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MarksJarvis: Sequestration likely to halt growth, upset market

Cuts, due Friday, come at bad time for fragile economy

Gail MarksJarvis

February 24, 2013

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It's coming, and not by popular demand.

The $1.2 trillion in U.S. government budget cuts, which both Republican and Democrat leaders say they detest, are arriving Friday, and analysts predict the so-called sequestration cuts will suck some of the wind out of a fragile economy as people lose jobs and companies lose government contracts. There could be some nerve-wracking moments in the stock market too.

"The sequestration is not catastrophic," but it will push unemployment higher at a time when "the economy is still struggling to overcome the legacy of the Great Recession," Macroeconomic Advisers said in a report. Instead of the economy growing at a subpar 2.6 percent this year, some economists predict sequestration will leave growth weaker at 2 percent. They expect "higher unemployment to linger for several years."

Sequestration cuts were designed by Congress in 2011 amid the rancor of the nation's debt ceiling debate and were scheduled to become automatic this March. But the cuts were never expected to happen. The thinking in 2011 was that the sequester was so mindless and harsh that Congress would spend 11/2 years thoughtfully planning so it could abort sequestration and implement more reasoned changes before 2013.

But that hasn't happened.

Although certain spending, like funding for the Afghan War and Social Security and Medicare benefits, is protected from cuts, there is no leeway in the sequester design to think about priorities. This year, 9 percent is supposed to be cut across the board in discretionary government budgets rather than preserving necessary spending and eliminating less important spending.

You could think of the rules of the sequester like this if applied to a household budget. Say you spend money each month on food, gasoline, child care and lawn care. You wouldn't have the option of cutting lawn care so you could keep spending as needed on child care. You would just mindlessly cut 9 percent out of each expenditure.

With sequestration about a week away, politicians have not come up with a more reasoned approach, even though economists have argued that the cuts are too sudden — and in some cases the wrong ones to make — for a weak economy. It appears that choosing priorities or doing long-range debt cutting is so distasteful politically that politicians may let sequestration happen even though that was once considered unthinkable.

About $85 billion is to be cut this year, and about $109 billion each year over the next nine years.

Harris estimates that the brunt of the "negative shock to GDP" will hit the economy in the second quarter, cutting growth 1.5 percent. In the third quarter, Harris says the impact on growth should be less, about 0.7 percent, and in the fourth, 0.2 percent.

The Congressional Budget Office has estimated that as the government decreases spending, about 800,000 jobs will be cut, but not all will be layoffs. Instead, hours could be reduced. The Defense Department plans to put civilian employees on four-day furloughs. "That would turn 1.8 million full-time workers into part-timers," said Ethan Harris, economist for Bank of America Merrill Lynch.

Macroeconomic Advisers notes that job reductions will hit the economy at a poor time. Consumers already have been hit by payroll tax increases. The tax, which funds Social Security, had been cut temporarily to stimulate the economy during the recession. But when it rose 2 percentage points in January, retailers such as Wal-Mart said customers were feeling the pressure and reducing purchases.

In a survey by the National Retail Federation, 73 percent of working Americans said in early February that they noticed the effect of the payroll tax increase on their take-home pay and were changing spending plans.

About 46 percent said they will spend less overall, with 34 percent reducing dining out and 25 percent cutting back on "little luxuries" such as trips to the coffee shop, manicures and high-end cosmetics. Among those making less than $50,000 a year, 23 percent said they would spend less on groceries.

Macroeconomic Advisers, along with numerous economists, has argued that given the weakness still in the economy, the government should create an extensive plan for debt reduction but avoid a sudden shock to the economy.

"By far the preferable policy is a credible long-term plan to shrink the deficit more slowly through some combination of revenue increases with broad tax reform, more carefully considered cuts in discretionary spending and fundamental reform of entitlement programs," Macroeconomic Advisers said.

Although the stock market slumped 1.9 percent over two days last week and Wal-Mart Stores' stock declined after noting customer reluctance because of the payroll tax increase, investors have shown little concern.

"We suspect that investors may have lost sight of some of the less obvious effects" that government cuts may have on stocks and the economy, said Citigroup strategist Tobias Levkovich. For example, while some have argued that defense stock investors have been aware of possible cuts and adjusted the prices they pay for the stocks, Levkovich noted that consumers could be hurt by cuts in unemployment benefits and spending for children with special needs.

Further, he said, there are less obvious possible effects on businesses. For example, he noted, engineering firms that do environmental testing, or publishers affected by deferred educational book orders, or travelers waiting in security lines as Transportation Security Administration employees are furloughed.

Besides the sequester that begins Friday, he said March 27 could prove to be a much more debilitating date. "That's when a government shutdown could occur if there is no resolution to allow the government to keep spending at its current pace."

If that happens, Levkovich said, checks to nonessential federal employees would cease.

Stocks could decline, as they did in connection with the 28-day shutdown as President Bill Clinton and House Speaker Newt Gingrich disagreed on budget issues in 1995 and 1996.

But Levkovich said investors are accustomed to fighting in Washington and expect last-minute agreements: "Investors have become inured to the goings on in the nation's capital."

gmarksjarvis@tribune.com

Twitter @gailmarksjarvis