A few weeks back, a Chapter 13 client from the Bond, Botes, & Lawson PC office in Knoxville, TN called to ask how the sequestration would affect her bankruptcy. She works at one of the government plants in Oak Ridge, TN and feared that her hours would be cut or worse that she may even be laid off. Unsure myself about this vague and rather complex issue, I set out to research what Sequestration is, why is it being discussed now and is it important? This article is the culmination of that research. Below is Part One of a Two Part blog about Sequestration.
There is an interesting debate on Capitol Hill (and to a lesser extent, the rest of the Country) about sequestration. I say interesting because it appears that many people seem to know very little about sequestration. One reason for this is that understanding sequestration and the debate surrounding it is complex and often partisan. I will attempt to explain this with little or no partisan opinions as both political parties have enough blame to share. And although this is a rather complex issue, it is important to understand. So, what is sequestration? The term sequestration actually derives from a legal term referring to the seizing of property, usually by a court or agent of the court, to prevent harm or damage to the property while a dispute over the property is resolved. In the present debate, the more apt term would be “budget sequestration”, which is a procedure in United States law that limits the size of the federal budget. This involves setting a cap on the amount of government spending. If spending exceeds the cap, automatic, across the board spending cuts are imposed, affecting all departments equally.
Budget sequestration first came into existence in 1985 under the authorization of the Balance Budget and Emergency Deficit Control Act of 1985 with the passage of the Gramm–Rudman–Hollings Act, which provided for automatic spending cuts if certain deficit reduction targets were not met. Unfortunately, the process set forth in the Act was ruled unconstitutional in 1986 in Bowsher v. Synar, 478 U.S. 714 (1986). After a series of revisions, Congress eventually passed The Budget Enforcement Act of 1990 (BEA) as part of the larger Omnibus Budget Reconciliation Act of 1990 (OBRA). The purpose of the BEA was to enforce, constitutionally, the deficit reductions set forth in the OBRA. However, a provision if the BEA allowed Congress to avoid the required deficit reductions if “the budget growth was outside of Congress’ control”. This effectively gutted the BEA as Congress would always argue the increase to the budget and budget deficit were “beyond its control”. Thus, with the exception of years 1998 through 2001, the United States has had a budget deficit (spending more money than it collects in tax revenue).
So where we are now and why is budget sequestration being discussed now? Both of these are very good questions with not so good answers. Starting in 2002, the federal government began running deficits again. There are probably numerous reasons for this; The Bush Tax Cuts, The Iraq War, The Afghanistan War, The War on Terrorism and most recently, the financial crisis that started in late 2007. Whatever the reasons, one thing is clear: The United States is now running budget deficits at unprecedented levels, with truly no end in sight. At present, the current budget deficit stands at $1,089 billion, or roughly $298 million per day. That’s right, the government is borrowing $289 million every day in order to maintain its current spending and budget obligations. In fact, the government has amassed $5,106 billion in budget deficits in just the last four years alone. This is truly mind boggling when you consider that from 1789 through 2008 the entire combined US federal deficit was $5,326.1 billion.
In just four years the US has amassed as much combined budget deficits as the previous 219 years of our nations history combined, which included the entire cost of our War of Independence, the Civil War, WWI, The Great Depression, WWII, the entire cost of building the infrastructure of the country, all railroads, public roads, highways, Interstates and bridges, the Vietnam War, The Korean War, the Stagflation of the 1970’s, the Savings & Loan bailout in the 1980’s, the stock market crash of 1987, the first Iraq War, all actions in Somalia, Bosnia and Kosovo, any and all other major and minor conflicts, the DotCom bubble and burst in the 1990’s, all costs for 9-11 through 2008, all costs for the War on Terrorism through 2008, and much of the cost of the second Iraq War and the Afghanistan War. In essence, every dollar that the United States Government has borrowed from 1789 through 2008 that was used to fund every project, War and any and all other expenditures needed to build and defend the Nation have been borrowed in the last four years alone. Sadly, this is where we are now. Which at least begins to answer the question: why is budget sequestration being discussed now?
