What is "The Sequester"?

In the United States, “budget sequestration” is the rather complicated legal term for the backup plan should government spending go over a defined limit. If these hard limits are exceeded, automatic spending cuts are triggered across certain federal agencies in equal proportion, bringing overall spending back within limits. The sequester mechanism has the benefit of preventing the federal budget from blowing out, but does so in a way that is fairly arbitrary and crude.

Why is the sequester relevant now?

During the Debt-Ceiling Crisis of 2011, one of the key conditions under which the Republicans allowed the ceiling to be raised was that the massive budget deficit would have to be reduced by US$2.4 trillion over the following 10 years. Half of these spending cuts were immediately identified, with a bipartisan “Super Committee” set up to agree on how the remaining $1.2trn of cuts would be allocated by 31 December, 2012. Sequestration was included in the deal as a guarantee that - one way or another – the spending cuts would take place before 2013.

While both sides agree that the sequester is a clumsy approach to cutting spending, the Super Committee never got around to agreeing on a suitable alternative and sequestration would have been enacted on 1 January, 2013, were it not for the last minute New Years’ deal to delay the fiscal cliff until 1 March; that is, tomorrow.

What’s the worst that can happen?

While it’s almost unanimous that the US will eventually need to rein in public spending to more sustainable levels, the sequester matters so much right now due to its timing and the almost arbitrary means by which the proposed cuts will be imposed if an alternate solution can’t be agreed upon in time.

To the matter of timing: cutting government spending right now would have a contractionary effect on a battered US economy, which is starting to show tentative signs of recovery. This year’s proposed sequestration is worth around US$85 billion (or 2.4% of the federal budget), which, combined with the New Year’s Day tax hikes, is estimated to cost around 1.5% of GDP. Federal Reserve Chairman Ben Bernanke testified last week that the Fed’s current monetary stimulus cannot overcome a fiscal contraction of this size and, if sequestration cannot be averted, it risks sending US unemployment back above eight per cent in the medium term.

So, in a year when US growth was otherwise tipped to come in around 2.0%, and at a time when Eurozone nerves are being re-ignited by Italy, sequester cuts now would threaten a good portion of US growth and even raise the spectre of a double-dip recession for the world’s biggest economy in the medium term. This obviously has bearish implications for markets globally.

What is likely to happen?

Given the ongoing stalemate between the White House and Republicans, with apparently no proposal anywhere near agreed, sequestration being triggered tomorrow appears the most likely outcome. In the short-term, financial markets should sell off in theory, but have instead shrugged it off so far, with the focus instead being on the Fed’s commitment to monetary stimulus, which appears safe for now. In reality, the effect of the cuts will be more like a slow motion train-wreck than a big bang, and probably won’t be felt immediately on account of the weeks and months required to be implemented. In that time, it is hoped that an alternative solution can be agreed.

The cuts, should they go ahead, will be split among most federal agencies, and then filter down to thousands of smaller programs and projects. Broadly, the sequester falls into three categories: defence (accounting for around half the cuts), then non-defence (things like labour, education, housing and transport) and Medicare. The US government’s largest outlays, healthcare and social security, are mostly out of the firing line, but around 1,200 different federal programs will absorb cuts, with up to one million civilian employees of affected government agencies forced to take unpaid leave, likely working four-day weeks from April. Government contractors and state officials will also be affected, which will of course have knock-on effects inside their own businesses and organisations.

Estimates of the full extent of the potential fallout are only guesses at this stage, and it will take months for the full effects to materialise, but absent any alternative deal, the sequester’s medium term effects are certainly contractionary and will undermine growth at a critical time.

Should we be worried?

If sequestration is triggered tomorrow, and it looks like it will, it’s unlikely to have a big impact immediately. The hope would be that Washington can agree on a more suitable alternative between now and April, when the spending cuts really start to take hold. The further we venture into 2013 without a better solution, the more the sequester will start to weigh on the economy, particularly unemployment.

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