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What Is Sequestration – Definition & How It Cuts the National Debt

By Michael Lewis

sequester aheadWhile our country’s ability to borrow money is a valuable asset, particularly in times of need such as wars or economic recessions, continuously maintaining high levels of the debt in comparison to our gross domestic product is detrimental, even devastating to citizens. Government debt is simply an IOU to be repaid by future taxes upon its citizens and businesses; excessive debt must be repaid eventually, as has been discovered in recent years by citizens of debtor countries such as Greece, Italy, and Spain.

Repayment of our national debt requires higher income taxes, elimination or degradation of existing government services, devaluation of our currency by inflation, or a combination of all three. In addition to repaying the principal of the debt, we bear an annual, ongoing expense in the form of interest paid on the debt. A rise – even a small increase – in interest rates can wreak havoc on our annual budget, requiring additional increases in the debt, massive tax hikes, or severe reductions in services and benefits.

For example, a one-half percent (0.5%) increase from its current rate would cost the nation’s taxpayers an additional $80 billion in interest – more than we spend on veteran benefits and services each year ($58.8 billion) – while a 1% increase will be about the cost of our veteran programs annually ($124.5 billion) and our expenditures for science, space, and technology ($30 billion).

The Origin of Sequestration

The original “sequestration” – a series of automatic cuts imposed unilaterally across domestic and defense spending programs – was passed during the Reagan administration as an amendment to an earlier political battle over raising the debt ceiling more than $2 billion. At the time, the national debt to gross domestic production (debt/GDP) ratio was 43%, its highest ratio since the Vietnam War.

Senators Phil Graham and Warren Rudman, Republicans from the states of Texas and New Hampshire, respectively, joined with Senator Ernest Hollings, a Democrat from South Carolina, to sponsor the Balanced Budget and Emergency Deficit Control Act of 1985, which became law in December of that year. The Act required automatic cuts to be made if targeted deficit goals were not met during the following five years, with the aim of having a federal balanced budget by 1991. By the end of 1989, the debt/GDP ratio had climbed to 52%, presumptively due to the costs of Desert Storm and the savings and loan crisis. The threat of sequestration, while well-intended, failed to control the growth of national debt.

In 1990, the Budget Enforcement Act (BEA) was enacted as part of the Omnibus Budget Reconciliation Act of 1990 during President George H. W. Bush’s term in office. Since non-discretionary, automatic cuts were unpopular with both political parties, the BEA replaced sequestration by establishing annual discretionary spending caps for federal expenditures with the requirement that any change in entitlements or taxes were to be deficit-neutral or deficit-reducing, commonly called “pay-as-you-go” rules.

President Bill Clinton led the passage of the 1993 Omnibus Budget Reduction Reconciliation Act, raising taxes and cutting appropriation spending. As a result of a growing economy and reduced deficits, the debt/GDP ratio fell to 56% by 2001. In the last two presidential terms, however, annual budget deficits have reappeared, causing the national debt as a percentage of GDP to explode. According to the Congressional Budget Office, the projected 2013 debt/GDP ratio of 77.8% will be almost 95% in 10 years.

treasury

National Debt and Its Effect on the Economy

Americans have enjoyed a love-hate relationship with debt since the founding of the country: Thomas Paine wrote in 1776 in his historical work “Common Sense,” “No nation ought to be without debt.” Even as Thomas Jefferson warned of letting “our rulers load us with perpetual debt.”

Prior to the 1930s and the social programs enacted by President Franklin D. Roosevelt, public debt was generally incurred to fight wars, and was paid off in the years following the conflicts. In fact, for most of the nation’s first 200 years, our annual budgets were balanced or produced surpluses. However, between 1970 and today, the country has experienced a single four-year period of budget surpluses (1998 to 2001), and the nation’s debt increased from $371 billion to over $16 trillion during that time.

The negative repercussions of our current high national debt level affect our country and economy in many ways:

1. Repayment Responsibility Has Been Unfairly Transferred to Future Generations
A particularly pernicious effect of government debt is the potential inequity between the beneficiaries of the original debt and those who must repay it. Much of the past 20 years of budget deficits has been to fund increases in social programs or necessary ongoing government services. Since raising taxes is unpopular, politicians have turned to debt, severing the connection between benefit and expense.

2. Payments for Interest Costs Divert Available Funds for Critical Investments in Infrastructure, Education, and Research
Interest expense on the U.S. national debt was almost $360 billion in 2012 on $16 trillion of debt, or about 2.25% in interest. And most observers believe that interest rates will go higher as worldwide economies improve. The problem is that a dollar spent in interest, particularly to a foreign holder of national debt, has little multiplier effect on the economy, whereas a dollar spent on infrastructure (roads, bridges, sewers, airport runways) returns $3.21 in increased economic activity over a 20-year period, with $0.96 coming back in tax revenues to the government.

