Sequester: Front-Loaded Pain, No Gain

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The sequester was supposed to be such a bad outcome that it would force a compromise. The across-the-board cuts were so rigid and hurt so many favored programs, BofAML notes, the “Super Committee” was almost certain to come up with a more flexible alternative. And yet, not only did the Super Committee fail to even make a proposal, the negotiations have now devolved into a blame game – the two parties are trying to pin the blame, and the political cost, onto the other party. As we have expected for some time, the sequester will very likely hit on March 1. This well likely add further downward pressure to the economy in the second quarter, with job growth averaging less than 100,000 per month and GDP growth slowing to 1%.

 

Via BofAML,

The Sequester Straitjacket

 

How big?

 

Federal budget accounting is incredibly opaque. There are two key complications. First, the sequester kicks in part way into a calendar year and about half way into a fiscal year, so figuring out the size of the shock requires first getting the timeframe correct. Second, it is important to distinguish between budget authority and actual spending; the latter depends on both past and present authority. The sequester cuts $1.2bn of budget authority over a nine-year period (2013-21).

 

Netting out about $200bn in savings from lower interest payments, that works out to about $109bn in reduced budget authority per year. However, there are three complications in calculating the actual cuts in spending this year. First, under the fiscal cliff compromise the cuts for this fiscal year don’t start until March and they are “only” $85bn. However, there are only seven months left in the fiscal year, so on an annualized basis the cuts are equivalent to a $146bn drop in appropriations. Second, the actual cuts in spending will be less than $85bn because the sequester cuts budget authority, not spending. Programs can use leftover appropriations from past budgets to cushion the immediate cuts. The CBO estimates the actual spending cuts will be $42bn.

 

That doesn’t sound too bad. Unfortunately there is a third complication. Currently, defense spending is running higher than the current annual cap. This overshooting has to be made up in the remaining months of the fiscal year. Thus we would not be surprised if actual defense spending drops more than the CBO estimates. Our rough bottom-line: we expect $50bn in cuts over the remaining seven months of this fiscal year, equivalent to 0.54% of GDP over that period.

 

How messy?

 

One of the most challenging things about the sequester is that it requires the cuts to be uniformly distributed at the “program, project, activity” (PPA) level. In other words, it doesn’t just cut spending, it freezes the way spending is allocated across projects. According to the Bipartisan Policy Center (BPC), this would have a dramatic impact on the allocation spending. For example, comparing Pentagon spending requests for 2013 to the sequester caps, it would cut spending on the overhaul of the USS Abraham Lincoln by 72%, but actually increase spending on the M-1 Abrams Tank by 442%. The cuts will be particularly damaging to longer term contracts. This creates a good deal of waste and expenses.

 

The cuts do not all hit on March 1; many will be phased in over a number of weeks. Many budget units are still triaging their spending cuts into “immediate, eventual and never.” The Defense Department is well advanced in its planning, but even they will phase in cuts over many weeks. For example, they plan to move about 80% of their 800,000 civilian employees to a four-day work week, but only starting in the last week of April.

 

Despite some implementation delays, we expect the bulk of the cuts for this year to be in place by the end of April. Every week that passes increases the cuts needed to meet the fiscal year target. Thus a department facing 10% cuts over the period from March to September will need to cut spending by 14% (=7/5 × 10%) if they wait two months to start.

 

How painful?

 

While the sequester makes a relatively small dent in the long-run deficit outlook, the cuts will be significant in the short run. The Federal government has about 2.2 million civilian workers with average salaries of about $75,000. There are also about 8 million contract workers, although most of these are presumably parttime. Some forecasters look for one to two million in job cuts. CBO expects about 800,000 in “full-time equivalent” employment cuts in response to the sequester by the end of 2014, and we are inclined to go with their numbers.

 

We think more than half of those cuts will come from reduced hours rather than layoffs. If other agencies follow the Defense Department and put 80% of their employees on four-day furloughs, that would turn 1.8 million full time workers into part timers. If that started in late April, it would save about $11bn in budget outlays. These savings are equivalent to cutting about 400,000 jobs. Presumably some contract workers would also face reduced hours rather than unemployment. Over all, we would expect actual job losses of a few hundred thousand.

 

We would expect job cuts to start in March, particularly from the defense budget, as it faces the toughest cuts and has the most advanced plans. Then, if the sequester is not watered down, we would expect even bigger cuts in April. For now we are penciling in 50,000 in cuts for March, 100,000 in April, and 50,000 in May, with much smaller cuts thereafter. We will revisit these estimates over time.

 

The shock to GDP growth will be equally noticeable. The CBO estimates a -0.5% impact on 2013 GDP. Macroeconomic Advisors (MA) recently ran the cuts through their model and estimated that the sequester would cut growth over the four quarters of this year by 0.5%, 1.3%, 0.6% and 0.1%, respectively. This is very close to what we have been assuming all along. If anything, the near-term shock could be slightly bigger than the CBO and MA exercises because they do not include the extra cuts needed to offset overspending in the first half of the fiscal year. We expect a negative shock to GDP growth over this year of 0.4%, 1.5%, 0.7% and 0.2% respectively.

 

Will it stick?

 

As we have argued before, and as press stories now confirm, Republicans have been reassessing their tactics for extracting spending cuts. Deficit hawks can choose among three spending deadlines to extract further cuts: the March 1 sequester, the expiration of the continuing resolution on March 27 and debt ceiling in May.

 

The sequester could be the most politically palatable path, for several reasons.

 

  • Both the debt ceiling and the continuing resolution are very blunt instruments for extracting concessions. Failure to extend these budget deadlines would result in a dramatic shutdown of large parts of the government. It is, in effect, throwing the budget baby out with the bath water.
  • President Obama is now in a stronger position to “call that bluff.” He won a solid victory in the election. He does not have to run for re-election. His popularity rating is much higher than that of Congress. And the public has gotten tired of brinkmanship moments in Washington, tending to put more blame on Republicans than Democrats.
  • Deficit reduction is painful, so better to get it over with now. The sequester will kick in more than a year and a half before the mid-term election. Moreover, the sequester requires no awkward negotiation.

 

At this stage we expect the full sequester to go through on March 1. We then expect a furious negotiation for the rest of the month, with three possible outcomes:

 

  1. Cut the sequester in half or more. The sequester is going to cause some ugly headlines, creating considerable pressure to scale it back. However, cutting it significantly would be a major capitulation for fiscal conservatives, particularly if they don’t want to make aggressive use of future brinkmanship moments. It would mean giving up on trying to “balance” the tax increases from earlier this year with spending cuts. We see a roughly 20% likelihood of a major watering down.
  2. No revision. As we noted above, the sequester is not only a significant cut, it is very rigid. However, we would not rule out a breakdown in the negotiations to loosen the straitjacket. Congress does not like to surrender to the President power to reallocate funds, and reaching Congressional agreement on specific reallocations may prove impossible. We see a roughly 20% chance that the straitjacket remains.
  3. Minor cuts in spending and looser rules. The one thing the two parties will probably be able to agree on is that freezing individual line items in the budget is very inefficient and there should be some flexibility in shifting funds among related programs. We anticipate a roughly 60% likelihood that most or all of the sequester sticks, but with some funding flexibility.

 

Front-loaded pain

We expect the sequester to add further downward pressure to the economy in the second quarter, with job growth averaging less than 100,000 per month and GDP growth slowing to 1%. Looking further ahead, however, we expect very little further fiscal tightening over the next two years as the two parties pull back and lick their wounds.