Feb 27 2013

Sequestration – a basic economic analysis

Ben Bernanke Lectures Congress on Austerity Economics : The New Yorker

In just two days, the United States will enact a massive contractionary fiscal policy known as the “sequester”, which includes over $1 trillion in federal spending cuts rolled out over the next ten yeas. The imminent sequester (which is defined as “to isolate, or hide away”) is the result of the failure of Democrats and Republicans to agree upon an acceptable combination of spending cuts and tax increases to put the US government on a more sustainable budgetary path (meaning lower national debt in the future). The sequester was never intended to occur, rather it was put in place to force the two parties to come up with a budget compromise that would cause less harm to the economy than the cuts that the sequester will impose.

The $1.2 trillion cut in spending will have several negative effects on the US economy, including 

…up to 2,100 fewer food inspections, 373,000 mentally ill adults and children going without treatment, 70,000 kids being kicked out of preschool, 2,700 schools losing federal funding, about 30,000 teacher layoffs, a reduction in federal law enforcement capacity equivalent to the loss of 1,000 federal agents, 1,000 fewer criminal prosecutions, and the list goes on and on. The chairman of the Joint Chiefs of Staff, Gen. Martin Dempsey, recently said before the Senate Armed Services Committee that sequestration will “make it much harder for us to preserve readiness after more than a decade of fighting in Iraq and Afghanistan.”

The effects on national output and employment in the US economy, which is still recovering from the Great Recession of 2009, will likely be devastating. According to the Federal Reserve Bank Chairman Ben Bernanke,

“Given the still-moderate underlying pace of economic growth, this additional near-term burden on the recovery is significant… Moreover, besides having adverse effects on jobs and incomes, a slower recovery would lead to less actual deficit reduction in the short run.”

Bernanke, a Republican himself, recognizes that any cut in government spending (known as a contractionary fiscal policy) will harm the US economy’s growth potential both in the short-run and the long-run. Bernanke believes that the primary goal of the government right now (and the Central Bank, which he is the head of) should be to promote increased employment to bring the nation’s unemployment rate down (back to its natural rate).

So what is the argument FOR a contractionary fiscal policy? Why would the Democrats and Republicans let this sequestration take place even when America’s leading economic voice is calling for it to be avoided? If you ask many of the Republicans in Washington, D.C., America’s biggest macroeconomic problem is not slow growth or high unemployment, it’s the large national debt. The debt (which is the sum of all of the country’s past budget deficits), has grown to nearly 80% of the nation’s GDP. This means that the nation owes the holders of that debt nearly as much as its total income in a year. If an individual had a debt level this high, that individual would probably have to cut back on his own spending (cut up those credit cards!), to begin paying back that debt; obviously, high personal debt ultimately leads to a decrease in the standard of living of the indebted person as it eventually has to be paid back.

But a nation’s debt is a little different than that of an individual. If the US government cuts back on spending to reduce the debt, the result is rising unemployment, lower incomes, reduced confidence among households and firms, a reduction in economic growth, and possibly, a recession. The goal of reducing the debt could ultimately reduce the national output and income, which could ironically make the debt an even bigger deal than it already is. Let me explain why.

Imagine two countries, Country A and Country G. Country A has a national debt of $12,000 billion dollars. Country G has a national debt of $355 billion dollars. Obviously, Country A’s debt is around 35 times the size of Country G’s. So if I asked you, which of these countries is facing a “debt crisis”, you’d probably say Country A, right? Well, you’d be wrong. Country A is America, and Country G is Greece. So why does Greece’s national debt of $355 billion, which represents 182% of Greece’s GDP of $195 billion, constitute a “crisis”, while America’s debt of $1,200 billion, or just around 80% of its GDP, is simply a cause of concern among one of the country’s political parties? The answer is, it’s not how large a nation’s debt is in dollar terms that matters, rather how large the debt is relative to the country’s GDP. A millionaire could handle a $100,000 debt just fine, while for an individual earning minimum wage, a debt of $100,000 would present a crushing burden that is unlikely ever to be overcome without that individual declaring himself bankrupt.