3. High National Debt Accentuates the Disparity in Income Between Citizens
Revenues to pay down debt or annual interest comes from taxes paid by all citizens, while the interest payments go primarily to wealthier households. Even though higher income households (the top 1%) pay greater taxes in total than any other group (36.7% of personal income taxes paid), the existing tax system disproportionately favors the wealthy with deductions, credits, and subsidies so that the wealthiest pay tax at rates generally lower than those who might make substantially less money.

4. Debt of the Federal Government Crowds Out and Increases Cost for Private Borrowers
U.S. Government debt competes with other potential borrowers for investment. While the total investment pool for loanable funds contracts and expands as worldwide economies rise and wane, dollars invested in U.S. debt cannot be invested elsewhere. In addition, when Treasury officials raise interest rates to attract investors, other borrowers are also forced to raise rates if they want to sell their debt.

5. High Debt Levels Encourage Inflationary Monetary Policies
Unlike private businesses or individuals, the U.S. Government can create more money at will. When a country’s money supply is divorced from real production, the result is either deflation where product prices fall (more goods and less money, so each dollar buys more product), or inflation where product prices increase (less goods, more money so more dollars are required to buy the same product).

Inflation to a bond holder means that the dollars repaid when the bonds mature are less valuable than the dollars given to the borrower when the debt was incurred. During times of economic stress, there is tremendous political pressure on a country’s leaders to rely on inflation to cover future repayments of debts, rather than institute austerity measures or raise taxes.

Congressional Gridlock and Political Partisanship

There is an old country saying, “You can’t get out of the hole until you quit digging.” It is unlikely, however, that our past and current practice of expanding government spending while reducing government income will change.

pew-research-government-spendingIn a Pew poll taken in late 2010, 93% of respondents described the federal budget deficit as a major problem, 70% indicating that it was a problem to be addressed immediately. Yet, more Americans favored increased spending than cuts for almost every sector of public expense except for employment aid and aid to the world’s needy.

According to Andrew Kohut, president of the Research Center, “There has never been an issue such as the deficit on which there has been such a consensus among the public about its importance – and such a lack of agreement about acceptable solutions.” The paradox between a desire for smaller government and fewer services and resistance to spending cuts or tax increases is apparent in repeated legislative standoffs in debt ceiling negotiations and failure after failure to take meaningful steps to lower the deficit and national debt.

While partisanship has always been present in the workings of Congress, it has become particularly virulent during the last two decades, fueled by several factors:

  • Gerrymandering of Congressional Districts Into Safe Partisan Strongholds. Lawmakers are reluctant to compromise because their biggest reelection challenges come from hardliners in their own party. As a consequence, centrist legislators are less and less visible in either political party.
  • The Rising Costs of Elections and the Influence of Big-Pocket Donors. In 2012 elections, incumbent members of the House of Representatives raised more than $546 million with a direct link between those who raise the most money and the most powerful legislative assignments, according to campaign finance expert Anthony Corrado. Influence groups either expecting favors or protecting the status quo are the biggest contributors to campaigns, enforcing party discipline and ideological purity by their pocketbooks.
  • A National Press More Interested in Controversy Than Compromise. Misleading, even false information is spread knowingly and carelessly by media and commentators in print, television, and Internet. Rational viewpoints and thorough analyses are increasingly rare, so the public, like their Congressional representatives, is understandably polarized.

The current sequestration is the result of a series of annual battles over the debt ceiling, a solution thought to be so penal that both parties would be forced to negotiate an acceptable compromise between spending cuts and increased taxes to avoid its implementation.

Our inability to reach agreement in Congress or between citizens is “reflective of our national mood,” according to Mark Leeper, a professor of politics at Wayne State College. “Both sides are dug in and doctrinaire. They don’t see compromise as a virtue. They see it as selling out principles.” In the meantime, the Congressional Budget Office expects deficits to continue to grow, annual interest costs to rise, and the national debt/GDP ratio to exceed 90% by 2020.

pentagon, department of defense

Is There a Better Way?

Predictably, following the sequester’s effective date, our political leaders are busy blaming the other party for their unwillingness to agree on a better approach. Depending upon the source and his or her political affiliations, the consequences of sequestration will leave the nation defenseless, the public subject to serious health and security risks, our borders open, and our children uneducated. