away even more basis points from the 2013 US GDP, unless the GOP votes affirmatively to extend them in what would then be seen as a move that destroys any last trace of leverage and credibility that GOP may have had.

From The Hill:

Rep. Paul Ryan (R-Wis.) predicted Sunday that “the sequester is going to happen,” and blamed Democrats for not producing an alternative set of spending reductions to circumvent the across-the-board cuts.

 

“We think these sequesters will happen because the Democrats have opposed our efforts to replace those cuts with others and they’ve offered no alternative,” Ryan said on NBC’s Meet the Press.

 

The sequester cuts, delayed by the “fiscal cliff” deal reached at the beginning of the year, are now slated to take effect on March 1.

 

Ryan added that the cuts needed to happen because Republicans can’t risk losing the only leverage they have when it comes to cutting spending.

 

“I think the sequester is going to happen, because that $1.2 trillion in spending cuts, we can’t lose those spending cuts, that was to pay for the last debt-ceiling increase, let alone any future increase.”

Ironically it is the military - so dear to the republicans - that may be impacted most acutely by the sequester, as Reuters explains:

Some Republicans have called for delaying the planned spending cuts in defense while increasing cuts in other areas of the federal government. The Pentagon said on Friday it had begun laying off most of its 46,000 temporary and term employees and cutting maintenance on ships and aircraft in an effort to slow spending before nearly $50 billion in new cuts are due to go into effect on March 1.

In addition to the sequester, there is also the stop-gap government funding measure, which is set to take place on March 27, and following which various government agencies will begin shutting down without much if any clarity as to what happens next:

March 27 is the expiration date for a stop-gap government funding measure. If Congress does not authorize a new spending bill by that date, government agencies and programs would have to start shutting down. In such a scenario, military activities could be curtailed and federal employees put on unpaid leave.

 

While Republicans in the past have threatened similar shutdowns to press for spending cuts, the tactic could backfire. Republican-led government shutdowns in 1995 and 1996 met with strong public disapproval.

 

Ryan played down a potential fight with Democrats over the stop-gap spending measure.

 

"No one is talking about shutting the government down," Ryan said.

 

The House last Wednesday passed a Republican plan to allow the government to keep borrowing money through mid-May, clearing it for quick enactment after the top Senate Democrat and White House endorsed it.

 

The measure includes a measure requiring the House and Senate to pass a formal budget resolution by April 15. Under the provision, if either chamber fails to meet this deadline, lawmakers' pay would be suspended until they pass a budget.

Ryan's interview can be seen in the clip below.

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The one topic that has been left untouched is what the impact on US growth as a result of the sequester will be, because while it is known that the expiration of the payroll tax cut extension will cut 1% of GDP, few have discussed the impact of the sequester. Luckily, some ten days ago we covered just this. We repost that analysis in its entirety now that the sequester is more than a fleeting possibility.

Here Comes The Sequester, And Another 1% Cut To 2013 GDP

Several days ago we showed an analysis that indicated that the elimination of the payroll tax cut would likely eat into 1.5% of 2013 US GDP and subtract as much as 3.5% of 2013 growth based on one submodel - a deduction to overall US growth which already puts US GDP forecasts in borderline recession territory. We also added the caveat that "no estimates take into account spending cuts, which may happen, and which will serve as a double whammy to consumption in addition to already enacted tax hikes." Today, we present the flip side to the GDP calculation, namely what may and likely will happen to US growth once the pound of flesh is extracted by the GOP in exchange for raising the debt ceiling, which will eventually be raised even if it means a shutdown in the government for an indefinite period of time.

The reason: the sequester, whose implementation most thought would be delayed until well into 2014, is now starting to loom as the logical counterpoint to the debt ceiling compromise. And here comes Goldman with the first shot across the bow on what this quid pro quo would likely mean for US GDP: "Allowing the sequester to hit would, in our view, have greater implications for growth than a short-lived government shutdown, but would not be as severe as a failure to raise the debt limit. Although Republicans in Congress generally support replacing the defense portion of the sequester with cuts in other areas, there is much less Republican support for delaying them without offsetting the increased spending that would result."

And in bottom line terms: "Sequestration would reduce the level of spending authority by $85bn in fiscal year (FY) 2013 and $109bn for subsequent fiscal years through 2021. The actual effect on spending in calendar 2013 would be smaller--around $53bn, or 0.3% of GDP--since reductions in spending authority reduce actual spending with a lag. The reduction in spending would occur fairly quickly; the change would be concentrated in Q2 and particularly Q3 and could weigh on growth by 0.5pp to 1.0pp."

In other words: payroll tax eliminates some 1.5% of 2013 GDP growth; on the other side the sequester cuts another 1%: that's a total of 2.5%. So: is the US now almost certainly looking at a recession when all the fiscal components to "growth" are eliminated? And what will the Fed do when it is already easing on "full blast" just to keep US growth barely above 0%?

Of course, don't tell the market, whose only illogical response to what is an increasingly ugly fundamanetal picture would be to... sell vol, and push the ES to new 5 year highs.

Full note from Goldman:

Spending Cuts Under the Sequester: A Question of When, Not If

  • Failure to raise the debt ceiling would have severe economic consequences, but for this reason Congress seems likely to increase it. By contrast, a temporary government shutdown would have a limited effect on growth if it were resolved quickly, and this lack of severe consequences makes it more likely to occur. In the middle of these two extremes lie the spending cuts under sequestration--allowing them to take effect in full could impose a meaningful drag on growth, but the effect might not be severe enough to dissuade Congress from allowing it to occur.
  • Our forecast assumes that $15bn in sequestration-related spending cuts will take effect in 2013, with the remainder implemented in 2014 and 2015. But while we have been assuming that the sequester will be allowed to take effect eventually, that moment may come sooner than we had expected, for two reasons: (1) many members of Congress dislike the sequester, but reversing it amounts to a spending increase, which would be politically difficult; and (2) the sequester takes effect March 1, and Congress may not have resolved the two other fiscal issues by that point.
  • While there is a growing risk that some of these cuts are allowed to take effect, we suspect that Congress will reverse at least some of them, potentially replacing them with phased-in savings elsewhere in the budget. The Dept. of Defense has already announced that it will have to undertake several disruptive steps, including employee furloughs, if the cut is implemented on schedule. Delaying it until the start of the coming fiscal year would avoid most of this disruption, but would not have that significant an effect on the 10-year budget projections.

Once again, the White House and congressional Republicans find themselves with seemingly irreconcilable differences on key fiscal issues. Speaker Boehner has insisted that an increase in the debt limit must be matched with spending cuts of an equal amount (when measured over ten years), while President Obama reiterated today that he will not negotiate on any other policy changes in return for the increase. Settling this disagreement will be harder than it was in 2011, when the debt limit was increased by $2.1 trillion in return for $2.1 trillion in spending cuts over ten years. Further budget savings would need to come mainly from entitlement programs or tax increases, which are much more controversial.

President Obama is unlikely to accept entitlement cuts without a second tax increase. Republicans are therefore looking for a way to convince the administration that agreeing to entitlement cuts will be better than what would occur if no agreement is reached. To be successful, the mechanism Republicans use to force the issue must have severe enough consequences that the White House will want to reach an agreement instead, but not so severe that no one believes it could be allowed to happen. They have three options to choose from:

Debt limit - severe effects but low likelihood: The Treasury has indicated it expects to exhaust its borrowing capacity "between mid-February and early March," similar to our previous projection of March 1. There is little risk to Treasury's ability to make scheduled interest or principal payments, in our view, given their small size relative to Treasury's overall cash flows. But there still would be two important consequences: first, the inability to borrow would force the Treasury to immediately eliminate the budget deficit, leading to a delay in payments to federal employees, federal contractors, and beneficiaries of entitlement programs, among others; second, rating agencies might downgrade the US rating following a failure to raise the limit in a timely manner. Even Speaker Boehner has described potential failure to raise the debt limit as a "financial disaster." The upshot is that since leaders of both parties accept the need to raise it and recognize the negative consequences of a failure to do so, opposing an increase in the debt limit is no longer as credible a threat as it was in 2011.

A government shutdown -- modest effects but increasingly likely: Congress opted in September 2012 to extend spending authority for six months, until March 27, 2013. This has been done frequently in recent years when lawmakers cannot agree on full-year spending levels. If spending authority is not extended further, the Obama administration will lose its authority to carry out activities funded by appropriations and will be forced to shut down non-essential government operations. This is not as bad as it sounds, for a few reasons: first, only 40% of federal spending relies on congressional appropriations; the remainder is unaffected by a failure to extend spending authority. Second, about two-thirds of that 40% is deemed "essential" and continues even without a renewal of spending authority. This includes defense functions and services "essential to protect life and property." The upshot is that a one-week shutdown of these activities would reduce federal spending by $8bn to $12bn (annualized). Since a shutdown that begins on March 27 would straddle the end of Q1 and the start of Q2, the effect on quarterly growth is hard to estimate but might be around 0.1pp in each quarter. (For more discussion of the effects of a government shutdown, see our April 8, 2011 US Economics Analyst).

