Vol 10 (2013) - Issue 2

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What Fiscal Policy?

Automatic spending cuts became a reality. How dire will it be? USD 85 billion in automatic spending cuts will go into effect on March 1, as no compromise was reached as of this writing. The Congressional Budget Office estimates the drag on growth from sequestration to be 0.6ppt of GDP, for a total fiscal restraint of 1-1.5ppt of GDP in the current fiscal year. This brings GDP growth below 2% this year, following 2.2% in 2012 and 1.8% in 2011. The effect of the spending cuts will start to be felt a month or so from now, as it takes time to organize pay cuts and furloughs. Relative to the average recovery in post-WWII, it is the first time that 8 and 12 quarters into the recovery, fiscal restraint sets in (circled in Exhibit 1).
The Budget Control Act of 2011 had adopted spending caps on discretionary spending (39% of total spending – Exhibit 2). It also called for the USD 85 billion automatic spending cuts, half from defence (20% of total spending) and half from non-defence spending if no agreement was reached on an additional USD 1.5 trillion in budget cuts over 10 years.
Since the Act stipulated that the mandatory spending category (55% of total spending), Social Security and Medicaid programs be exempted and cuts to Medicare limited, the burden of the non-defence spending cuts will disproportionately fall on discretionary spending, which represents only 19% of total spending. As a result, 71% of the spending cuts will likely be concentrated in discretionary spending and 13% in non-exempt mandatory spending.