Automatic spending cuts in the sequester established by the Budget Control Act of 2011 were delayed until March 1 by the patchwork "fiscal cliff" deal cobbled together by U.S. politicians over the holidays.
The cuts amount to approximately $109 billion in spending each year through 2021 – approximately half of those cuts from the defense budget, and the other half come from non-defense discretionary spending.
The hope is that Republicans and Democrats can arrive at a deal that will avert a full sequester, thus preserving some of the government spending measures on the chopping block.
However, Republican House Speaker John Boehner now appears to be using the prospect of the automatic cuts as his main point of leverage over President Obama and congressional Democrats in upcoming budget talks.
So, it's worth taking a look at the impact on the U.S. economy in the event that we get a full sequester, and none of the automatic spending cuts are averted on March 1.
There are a few estimates of the impact to GDP floating around on Wall Street, but crucially, they depend on the fiscal multiplier used in the calculation – an unknown variable that must be estimated.
The fiscal multiplier basically states how many dollars GDP is reduced for each dollar of spending that is cut from the government's budget. So, if the multiplier used is above 1, each dollar of spending cut from the budget results in more than a dollar being subtracted from GDP. If the multiplier is below 1, the opposite is true: each dollar of cuts subtracts economic growth by less than a dollar.
Another variable is the type of spending cut being examined. Cuts to funding for food stamps, for example, will have a different multiplier than cuts to funding for defense.
The fiscal multipliers used on Wall Street vary.
BofA Merrill Lynch economist Ethan Harris uses a multiplier of 1.2 – on the high end, but one he deems "conservative."
Harris says a fiscal multiplier of 1.2 implies a 1 percentage point drag on GDP growth:
As most of our readers know, the spending sequester is a legacy of the debt ceiling agreement back in August 2011. At that time, Republicans argued that any increase in the debt ceiling should be matched by equal cuts in spending over the next 10 years. Indeed, that one-for-one rule is sometimes called the “Boehner rule.” Under that agreement, the debt ceiling was raised in two steps. The first set of cuts is already under way and will accelerate from $20 bn last year to $40 bn this year. The second set of cuts is the sequester: more than $100 bn in across-the-board cuts in both defense and nondefense discretionary spending per year.
Under the cliff compromise, these cuts were delayed for two months and only by agreeing to $24 bn in new austerity. This, in effect, preserves the Boehner rule. In fact, at this rate there will need to be $144 bn (= 6 x $24 bn) in austerity to delay the sequester through the end of the year.
Absent new legislation, the across-the-board cuts kick in at the start of March. Assuming a conservative spending multiplier of 1.2, that implies about a 1% hit to GDP growth.
Société Générale economists use a much lower fiscal multiplier – 0.5. when they apply that to the prospect of full sequestration, they get a much lower estimate of the hit to GDP: 0.4 percentage points.
Similarly, Credit Suisse economists believe that "If the automatic spending cuts are implemented, then there is another 1⁄2% hit to GDP growth." So, Credit Suisse is probably using a multiplier closer to SocGen's 0.5 estimate than BofA's 1.2 figure.
To sum it up, Wall Street economists seem to think a full sequester including all of the automatic spending cuts slated for March 1 could reduce GDP on the order of 0.5 to 1.0 percent.
More From Business Insider
- HTML5 vs. Apps: Here's Why The Debate Matters, And Who Will Win
- The 'Fear Index' Is Near A 6-Year Low
- Is The Market Going To Develop An Immunity To Washington DC?
- Politics & Government
- Budget, Tax & Economy
- discretionary spending