Wednesday, February 27, 2013

Effects of the possible sequester


We are again close to a fiscal cut deadline, the by now infamous sequestration. This one of around US$ 85 billions in the first year (around 40 billions or so in defense spending), mostly in discretionary spending (10 billion or so in Medicare), accumulating to a total of US$ 1.2 trillions until 2021, which is obviously not what the doctor recommended. Some have suggested that the size of the initial cut is small, around 0.5% of US GDP, and should have limited impact.

Some simple back of the envelope calculations suggest that the effects might be worse than they think. So let's say that the multiplier is between 1 and 1.5, which wouldn't be completely out of line with some measures in the literature. This suggests a fall in output between 85 and 127.5 billions, or between 0.5% and 0.75% of GDP. Assuming an Okun effect of 2, that is that a decrease in output of 2% increases unemployment in 1%, then an increase in the unemployment rate between 0.25% and 0.375% should be expected. Does not seem that large indeed, but that is if you're not looking for a job.

But note that this comes on top of an economy that has already a relatively high level of unemployment (even larger than the official numbers), and that it is the first (and the smallest) in a series of cuts that will continue (if the sequestration goes as planned) for 9 years. So it will make a very weak recovery, even weaker. Finally, given that a lot of the cuts will go to discretionary spending, affecting unemployment insurance and education, for example, it will hurt disproportionally the more vulnerable in society. So the point is that it is a big deal, depending on where you stand.

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