Reflections on Sequester

A clearly inebriated man is searching the ground around a lamppost. As pedestrians pass by, a few decide to help the poor fellow. As they search around the lamppost, one asks, “What are we looking for?” The drunk replies, “My house keys.” After 20 minutes of fruitless searching, one of the searchers asks, “We have been looking here for a while…where were you when you noticed they were gone?” The drunk points down the street. “Why are we looking here?” “Well,” the sot says, “The light is much better.”

Over the past several weeks, the notion of sequester, a plan of across the board spending cuts, has been dominating the news. The sequester was a program designed to never go into effect. In the dark days of 2011, when the debt ceiling debate threatened to cause the U.S. to default on its debt, the administration and the House GOP made a deal. In return for a higher debt ceiling, one high enough to ensure that it would not be hit before the 2012 presidential elections, a commission was tasked to make significant cuts to fiscal spending. If this bipartisan commission failed to agree, then automatic, across the board cuts were to be implemented on March 1, 2013.

Both sides of the political spectrum believed that the other would not tolerate these spending cuts. Democrats relied on the idea that defense cutbacks would be so repugnant to the GOP that a deal would be struck. Republicans thought that furloughs of government workers would compel Democrats to work out a better deal.

The sequester is an example of what can go wrong when parties make long term deadlines. No one can predict what the conditions will be when the deadline arrives. The GOP, smarting from the perception of “caving” over the fiscal cliff, is now determined not to give the president what he wants. In addition, the Democratic leadership still does not seem to understand the divisions within the Republican Party that make a deal even harder.

The Weekly Geopolitical Report generally has an international focus. However, this week, we want to spend some time discussing the U.S. fiscal and political situation because it affects how America performs its superpower role. And so, in this report, we will discuss how fiscal policy has evolved in the post Cold War period, the divisions within the GOP and the long-term risks to the nation’s ability to maintain its superpower status. As always, we will conclude with the long-term impact on the financial markets.

The Fiscal Conundrum

To understand the U.S. fiscal situation, a few terms need to be defined. Government spending is broadly defined into three categories. The first is discretionary spending. Simply put, this spending is defined as expenditures that require annual Congressional approval. Defense appropriations or monies granted to the National Institutes for Health are examples.

The second category is called mandatory spending, defined as expenditures that are required by law. Essentially, if a person meets the requirements of the program, the government is required to provide benefits. Examples include Social Security, Medicare and unemployment insurance. If a citizen is the right age, he gets Social Security and Medicare. If one is unemployed under the law’s guidelines, he/she receives benefits. The third is net interest. That is simply the interest paid by the Treasury to service America’s Federal Government debt.

The trend of mandatory and discretionary spending is probably the most important.

This chart shows mandatory and discretionary spending in 2012 dollars. Note that in the early years, discretionary spending far exceeded mandatory spending. However, as the Great Society programs, such as Medicare and Medicaid ramped up spending, mandatory spending started rising at a very rapid clip. By the early 1990s, mandatory spending exceeded discretionary spending. In fact, in that decade, discretionary spending fell as military spending declined after the end of the Cold War.

The relentless rise of mandatory spending is forecast to increase steadily into 2023. This rise is mostly due to two factors. The first is the steady aging of the population. The baby boom generation is entering their retirement years which mean that Social Security and Medicare spending will rise by default. Second, the continued increase in health care costs is driving spending for government supplied health care.

This chart shows the level of overall and medical care inflation, rebased to 1980. Over that time frame, overall inflation (which does not exclude medical care costs) rose 2.5x. Over the same time frame, medical care costs jumped 6.25x. As the previous chart indicates, projected spending on retirees is expected to rise significantly in the coming years.

The evidence is starker when compared to GDP (and forecast GDP).

When spending is viewed in terms of percentage of GDP, it shows how rapidly mandatory spending rose from the early 1960s into the late 1970s. Discretionary spending declined at nearly the same pace. Mandatory spending held mostly steady into the 2008 Great Recession, but spiked due to increased spending for unemployment compensation and the increase in disability payments. What is interesting (and discomforting) is that the Congressional Budget Office (CBO) does not anticipate a decline in mandatory spending. Instead, it is (perhaps optimistically) expecting mandatory spending to rise at the same pace of nominal GDP. Discretionary spending, in contrast, is forecast to fall to 5.4% of GDP by 2023.

This analysis brings us to our opening story. If the country is serious about reigning in spending, it seems ludicrous to focus on the discretionary outlays. They are being dwarfed by mandatory spending. The real key to controlling fiscal spending is to address the mandatory budget. Instead, like the drunk looking for his keys where the light is better, the focus is on the discretionary budget.

Military spending lies in the discretionary budget. And so, the squeeze hitting this side of spending is reducing defense budgets as well.

This chart, from the CBO, suggests that after 2015, defense spending as a percentage of GDP will fall to under 3% of GDP. And, this chart does not take into account the sequester. This event will take another $55 bn per year out of defense spending, or another 0.3% per year, approximately.

Budgets are concrete expressions of our decisions. The fact that the budgetary process in Washington is in such disarray is because there is no consensus on the way forward. Unfortunately, even when our goal is to avoid hard decisions, they eventually are thrust upon us. Essentially, what the political class is saying, (and remember, the political class represents the voting public) is that they are willing to sacrifice discretionary spending, and the military budget, to maintain the mandatory spending.

