Sequester The Fed

The President gave a speech implying that first responders' jobs were on the line if Republicans didn't come to their senses and postpone or eliminate the "brutal" spending cuts of the sequester. While federal government doesn't directly employ those individuals, the message was clear that important things everyone needs are on the line if spending is cut by 1.2%.

Joe Calhoun
February 24th, 2013
Alhambra Partners

The President gave that speech surrounded by police and firefighters the implication being that those first responders’ jobs were on the line if Republicans didn’t come to their senses and postpone or eliminate the “brutal” spending cuts of the sequester. Given that the federal government doesn’t directly employ any of those people it seems highly unlikely the axe will fall on them but the message was clear – important things that everyone needs are on the line if spending is cut by 1.2%. Leon Panetta wins the award for hyperbolic hand wringing though saying that every one of the 800,000 civilian employees of the Defense Department will face furloughs if the cuts go through as planned.

The most shocking thing about Panetta’s statement to me is that we have 800,000 civilian employees at the DoD. I have a hard time believing that at least some of those people aren’t doing something we could get along without. In fact, I’d be willing to bet that if we knew what some of those people are doing, we would, as a nation, demand that they stop forthwith. But I digress. I have resisted for some time now the urge I often have to go all Howard Beale at the cesspool of venality that our government has become and I’ll continue today. Okay, I’m not always successful but I do try to stay on script and the topic of the day is whether these shocking – shocking I say! Did you hear me?!! Shocking! – budget cuts will hurt the economy.

The sequester goes into effect this Friday, March 1st. As best I can tell – and government math is not my strong suit so I may be wrong – it will mean cuts of a bit less than $50 billion in government spending this year. Even if the sequester goes through I have serious doubts as to whether government spending will actually fall since spending “cuts” don’t mean the same thing in government math as in actual, you know, math. Government cuts most often mean a cut in the rate of increase and while I haven’t actually read enough of the details on this to find out if that is true this time, I would be shocked (obviously I am easily shocked this week) if this time is different. Now $50 billion sounds like a lot of money but in a country with a GDP of over $16 trillion and a federal budget of almost $4 trillion it really doesn’t amount to much.

And that is the point. Shaving 1.2% off the federal budget or the equivalent of 0.3% of GDP is not going to usher in an era of austerity. Our borders will not be over run by terrorists or Mexicans looking to take American jobs. Public safety will not be compromised. Buildings will not be left to burn. Planes will not fall from the sky. Plagues will not be allowed to sweep the nation – unless you count reality television. The President will be free to keep wasting money on green energy boondoggles. We’ll still pay farmers to not plant some things and to turn other things they’ve planted into inefficient fuels while simultaneously raising the price of essential foods for citizens of the third world (a government policy threefer). Republicans will still be able to overcompensate for something by funding weapons programs we don’t need. We’ll still keep killing people in far away lands via joysticks in Nevada. So calm down and back away from the heated rhetoric.

Cutting spending by that amount won’t cause a recession either. Despite the scare reports saying that it will cost 700,000 jobs the effect on employment will be minimal. In fact, if the government spending multiplier is less than 1 – as I and a whole bunch of people believe – the sequester might actually be a boost to growth rather than a retardent. There are lots of reasons to fear for the future growth of our economy but the sequester isn’t one of them.

Of greater concern in the short term is the effect of the payroll tax hike and the policies of the Federal Reserve. The payroll tax hike is equivalent to roughly $125 billion per year in higher taxes on virtually every American. Even if we assume that tax changes and spending changes have the same effect on the economy – the research says tax changes have about 3 times the effect although I don’t believe the impact of these expected changes will be that great – the payroll tax hikes will have 2.5 times the impact of the sequester. If we get a reduction in GDP growth of 0.75% in an economy growing at 2% – and that might be generous – any additional shock to the system might well have us looking down the barrel of another recession.

The hike in payroll taxes also neatly explains the Fed’s expansion of quantitative easing in December. It appears to me that the Fed upped the outright purchases to $85 billion per month in anticipation of this additional drag on the economy. The problem is that quantitative easing isn’t having – and in my opinion can’t have – a large enough effect to offset the tax hike. The two most obvious effects of QE are the rise in stock prices and the rise in oil prices which tend to offset each other. The wealth effect from higher stock prices cannot offset the income effect of higher gas prices and the payroll tax hikes. The wealth effect from changes in stock prices are minor compared to the effect from changes in disposable income (1/100th according to recent research by Credit Suisse). Of course, real estate prices have been rising too and that has an effect but again not as much as changes in disposable income. Furthermore, I question whether the recent gains in real estate wealth can be sustained with incomes falling. Rising house prices and falling incomes would not seem to be compatible unless banks are about to start just giving away money.

The only way for the Fed to even theoretically offset the effects of the rise in payroll taxes and the rise in gas prices is to inflate another bubble in the stock market. The minutes of the January FOMC meeting shows there is already dissent at the Fed about the wisdom of continuing the present course of asset purchases. Yes, I know that the dissenters are not in control but even a hint that the purchases might be curtailed sent the stock market down a couple of percent. Anyone buying stocks at these prices better hope the other market participants don’t discover a calculator and figure out that the Fed is impotent even at these levels of asset purchases.

That isn’t to say the Fed’s efforts are having no effect at all. The recent rise in merger and acquisition activity is evidence that easy money is affecting animal spirits if nothing else. Companies sitting on lots of cash is always a dangerous thing since it is at such times that CEOs find it easy to build empires over which they inevitably lose control. Having private equity firms sitting on lots of cash and borrowing capacity just makes it that much more dangerous. The price of the recent Buffet backed Heinz deal does not exactly scream prudent use of capital. The effect on economic growth is probably not zero but it also isn’t nearly as encouraging as it would be to see companies investing in new plant and equipment or human capital.

The current action in the market is enough to convince me that Fed policy – and all the other economic policies for that matter – is failing. The rising dollar, falling growth scenario is one that we take very seriously and it calls for maximum caution. While the Fed appears to have the accelerator to the floor it isn’t enough yet to overcome the deflationary impulse of the deleveraging global economy. Even more disconcerting to me is that as ineffective as this hyperactive monetary policy has been at boosting growth, its eventual unwinding holds the promise of even greater turmoil. I see no reason to believe the Fed will be successful in shrinking its balance sheet when the time comes and the longer they wait the harder it will be. In the meantime, they are doing just enough to prevent the politicians from getting serious about fixing our problems. The sequester we need to implement for the sake of long term growth is at the Fed. Lock them up for a few years and keep them away from the printing press and the speech making circuit. It would be painful (well not the lack of speechifying) but it might be the only way we will ever get the political class to address our real problems. Sequester The Fed.

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