Sequester 101: Is all this fuss really necessary?

The sequester spending cuts set to kick in March 1 address a serious long-term problem. But are they needed this year and in this way? No one thinks it's a perfect step.

The federal government is about a week away from major spending cuts called the "sequester," which are poised to affect most federal programs in a sudden and significant way.

But is this focus on fiscal discipline really necessary?

Well, yes and no – and if that sounds wishy-washy, hang in there.

"Yes" is the long-term answer. Persistent federal deficits driven by increases in entitlement spending must be dealt with. If they are not, forecasters say, the rising national debt will, at some point, significantly damage the country’s economic health. The debate is about when that damage will arrive, not whether the problem is a real one.

"No" is the shorter-term answer, because economists are divided about whether the federal government should tighten up on spending during the current fiscal year. Even those who support spending cuts don’t like the rigid nature of reductions that mandated in the sequester, which are split equally between defense and a wide range of non-defense programs.

In the end, if the sequester forces Congress to talk constructively about the shape of fiscal policy, it could serve a purpose beyond the spending cuts.

“Debate is healthy and long overdue on entitlements,” economist John Silvia of Wells Fargo writes in a recent analysis of US fiscal affairs. Programs like Medicare, Medicaid, and Social Security “make up the largest share of federal spending and the fastest growing segment of spending.”

But where does that conversation need to go? Here’s a look at some of the arguments that some politicians and pundits are making in the fiscal debate:

Perception: We could solve this whole deficit problem if we’d just _________ (insert solution here: raise taxes, cut spending, etc.)

Reality: If you hear an argument saying the solution is all about some tax hikes, or spending cuts, or even a mix of the two, remember this: There’s another big part of the equation called economic growth. Economists worry when the national debt is large or rising relative to the size of the economy.

Right now, it appears to fit the definition of “large” – with gross federal debt roughly equal to a year’s gross domestic product (GDP). When the debt was similarly high after World War II, the nation successfully reduced that debt during the next two decades, as a share of GDP. Annual federal deficits weren’t eliminated, but they were outpaced by growth in the private sector.

Yes, tax policy and spending policy are vital elements of the mix. But both need to be paired with a growing economy.

Perception: Federal spending is out of control, thanks to President Obama.

Reality: The notion that federal spending is out of control is open to debate, but some of the overall numbers don’t look worse for Mr. Obama than for other presidents. Discretionary spending is poised to be lower this year than it was in 2008 or in 2009, the fiscal year during which Obama took office, as a share of GDP. That's according to historical budget numbers reported by the White House.

Recovery Act spending was large, but mainstream economists generally say the stimulus effort served a needed purpose, nudging the economy forward amid a deep recession.

Overall spending, lingering above 22 percent of GDP, remains higher than average as Obama starts a second term. That’s partly because entitlement spending has continued to grow no matter who is president.

Perception: If there's a spending problem, it's with entitlements. Let's not cut discretionary programs.

Reality: Many budget analysts say that, although forecasts of future spending growth hinge heavily on entitlements programs, it's also appropriate to look for trims in discretionary spending. But they caution: spending on things like scientific research, transportation systems, and education often promote economic growth in the long run. So policymakers should ensure that needed investments aren't shortchanged.

Perception: Health-insurance costs aren't rising so fast, so future deficits may not be that bad.

Reality: It’s true that since the recession, medical costs have been growing at a slower pace of about 4 percent a year (compared with 7 percent previously). But health-care experts warn there’s no reason to think the cooler pace of price hikes in the health sector will become the long-term norm.

And even if it does, health care will still weigh on the federal budget. In the long run, health care looks to be the largest driver of fiscal challenges – and a 4 percent annual rise in costs is still faster than overall inflation. (Moreover, there’s the tide of baby boomers moving onto Medicare rolls to consider.)

Perception: We have to restrain spending now or the US could face a new financial crisis.

Reality: Financial forecasters don’t know when or if US fiscal policies will cause a financial crisis. Credit analysts have already downgraded their ratings of US Treasury debt, or warned that this could happen. Yet interest rates remain near historic lows – indicating that the US has no trouble finding buyers for its debt.  So there’s no clear hint of an imminent crisis, but also no guarantee the calm period will last for years.   

Perception: Bond investors aren’t dumping their Treasury bonds. The debt crisis is just a figment of fiscal-hawk imaginations.

Reality: This “don’t worry” argument is the questionable rebuttal to the “be very afraid” argument just discussed. Just because interest rates are low now doesn’t mean they will remain so. A more plausible view, taken by many forecasters, is that the US has window of opportunity – but perhaps a relatively short one – to address its fiscal problems. Failure could lead investors to conclude the US has no sustainable plan for servicing its debts.

On the comforting side, it’s possible that the nation’s debt-to-GDP ratio could remain stable for the next decade, if economic growth is solid and some budget adjustments are made.

But that’s no reason for complacency. That outlook doesn’t factor in uncertainties like possible recession or special national-security needs. And economists warn that the longer the US waits, the bigger the needed tax hikes or entitlement cuts will be.

“Beyond a certain level, debt is a drag on growth.” That’s the blunt message delivered in 2011 by researchers at the Bank for International Settlements (BIS), a multinational institution based in Switzerland. There’s debate about exactly where that threshold level lies, but the US may have already crossed it.

The BIS economists, led by Stephen Cecchetti, concluded that the danger zone for government debt is when it reaches about 85 percent of GDP. By their measure US public debt had reached 97 percent of GDP as of 2010.