In 2011, Congress passed the Budget Control Act of 2011. This Act came to be as a result of a standoff between Republicans and Democrats over raising the Debt Ceiling. The Debt Ceiling is a legislative restriction or limit on the amount of National Debt that the US Treasury can issue. The previous paragraph discussed the federal budget deficit, which is the annual amount of money the government borrows in order to fund that years operations. The National Debt is the cumulative amount of all those budget deficits. By law, the Nation is only allowed to borrow (have National Debt) of a certain amount. The primary way in which the government funds budget deficits is to allow the US Treasury to issue new debt to both foreign and domestic lenders. In 2011, the US reached its debt limit (not for the first time) and a bitter and often very partisan debate ensued concerning the Nations’ soaring budget and national debt. The debate lasted for much of 2011 and eventually led to the first ever credit rating downgrade in the US’s history. Congress eventually raised the Debt Ceiling through the passage of the Budget Control Act of 2011 (BCA). Among other things, the BCA created the budget sequestration debate that Congress and the President are now having. In essence, the BCA agreed to raise the Debt Ceiling in exchange for $2.4 trillion of deficit reduction over the next ten years. This included $1.2 trillion in deficit reduction identified in the BCA, with the remaining $1.2 trillion to be determined by a “bipartisan group of Senators and Representatives known as the “Super Committee” or officially as the United States Congress Joint Select Committee on Deficit Reduction. When the “Super Committee” was unable to reach an agreement on the remaining $1.2 trillion in deficit reductions, an automatic trigger in the BCA was activated to implement across the board reductions in the rate of spending, known as sequestration.
So, what does this mean and is it important? In light of the amount of deficit spending over the last four years and with little relief in sight, it is imperative that the Nation addresses its spending. The current sequestration is one such attempt (although a feeble one, as we will see in a moment) to address this debt crisis. Unfortunately, the time for real action may have passed and the majority of action from Congress and the White House seems “knee jerk” at best. The reason that the Nation is dealing with sequestration at all is because neither Congress nor the White House seem to take seriously the current debt situation in America. Again, America has accumulated as much debt in the last four years as it did in the previous 219 years combined. If that doesn’t scare you enough into real action, I hate to think what will.
Deficit Reduction vs. Spending Cuts
The current solution, the aforementioned sequestration, is hardly “real action”. First, the sequestration is calling for deficit reduction not spending cuts. This is very important because the two are not the same and Congress and the President were very clear when they wrote this into the law. Spending cuts would mean a true reduction in the amount of spending for item, department or whatever. For example, if the Pentagon’s budget was $525.4 billion for 2012 (which it was), then a spending cut would reduce the amount that the Pentagon would be spending next year. Instead, under deficit reduction, the amount of spending for the Pentagon will not be reduced, but rather the amount of automatic increases built into the government’s 10 year budget will be reduced. The Pentagon will spend more money in 2013 than it did in 2012. Cutting spending and reducing the rate of increase in spending are not the same. While the sequestration could have an effect on our client as her livelihood is dependent on government spending, the current reductions in rate of increases in spending are mild compared to the amount of increases in spending still projected. That being said, individuals like our client could be affected by these reductions by not receiving or receiving fewer pay raises in the future. In the most severe case, our client may have her hours cuts or lose her job altogether, although, based upon what we will see about the sequestration, that seems unlikely.
The sequestration being debated currently is only aimed at reducing the current amount of deficit spending by $1.2 trillion over the next ten years. While this may seem like an incredible amount of money, and it is, it pales in comparison to the amount of budget deficits that are projected over the next ten years. On the current trend, using the average annual budget deficit over the last four years, the cumulative deficit would total $12.7 trillion. Reducing the budget deficit by a mere $1.2 trillion over the same time frame would still add another $11.5 trillion to the national debt. This would mean that the Nation’s budget deficit for a 14 year period (the previous four years and the next ten years) would be 3.16 times the amount of the previous 219 years and the National debt would exceed $28 trillion. By any stretch, sequestration is not an answer to the debt crisis America is facing. Furthermore, the amount of deficit reduction proposed under the current sequestration is not evenly weighted. The bulk of the deficit reduction comes at the end of the ten years. For FY 2013, only $85 billion is budgeted for deficit reduction. This amounts to roughly 2.4% of the Nation’s $3.5 trillion annual budget for 2013. It seems disingenuous at best to assume that a nation that has doubled its budget deficit from the previous 219 years in just four years would seriously think that a 2.4% reduction in the increase of spending is a substantive move to bring its spending under control.
Can the Government Truly Cut Spending?
