IHS Global Insight – Sequester Will Take 1.5% Off 2nd Quarter GDP

Despite having spent weeks wheeling out members of his cabinet to explain quite how bad sequestration will be, President Barack Obama has failed to persuade congress to unpick the punitive spending cuts created by the 2011 Budget Control Act that come into effect today (1 March). The Republicans have stuck to their view that the issue of tax increases was closed by the New Year American Taxpayer Relief Act (ATRA), which averted the so-called “fiscal cliff” by creating a new top rate of income tax and allowing the temporary payroll tax cut to expire. Since then, however, the Democrats have continued to demand more tax increases as a condition of any deal to avert the sequester. This impasse yesterday led the Speaker of the Republican-led House of Representatives John Boehner to permit his legislators to leave Washington for the weekend, without a deal. The Democrat-led Senate was scarcely less lethargic. A bill to replace the sequester with tax raises and spending cuts failed, with four Democrats joining Republicans in voting against. A Republican bill to hand the White House responsibility for the allocation of the sequester cuts was also voted down by the Democrat majority.

Fiscal hawks within the Republican caucus have said they view the sequester as a positive development, insofar as it forces major spending cuts upon the federal budget. Downsizing the federal government is the paramount concern of the “Tea Party” movement, which was credited with the Republicans’ success in winning the House in 2010 but whose influence was much less evident during last year’s presidential and congressional campaigns. The sequester now offers the Democrats an opportunity to create a major public backlash against the Tea Party Republicans. They have set about demonstrating the consequences of the sequester for jobs and national security. For instance:

Transport: The vast majority of the Federal Aviation Administration’s 47,000 employees will be furloughed for one day per pay period. From 1 April, 90 minute delay to flights between major cities due to a shortage of controllers; closure of more than 100 flight control towers at small airports; and end of night-time flights at a further 60; delays of container examinations at seaports of up to six days; increase in domestic passenger wait times due to limited availability of security officers at airports; land-port waiting times of up to five hours on the southwest border.

Welfare: Approximately 70,000 low-income children would lose Head Start and Early Head Start services; there would be a significant curtailment of federal grants for medical research; six hundred thousand women and children would lose nutrition assistance; the Food and Drug Administration and the Department of Agriculture would cut back on food inspections, potentially increasing health hazards.

Defense and Policing: A reduction in the FBI’s law-enforcement capability; hundreds of prosecutors would be furloughed from the Department of Justice; Coast Guard would have to reduce its Arctic presence by a third; reduction in the detention and removal of illegal immigrants; huge lay-offs among Pentagon staff, although less scope to cancel big-ticket arms purchases, creating a “hollowed out” force (see United States: 28 January 2013: Pentagon begins laying off 46,000 temporary workers ahead of sequestration in US).

Emergency response: A USD1 billion reduction in the disaster-relief fund; the Federal Emergency Management Agency (FEMA) would have to eliminate funding for firefighters and other emergency personnel.

Foreign policy: Massive reductions in US aid, and therefore influence, in vital Middle Eastern countries; big cuts to AIDS programmes in Africa; an increase in visa waiting times (see United States: 20 February 2013: US warns of foreign aid “sequester” cuts to Arab Spring states).

Republicans have accused the administration of scare-mongering over the effects of the sequester, but the Democrats are nevertheless well-placed to blame the Republicans should any, or all, of the above take place as the result of the failure to reach a deal. It should be noted that the Office of Management and Budget calculates that the sequester requires a real annual budget reduction of 9% for non-security budgets and 13% for security budgets from the seven months from 1 March, ensuring that there will be without question real reductions to public services as a result.

The economic impact of the sequester, assuming it comes fully into force, will build towards the end of the year. IHS Global Insight estimates the drag from the sequester at only 0.3 percentage points in the first quarter. But if the sequester continues through June, we estimate it would take 1.8 percentage points off second-quarter growth, temporarily pulling growth back down below 1% in that quarter. For the year 2013 overall, we estimate that full implementation of the sequester would take about 0.5 percentage point off the calendar year growth rate (1.5% instead of 2.0%).

Outlook and implications

Today’s deadline was a soft one, given that the full extent of the spending cuts will play out month-on-month rather than instantaneously. A harder cut-off arrives on 27 March, when the continuing resolution that funds the federal government expires. This second deadline explains the House and Senate’s weak response to the sequester; they will have to spend March discussing the budget in order to avert a government shutdown, and the sequester’s impact can be addressed within that context. Although large-scale spending cuts will be an almost-inevitable component of whatever agreement is decided by 27 March, it is likely that the sequester itself will be watered down. As its effects begin to bite House Republicans – even fiscal hawks – will become nervous over the sequester’s impact on their mid-term re-election prospects in 2014, particularly given that traditionally pro-Republican military and security communities are bearing the brunt of the cost curbs. This will strengthen the Democrats’ hands in negotiations, although it will be extremely difficult for Boehner to countenance further post-ATRA tax increases.