Sequester -- meaningful effects and quite possible: Allowing the sequester to hit would, in our view, have greater implications for growth than a short-lived government shutdown, but would not be as severe as a failure to raise the debt limit. Although Republicans in Congress generally support replacing the defense portion of the sequester with cuts in other areas, there is much less Republican support for delaying them without offsetting the increased spending that would result.

Among these three options, the sequester may present the greatest risk to growth in 2013 because it might actually happen--unlike a debt-limit induced default which is very unlikely--and because it would have longer lasting effects, unlike a government shutdown, which would be reversed quickly.

Sequestration would reduce the level of spending authority by $85bn in fiscal year (FY) 2013 and $109bn for subsequent fiscal years through 2021. The actual effect on spending in calendar 2013 would be smaller--around $53bn, or 0.3% of GDP--since reductions in spending authority reduce actual spending with a lag. The reduction in spending would occur fairly quickly; the change would be concentrated in Q2 and particularly Q3 and could weigh on growth by 0.5pp to 1.0pp.

The sequester would weigh on growth mid-year

Unlike the other two issues noted above, the sequester is not a "cliff." There would be few spending cuts implemented in the days immediately following March 1 if Congress allows the sequester to take effect on schedule. It would probably take federal agencies several weeks to put the cuts into effect. Moreover, the law provides federal agencies 120 days to take "administrative regulations or similar actions implementing sequestration." So it is possible for Congress to allow the sequester to be implemented on schedule, but to "turn off" the sequester a few weeks later without a significant effect on spending.

If the sequester were fully implemented, it would have very disruptive effects in some areas of the budget, particularly defense. In order to fulfill the requirements of the sequester, the Department of Defense (DoD) would need to reduce spending authority by around 9% for FY2013. The administration would have little flexibility in how to implement this cut, so every program, project, and account would need to be cut by the same amount. This would mean, for example, furloughing most civilian DoD employees for a full month before the end of the fiscal year, and cutting basic activities like healthcare for active-duty military and aircraft maintenance. On the non-defense side, the cuts would be similarly disruptive though the political effects might not be as salient.

Sequestration would be much more disruptive in 2013 than it would be in 2014 and beyond. The budget agreement that Congress reached in the summer of 2011 cut spending through two mechanisms: (1) annual caps on congressional appropriations and (2) the sequester, which cuts the level of spending authority by $109bn below the cap just mentioned. Since the 2011 law called for sequestration to take effect January 1, 2013--three months into the fiscal year--it was structured as an across the board cut to the spending level already in place. For 2014 and beyond, the sequester simply lowers the cap mentioned earlier by an additional $109 billion. That means that instead of across the board cuts, for FY 2014 and beyond Congress can appropriate funds as it sees fit as long as it stays below the caps. Delaying the sequester to the start of the coming fiscal year would not simply "kick the can" on fiscal restraint but it would also allow a less disruptive and more efficient cut to be implemented.

However, the cost of a delay could be a problem. Delaying the entire sequester until the next fiscal year starts (October 1, 2013) would increase projected spending over the next ten years by $85bn. Finding savings elsewhere in the budget to offset that increase in spending would be difficult, particularly if Republicans insist that the new deficit reduction measures used to replace the sequester should come entirely from domestic spending like entitlement programs. If the budget effects of a delay become prohibitive, Congress might opt to reduce but not eliminate the sequester for FY2013.

Even if Congress does manage to delay the onset of the sequester past March 1, the cuts are likely to be implemented eventually. As noted above, our forecast assumes that $15bn of the cuts will be implemented in 2013 (versus $53bn if Congress takes no further action) with the remainder implemented in 2014. This is based on the premise that although neither party likes the sequester, the entitlement spending cuts and tax increases that would be necessary to replace the sequester over the longer term are even less popular.

Ultimately, it is only a matter of time before the sequester will be implemented. While we have assumed that Congress would delay part of the sequester until 2014, when it could be implemented with much less disruption to the military and other federal activities, it is very possible that some or most of it could take effect earlier than expected, in 2013.