If the sequestration takes place, America’s GDP may fall, as Bernanke has warned. But its debt will continue to grow (albeit less slowly than it would without the sequester). If the GDP falls while the debt grows, the country’s debt burden actually increases, despite the desired outcome of the sequester, a reduction in debt. In other words, the sequestration will make America more like Greece (the guy on minimum wage) and less like America (the millionaire!).

Rather than working towards debt reduction, as the mainstream of the Republican party advocates, Ben Bernanke would prefer the federal government focus on policies that reduce unemployment. Unemployment, defined as “the state of actively seeking a job, but being unable to find one”, has several negative effects on individuals and the economy as a whole. Here’s Bernanke explaining to the US Congress the consequences of unemployment:

High unemployment has substantial costs, including not only the hardship faced by the unemployed and their families, but also the harm done to the vitality and productive potential of our economy as a whole. Lengthy periods of unemployment and underemployment can erode workers’ skills and attachment to the labor force or prevent young people from gaining skills and experience in the first place—developments that could significantly reduce their productivity and earnings in the longer term. The loss of output and earnings associated with high unemployment also reduces government revenues and increases spending, thereby leading to larger deficits and higher levels of debt.

Many economists believe that America’s huge national debt (in dollar terms) is really not all that bad when compared to its even huger GDP. A nation’s debt really only becomes a problem when that nation, like an individual burdened with a high level of personal debt, is forced to reduce its spending and begin paying that debt off. A nation can maintain a high level of debt as long as it can continue to borrow more money to pay off its past debt. And in the current global economy, no nation can borrow money more easily than the United States of America.

The cost of borrowing money is the interest rate that must be paid on loans made to an individual or government. At present, the US government can borrow money at very low interest rates (it pays between 1% and 3% on most of the government bonds it issues). This fact indicates that America’s debt, while it is a primary concern of the Republican party, is not a major concern among those to whom the US government owes money, nor to those who may lend it money in the near future.

The tradeoff America faces as it enters this period of sequestration, government spending cuts, and the resulting reduction in aggregate demand, income, output and employment, is one between future debt and future prosperity. The sequester may reduce the level of debt in the future, but it will also increase the debt burden (as Bernanke explained). In exchange for a smaller dollar value of its debt, America may have to accept  increased unemployment and a slower recovery from the Great Recession, which together will make the US less competitive, reduce standards of living, and make it more difficult for future generations to enjoy the quality of life experienced by their parents and grandparents.

Discussion Questions:

  1. What is the Unemployment Rate in the United States today? What is thought to be the US’s “natural rate of unemployment” How is unemployment measured (simply state the formula)?
  2. Based on America’s current unemployment rate, where would you expect the US to be on its business cycle? Draw a business cycle model and indicate where the US is most likely to be.
  3. Based on America’s current unemployment rate, where do you think current US equilibrium output is compared to full employment output? Draw an AD/AS model and indicate the likely equilibrium the US is currently experiencing.
  4. If you were in charge of fiscal policy, identify two possible policy recommendations that the US should consider given its current level of unemployment. Explain how each would impact the level of unemployment in the economy.
  5. Assume the marginal propensity to consume in the United States is 0.6, and the government decides to cut military and domestic spending by $85 billion. Calculate the effect this will have on America’s GDP.
  6. On the business cycle and AD/AS diagram you drew above, show the effect of the $85 billion spending cut.
  7. Explain how the spending cut will will impact the level of unemployment in the economy.
  8. Discuss with your table the wisdom of the $85 billion spending cut described above.


About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author


2 responses so far

2 Responses to “Sequestration – a basic economic analysis”

  1. Lewison 01 Jun 2014 at 9:14 pm

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  2. Peteron 26 Jun 2014 at 7:45 pm

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