The defense budget was already cut as part of earlier negotiations, so the sequester would simply add to those reductions. This isn’t to say there isn’t waste in the defense budget. Cost overruns are endemic and there appears, at times, the desire to create weapons systems that fail to fit the mission. Unfortunately, military planners must prepare for missions that don’t exist yet and can only speculate on future enemies. Thus, it is difficult to know if a future weapons system will meet the needs of the wars yet to be fought. The men who built the B-52 would probably be shocked that it is still flying today and the ones who built the B-2 for penetrating Soviet radar would be surprised it still exists, for the need has vanished.

The current cuts will adversely affect maintenance and readiness. Tours of duty are being extended because it is cheaper to keep a soldier in place than to rotate him out with a replacement. Maintenance is being delayed. The USS Harry Truman, scheduled to deploy to the Persian Gulf, remains in port due to cost considerations. The ability of the U.S. to project power is being undermined by sequester; perhaps the most damaging effect is the across the board nature of the cuts. If planners could address the cuts with more flexibility, the effects would be less damaging.

What kind of government does a superpower need?

A superpower has two primary roles, one financial, the other military. The financial role is to have a large enough economy to provide the reserve currency and to become the importer of last resort. Other nations need to become “addicted” to the superpower nation’s consumers. This gives the superpower the influence to sway other governments to support its policies. Not playing along means that a nation risks losing access to the superpower’s markets. On the military side, the superpower needs a large enough military to deter competition. It must be powerful enough to make the prospect of attacking the superpower hopeless and to make the cost of retaliation far too high to entertain. At the same time, it must be able to project power broadly enough in the world to protect allies and deter other nations from attacking an ally.

In the modern world, one cannot be a superpower with a small government. The government must ensure that consumption is reliable enough to be the global importer of last resort. Although the creators and supporters of Social Security likely had other issues in mind, the creation of Social Security supported consumption because it reduced the necessity of saving for retirement. Mandatory spending is a part of maintaining consumption. If the U.S. wants to remain the global superpower, mandatory spending will remain elevated. Slowing spending is probably a “micro” problem. In other words, means testing, cost containment for medical care and a review of age eligibility are probably the best way to slow the pace of increase. Think of it this way. Social Security is an effective way to maintain consumption; Medicare is less effective because the spending is too narrow and the benefits of the spending are less widespread.

The Battle for the GOP

The past presidential election laid bare the divisions within the Republican Party. Ideology was the battleground as one branch of the conservative wing of the party continued to offer new candidates on a regular basis during the primary season to prevent Mitt Romney from winning the nomination. In the end, their efforts failed. However, Romney also was unable to defeat President Obama.

It appears that the ideological split can be described with this graph.

This chart shows government spending as a percentage of GDP, going back to 1792. From that year to 1929, excluding the wars (which are spikes on the graph), Federal government outlays averaged 2.6% of GDP. This level of government spending is consistent with a republic. The government had limited responsibilities—defend the shores, deliver the mail, address interstate law enforcement and provide a court system.

To some extent, the Tea Party, Grover Norquist, and the Libertarian Party seem to want a return to this republic period. Norquist’s famous quip that he wanted a government “small enough to drown in a bathtub” would fit this period. Although the Tea Party seems to support a large military, some members also want to avoid foreign entanglements (frankly, the Tea Party is a broad coalition which can make them hard to pin down). Libertarians are clearly in the camp of wanting a small government along with a relinquishment of empire.

On the other hand, the Cold War Republicans are really large government supporters. The Cold War Republicans want to limit mandatory spending, in fact, all spending not related to the military, but also acknowledge that the mandatory spending programs are necessary for the superpower role.

This division within the GOP does not seem to be recognized by the Democratic Party leadership. They keep negotiating with the Cold War Republicans without realizing that the small government Republicans have an entirely different vision of government in mind. Thus, the sequester isn’t much of a threat to the small government types; since they view most government spending as unnecessary, they are more than willing to suffer some of the cuts to important government roles if for nothing else than to start the process of reducing the size of government.


A persistent theme in our analysis is the semi-hidden nature of America’s superpower role. The government seems to conduct policy with only a glancing view of that role at times and the public can act as if it is unaware of what it entails.

The sequester poses a threat to this role. Cutting defense spending further runs the risk of not being able to meet some of the requirements of the superpower mission. Only a political figure planning on leaving the “industry” would point out that we may have to choose between funding the military and our mandatory spending. Since Lyndon Johnson, we have believed we could have “guns and butter” without constraint. That illusion is being sorely tested and soon we may have to actually decide if the nation will maintain its superpower status.

From a market perspective, uncertainty over the superpower role is, in our estimation, the primary cause of the secular bear market in equities. Given how difficult these decisions are, the secular bear remains (even in the midst of the current cyclical bull). A balanced portfolio, holding both equities and fixed income, along with an allocation to real assets, is the preferred way to invest in this environment.

Bill O’Grady

March 4, 2013

This report was prepared by Bill O’Grady of Confluence Investment Management LLC and reflects the current opinion of the author. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

© Confluence Investment Management

© Confluence Investment Management

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