The Domino Effect of US Spending Cuts

Due to the U.S. government's failure to reach an agreement on a plan to cut the deficit, automatic spending cuts took effect on March 1, when President Obama signed an order to begin official implementation of the sequester. It is estimated that federal spending cuts will not only affect the government operations and economy of the U.S. but will also be a blow to its trade partners and the global economy at large. This domino effect cannot be ignored.

The automatic spending cuts were agreed upon by Democrats and Republicans in 2011 during negotiations on the debt ceiling and bills to lower the deficit. Its purpose was to automatically cut a total of $1.2 trillion from the federal budget in both defense and non-defense programs over a period of approximately 10 years starting in 2013 if the two parties remained unable to come to an agreement on reducing the deficit. The plan was originally proposed by the White House, which hoped that it would force the two parties to reach an agreement on a plan to reduce the deficit before the wide-reaching sequester came into effect. However, this hope was not realized, as Democrats and Republicans had continual difficulties reaching a consensus due to their disparate political agendas. Although they managed an agreement on increased taxes for the wealthy and delayed the sequester by two months to prevent the U.S. from falling over the "fiscal cliff," nobody thought it likely that the two sides would come together on a plan to replace it in time.

Within the past two weeks President Obama has sought cooperation from the GOP on a deficit reduction plan of $1.5 trillion that strikes a balance between spending cuts and increased taxes, but he has been met with stiff opposition from Republicans firmly opposed to tax hikes. In the end, the automatic spending cuts were allowed to come into effect on March 1. Because the two parties' fundamental political ideologies run counter to each other, the sequester may extend for some time, and its effects will gradually become apparent.

The beginning of the sequester will reduce U.S. government expenditures by $85 billion this year, corresponding to 2.4 percent of the total federal budget. The breadth of cuts will include defense spending, housing, education and transportation, as well as Medicare and other programs in three main categories for a total of 1,200 programs. Those affected include the White House, federal government, state and local governments and institutions, and even the companies that do business with the government — its suppliers and contractors. Among these, over one million federal employees will be put on furlough or have their salaries reduced starting in April. According to conservative estimates, these reductions in spending will cause a minimum drop in the U.S. GDP of half a percentage point and cost nearly 750,000 jobs. However, there also exist more optimistic estimates, which point out that, in practice, spending cuts will proceed slowly due to procedural delays, and the actual amount cut by September will likely only be $43 billion, limiting its effect. It is also for this reason that the reaction of financial markets to the sequester has thus far been fairly moderate.

Despite this, the domino effect that these spending cuts will have cannot be underestimated. First, the growth rate of the U.S. economy this year is expected to be under 2 percent, and the economic recovery still lacks strength. Reductions in government expenditures will weaken consumption and investor confidence, slowing the already-fragile economic recovery or even bringing it to a halt. Secondly, the global economy is currently still in a difficult stage. The eurozone remains stuck in a recession, Japan is not shying away from waging a currency war to shake off its difficulties, emerging markets remain highly dependent on the U.S. and, once the effects of the U.S. government's spending cuts spread, its trading partners will suffer, as will the growth of the global economy. Furthermore, if the issue remains unresolved, its real effect on the economy will gradually broaden, the uncertainty will shake the world's financial markets and the resulting variables will be difficult to gauge. The IMF has warned that if the U.S. sequester is carried out in full it will harm both the U.S. and global economies, and its economic growth rate forecasts will also have to be adjusted significantly downward.

It is precisely because of the uncertainty brought by the sequester that the Obama administration repeatedly emphasized prior to the deadline that sharp reductions in expenditure could have disastrous effects. However, following the order for cuts to come into effect, the White House has made obvious attempts to soften the blow. As the impasse between parties and political jousting will in all likelihood persist for some time, Obama and the GOP are both seeking increased popular support to force the other side to yield. Obama advocates supplementing the government's income through increased taxes on specific brackets to avoid the impact that spending cuts would have on government operations and seemingly holds the advantage in terms of popular opinion. Nonetheless, Republicans are not entirely without hope for success, as the impact of tax increases will be far-reaching.

The deadlock will very likely cause popular dissatisfaction with both parties. Consequently, in order to prevent the impact of the sequester from becoming too widespread, both sides must be prepared to make compromises, such as passing a new bill through Congress prior to March 27 that will authorize federal funding and avoid a government shutdown. The White House will also request greater flexibility when making cuts to programs. The financial problems of the U.S. will presumably be dragged out in a manner similar to the European debt crisis, and a plan to resolve the issue will be difficult to produce; all that can be done is to address these issues step by step.