Have you ever heard the
saying, “Out of the frying pan, into the fire?”
Basically, the phrase describes any situation where, after leaving one
obstacle behind, you find yourself immediately confronted with another.
Such a situation is
exactly what the United States Congress finds itself in. Less than two months after striking a deal to
avert the fiscal cliff, Congress has a new problem to deal with … or rather, an
old problem never properly dealt with in the first place. This problem is called sequestration. It could have a profound effect on our
economy—and by extension, the markets—so as your financial advisor, I want to
make sure you’re up-to-date on what’s going on.
Sequestration
Let’s rewind back to late
2012. Remember the fiscal cliff? It was the combination of automatic tax
increases and budget cuts that, taken together, would probably have sent the
economy into another recession. Thanks
to an 11th hour deal, Democrats and Republicans agreed to a
compromise that lessened the tax increases, while simultaneously postponing the
automatic budget cuts. In effect, they
patched over one problem, while punting on the second.
Unfortunately, their punt
wasn’t a very long one. Per their
agreement, the budget cuts (also known as sequestration) were to take place on
March 1st if another deal wasn’t struck.
Now come back to the
present. March 1st is right around
the corner, and a deal isn’t looking very likely.1 The budget cuts are a real possibility. So what are these cuts, what will they do,
and why do they have to happen in the first place?
Let’s take the last
question first. The budget cuts are a response
to an even bigger problem: the national debt.
Currently, our country’s debt is over $16 trillion dollar,2
and for this year alone, we have a $0.9 trillion deficit.3 That means the government is expected to
spend almost $1 trillion more than what it actually has. These numbers simply cannot continue, but
Congress has been unable to take concrete steps to lower them. To give themselves extra incentive, Congress
passed the 2011 Budget Control Act, which stipulated that if they could not
lower the deficit, across-the-board spending cuts would be enacted to do it for
them.
The problem with
automatic, across-the-board cuts is that it’s like using a bomb when a scalpel
will do. The cuts are large, broad, and
fairly sudden. You just can’t make cuts like
that without feeling negative effects. If you compare our debt to having a drug
problem, these cuts are like quitting drugs cold-turkey. Sure, it will help your drug/debt problem … but
the shock could be very painful.
Here’s why. The
cuts for 2013 total $85.3 billion, and are divided like this:4
·
$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.
These numbers are just the cuts that will take place
within the next seven months. Much
larger cuts, totaling almost $1.2 trillion,5 will ultimately occur
over the next ten years, assuming the current plan remains in place. It would take up too much room to break down
exactly what all of those cuts will do, but it’s enough to say that many jobs
will be lost. The cuts would mean
government departments will have to either furlough or layoff thousands of
people. And decreased government
spending means that even private companies will be affected. For instance, if the government spends less
in defense, defense contractors could have less business. Less business means less revenue, which means
fewer jobs. In fact, the Bipartisan
Policy Center estimates that as many as 1
million jobs could be lost if the sequester occurs.6
A few other effects:7
·
Unemployment benefits
will go down by 9.4%.
·
The price of some
types of food will go up.
·
Furloughed
airport workers means there will be longer lines at airports.
Ultimately, the loss of so
many jobs, combined with the belt-tightening that many Americans will have to
face, means the economy could decline by 0.7% in 2013.6 Considering that our economy’s growth was
already slow (projected to be just 2%), 0.7% is a big number. It’s impossible to say how the markets will
react, but an economic slowdown usually doesn’t mean good things.
So What Happens Next?
That’s enough of the gory
details. Now let’s look at what could
happen next.
With a few individual
exceptions, neither political party wants sequestration to take place. The problem is, neither party can agree on
what the alternative should be. Both
sides profess to want to decrease our debt, but have vastly different ideas on
how to do it. Generally speaking,
Republicans don’t want to cut from defense spending, and Democrats don’t want
to cut from social programs. Democrats
want to increase revenue to help pay down the debt, in the form of higher taxes
on the wealthy. Republicans won’t hear of the idea.
Because of all this, it’s
probable that sequestration will happen.
It’s still possible the two parties could come to an agreement on how to
make more targeted cuts, but it’s doubtful they can do it by March 1st. Instead, Congress’ best bet is to either
waive the cuts altogether, or postpone them again.
If neither happens, the
next thing Congress can try to do is make changes after sequestration starts but before
the full effects are felt.
Unfortunately, Congress has another major problem to deal with. They will soon run out of money to fund government
operations for the rest of the 2013 fiscal year. If they do not come up with a new funding
bill by March 27, the government will shut down.8 If that happens, it means even more furloughs and a greater loss of
government services. On the other hand,
if Congress can agree to a funding bill by that date, it’s possible they could
reverse some of the automatic spending cuts at the same time.
Now the Good News
There’s no denying that Congress has become a
legislative quagmire. But there’s one
thing they’re still good at: avoiding the worst. Congress has a vested interest in ensuring
the economy remains strong, and when their backs are against the wall, the most
influential members of both parties have a history of abandoning their talking points
in order to compromise.
One last point. I don’t want to toot my own horn but it’s situations like this where it’s good to
have a financial advisor. Despite the
complexity of the situation, remember what I always say: my team and I are
constantly watching both Washington and the
markets. We’re keeping tabs on the
situation, and we have a plan in place in case sequestration does happen.
I hope you found this
letter to be informative. If you have
any questions about the effects of sequestration, or if you just want to
discuss your investments, please don’t hesitate to give me a call. I’d love to talk with you. In the meantime, remember that we’re here and
we’re watching out for you. And as
always, thanks for your continued trust in us.
It’s a pleasure to have clients like you.
Sincerely,
P.S. If you have any friends or family that are
confused about what’s going on in Washington, please forward this letter to
them, and let them know we’d be happy to talk with them, too.
Sources:
1
Andrew Taylor and Julie Pace, “John
Boehner: Budget Cut Burden Lies with Democrats,” The Huffington Post, February 13, 2013. http://www.huffingtonpost.com/2013/02/13/john-boehner-budget_n_2682656.html?utm_hp_ref=politics
2 “The
Debt to the Penny and Who Holds It,” TreasuryDirect,
accessed February 19, 2013. http://www.treasurydirect.gov/NP/BPDLogin?application=np
3
“Federal Budget for FY13,” usgovernmentspending.com, accessed
February 19, 2013. http://www.usgovernmentspending.com/federal_budget_fy13
4
“The Sequester: Mechanics and
Impact,” Bipartisan Policy Center, accessed
February 21, 2013. http://bipartisanpolicy.org/sites/default/files/Sequester%20Overview.pdf
5
“Sequestration Reports,” Congressional Budget Office, accessed
February 19, 2013. http://www.cbo.gov/latest/Budget/Sequestration-Reports
6
Steve Bell, “Now It’s Time for
Sequester Anxiety,” Bipartisan Policy
Center, January 29, 2013. http://bipartisanpolicy.org/blog/2013/01/now-it%E2%80%99s-time-sequester-anxiety
7
Jennifer Liberto, “7 spending cuts
you’ll really feel,” CNN, February
21, 2013. http://money.cnn.com/2013/02/21/news/economy/federal-budget-cuts/index.html
8 Erik Wasson, “House
and Senate working quietly to avoid government shutdown,” The Hill, January 6, 2013. http://thehill.com/blogs/on-the-money/budget/275703-house-and-senate-work-quietly-to-avoid-government-shutdown
