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The specter of the sequester

February 27, 2013

Longer-term investors need not necessarily react to the inevitable rise in political rhetoric in the days ahead.
-David Joy, chief market strategist, Ameriprise

Barring a last-minute deal, the automatic federal spending cuts, known as the sequester, will take effect this Friday, March 1. These cuts are designed to reduce discretionary spending across the board, and will fall especially hard on the Department of Defense. Voices decrying this indiscriminate budgetary ax can be heard from a number of quarters. The Obama Administration warns of layoffs to teachers, fire, and police, as well as air traffic and TSA personnel. Governors warn of recession in those states most dependent upon defense spending. Others warn of an unacceptable decline in our nationís military preparedness.
Background
If so few seem to think the sequester is a good idea, why are we doing it? It all goes back to the deal that was struck in Congress in the summer of 2011, during which the debt ceiling was raised in exchange for these automatic spending cuts as a way of ensuring that the federal budget deficit would be reduced over time and that the rate of growth in the nationís debt would stabilize and, eventually, decline. The cuts were purposely designed to be so simplistic, and, as a result, so unappealing, that Congress would surely devise a better plan if given enough time. Presumably to increase the odds of a bipartisan deal, a small working group of twelve members of Congress was empaneled to craft a solution. They failed, leaving the sequester to take effect on January 1, 2013. The problem was that the Bush tax cuts were also scheduled to expire on this date, after having been extended for one year. This combination of tax hikes and spending cuts, otherwise known as the fiscal cliff, was widely forecast to push the U.S. economy into recession if allowed to take effect. So, at the start of the new year, Congress agreed on a permanent extension of the Bush tax cuts for most Americans, except for those in higher income brackets. The effective date of the automatic cuts was simultaneously postponed until March 1, presumably, once again, to buy enough time to reach a deal.
Of course, no deal has been made. The two biggest sticking points between the parties seem to be whether entitlement programs should be reformed as part of any deficit deal, and whether sources of additional tax revenue from high-income taxpayers should be identified at the same time. The president and Democrats in Congress are counting on Republicans being pressured into altering their position by polls that show they would overwhelmingly take the blame for the economic consequences of the cuts. Republicans counter that if the sequester is the only way to slow out of control spending, so be itóbetter that than having the country end up like Greece.

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