If Sequestration is not about cutting spending but rather reducing projected increases in spending, this leads to the question; can the Government truly cut spending? At present, 62% of all Government spending is considered “Mandatory”. This includes Social Security, Medicaid and Medicare. Another 17.7% of the Federal budget goes to Defense spending and 7% goes to pay interest on the National debt. This leaves about 13.3% for Discretionary spending or roughly $492.1 billion of the current $3.7 trillion budget. Thus, if all discretionary spending were cut from the Federal budget, the US would still have an annual budget deficit of over $708 billion. This is under the current sequestration and the 2013 Federal Budget just passed on March 23, 2013.
Under the current sequestration, spending INCREASED not decreased by $200 billion from FY 2012. The numbers above for interest expense are assuming that interest rates do not rise. Right now, interest rates are as low as they have ever been. And if there is one thing that all economists agree on it is that interest rates will rise. They have to. It is impossible for rates to remain at or near zero forever. Besides, the whole point of all of this government spending over the past four years is to help the economy recover. If the economy recovers, interests will recover with it.
Growing Debts and Interest Rates
On January 2, 2007 (before the current financial crisis), the 1 yr Treasury was yielding 5.00%. As of March 27, 2013 the rate was .14%. What would happen to the Federal budget if interest rates reverted back to 2007 levels? Remember, the main way the Government funds its budget deficit is by selling US Treasuries. Interestingly, the Congressional Budget Office (CBO) issued a report dated 12/14/2010 that projected the National debt (which at the time was $5.8 trillion) would exceed $16 trillion by 2020. The CBO was off on its projection by 7 years as the National debt is $16.7 trillion now. The report warned of the “catastrophic” effects that rising interest rates would have on the Nation if interest rates were to rise back to the historic norm. The interesting item in the article is that the CBO was projecting this catastrophe in 2020 not 2013. In 2012, the average interest rate on public debt was 2.791%. This is extremely low relative to history. The historic interest rate for public debt has been around 6%. Thus if interest rates increase back to historic averages, the interest expense alone on the current national debt would equal $1 trillion. This nearly equals the entire amount that the government currently spends on Medicare, Medicaid and all discretionary spending combined.
Under the current budget, if interest rates moderate back to historic norms, interest on the debt would balloon to 28% of the total budget. Given that currently 62% of the budget is “Mandatory” spending, that only leaves 10% of the budget to fund everything else, including defense spending. This also assumes that the national debt does not increase above its current level, which is a fantasy at best. At its present rate of deficit spending, the National debt will be $20 trillion by the end of 2016. At $20 trillion, under normal historic interest rates, the interest on the National debt would equal 34% of the current federal budget leaving only 4% to fund everything else, including all military and defense spending and any discretionary spending. The “Mandatory” spending for the Government will only increase as this is spending for Social Security, Medicare and Medicaid.
The Retiring of the Baby Boomers
The “Baby Boomers” are just now starting to retire in mass. It is projected that by 2030, 72 million people will be over 65 and eligible for Social Security, Medicare and Medicaid. This is compared to roughly 45 million in 2012. This is truly uncharted territory. Not only has a nation never amassed as much debt in four years as it did in the previous 219 years, but combine this with what will be unprecedented “Mandatory” increases in spending to fund the retirement benefits for people over 65 and you easily see the potential for catastrophe. At present, roughly $2.3 trillion of the $3.7 trillion Federal Budget for FY 2013 is being used for Mandatory spending. That number would increase to $3.2 trillion by 2030 with the retirement of the “Baby Boomers”. With no clear end to the increases in spending in sight, it appears that Sequestration will have little if any meaningful effect in restoring America’s financial security.
In regards to our client, our firm represents clients that are contemplating or who are already in bankruptcy and we welcome the opportunity to assist them in any way that we can. We regularly field questions from potential and current clients regarding the consequences of various issues dealing with both the macro and micro economy. Based upon Knoxville’s very close proximity to Oak Ridge, TN and the Oak Ridge National Laboratory, our clients are naturally concerned anytime there is talk of reducing government spending. While it is impossible to know what will ultimately happen in any given situation, our firm routinely investigates, researches and monitors both the macro and micro economic environment to help guide and advise our clients on these issues and there potential consequences. Please feel free to contact any of our offices with questions regarding this or any other issue or concern you may have.