On Friday,
March 1st 2013, a series of Federal spending cuts—known as the
“sequester”—went into effect. While the
story has dominated the news, a lot of the information out there can be hard to
decipher. There are so many numbers to
keep track of, and so many ways to spin these cuts politically.
But what is the sequester? What exactly happened, and why? Most importantly, what kind of affect will it
have on the economy, and by extension, the markets? As a financial advisor, I want to help answer
these questions for you. So I’ve
included some of the most frequently asked questions about sequestration on the
following pages, along with the simplest, clearest answers I can provide.
Of course,
if you have any questions this letter doesn’t
answer, please feel free to contact me.
My team and I are monitoring the markets, Washington, and the
relationship between them, so we stand ready and waiting to help you understand
anything that might be unclear to you.
Providing help for investors is our business, so please let us know if
there’s ever anything we can do.
Frequently Asked Questions about the Sequester
Q: What is the
sequester?
A: The sequester is a series of automatic budget cuts
that will decrease Federal spending by $85 billion dollars this fiscal year
alone.1 (The fiscal year ends
on September 30.) Assuming that Congress
does nothing to stop them, these cuts will eventually total $1.2 trillion over
10 years.1
Q: Why is the
sequester happening?
A: In 2011, the United States faced what’s become known
as the debt-ceiling crisis. The debt
ceiling is an often misunderstood term, but in essence, it’s the limit beyond which the Department of the
Treasury cannot borrow. The debt ceiling
does not prevent Congress from
creating legislation that would incur more debt, so in 2011, President Obama
asked Congress to raise the ceiling in order to pay for the obligations we’ve
already incurred. Many in Congress were
opposed to this, so a deal was negotiated.
Congress passed the 2011 Budget
Control Act, which did three things.
First, it raised the debt ceiling.
Second, it created a special committee, whose purpose was to find ways
to reduce our deficit by $1.2 trillion.
Third, it created the automatic budget cuts, that would take place if
the committee could not agree to
reduce the deficit, totaling the amount the committee was supposed to have reached.2
The point of the
budget cuts—called sequestration—was that they were so large, and so
indiscriminate, that they would act as an incentive for Congress to
compromise. Unfortunately, Congress was
not able to compromise, so what was originally intended to act as an artificial
threat became reality.
Q: What do these
automatic budget-cuts do?
A: I’ll try to keep this answer as number-free as
possible. The $85 billion dollar cut is
divided in half between defense spending and non-defense spending. The total can be broken down like this:3
·
$42.7 billion decrease in
discretionary defense funds.
·
$26.5 billion decrease
in discretionary non-defense funds.
·
$11.2 billion decrease
in Medicare spending.
·
$5.0 billion decrease
in other areas.
The latter three
categories all make up “non-defense” spending.
Q: What does “discretionary”
mean?
A: Broadly speaking, there are two different ways the
Federal government spends money: mandatory
and discretionary spending. Discretionary spending is all money spent at
Congress’s discretion, which is set on a yearly basis through appropriation
bills. Mandatory spending refers to
money allocated to areas that do not have
to be renewed on a yearly basis. These
areas are provided for by laws other
than appropriation bills. Three examples
of mandatory spending are Medicare, Medicaid, and Social Security. The government must spend money on these areas unless a separate law is passed
saying otherwise.
As far as the
sequester goes, most of the budget cuts are from discretionary funds, meaning
the spending Congress sets on a yearly basis rather than on the more permanent
areas. This means that Social Security,
Medicaid, and active-duty military spending is untouched. The exception to this is Medicare, where
payments to providers and health insurance plans will be cut by 2% for a total
of 11.2 billion.
Q: Why does this
matter?
A: All these budget-cutting efforts are for one thing: to
get a handle on our national debt. But
the fact that most of the cuts are on discretionary spending, rather than
mandatory, lessens the impact of these cost-saving measures. Why?
Because mandatory spending—on Social Security, Medicare, Medicaid, and
defense programs—is rising at a much faster rate than discretionary
spending. Imagine it like cleaning your
house. Congress is cleaning up the
kitchen and the living room, but it’s the basement and garage that are filling
up at the fastest rate. Some cleanup is
better than nothing, but if the basement and garage fill up faster than you can
clean the other rooms, you’ll still end up with a bigger mess to clean than when you started.
Q: So is the
sequester good or bad?
A: There’s a fundamental truth when it comes to all government decisions on spending: if
you try to fix one problem, you will probably make another worse. It’s not really anyone’s fault, it’s just the
nature of the beast. For example, right
now we have both a debt problem and an unemployment problem. But fixing one means exacerbating the
other. To directly create jobs, the government must spend money. But that increases our debt. To lower our debt, the government must make
cuts, but that will cause us to lose jobs.
So from a
debt-problem standpoint, the sequester is good.
Not nearly good enough, but better than nothing. Economically speaking, however, the sequester
is like playing with fire. Our economy
is growing at an extremely slow rate, and experts expect these cuts will slow
it down even more.4 Whether a
further slowdown will lead to a second recession is uncertain, but it’s
possible. In addition, these budget cuts
mean many government departments will have to lay off or furlough their
employees. This will increase our
unemployment rate. Here’s how I look at it:
imagine you are in the hospital recovering from surgery. You’re getting better, but before you get
released, you decide to start losing weight by running hard on the
treadmill. Well, the exercise could help
your weight problem, but it would probably delay your recovery from surgery. That’s sort of what the sequester is like for
the economy, and it’s the main reason for all the doom and gloom headlines
you’ve been seeing lately.
Q: So how will this
news affect markets? How will it affect
me?
A: So far, the news doesn’t seem to have affected the
markets very much.5 When you
consider that we’ve known about the sequestration for months and have had time
to prepare, this isn’t surprising.
Generally speaking,
an economic slowdown isn’t good for the markets. And when the government cuts spending, it can
sometimes impact certain private sectors.
For example, defense cuts could impact the defense industry, because
contractors could have less business. We
won’t know for a while what the real effects will be, because the cuts don’t
all go into place at once. It’ll be
several months down the road, when the lay-offs start happening, when national
parks start closing, and when lines at airports get longer, that we’ll start to
see a visible difference. How the
markets react then is still
unknown.
The best thing we
can do is be aware of what’s going on.
Now you know what’s happened, and you know what could happen. So the smart
thing to do is plan ahead. My team and I
can help you watch the markets and discuss how to prepare for any potential
downturn. Give me a call at 215-886-2122. I’d love to speak with you.
Sources:
1 “The Budget and Economic Outlook: Fiscal Years 2013 to
2013,” Congressional Budget Office, accessed
March 4, 2013. http://www.cbo.gov/sites/default/files/cbofiles/attachments/43907-BudgetOutlook.pdf
2 “Estimated Impact of Automatic Budget Enforcement
Procedures Specified in the Budget Control Act,” Congressional Budget Office, accessed March 5, 2013. http://www.cbo.gov/publication/42754
3 “The Sequester: Mechanics and Impact,” Bipartisan Policy Center, accessed
February 21, 2013. http://bipartisanpolicy.org/sites/default/files/Sequester%20Overview.pdf
4 “Automatic Reductions in
Government Spending—aka Sequestration,” Congressional
Budget Office, accessed March 5, 2013.
http://www.cbo.gov/publication/43961
5
“S&P 500 Index,” CNN Money,
accessed March 5, 2013. http://money.cnn.com/data/markets/sandp/?iid=C_MT_Index
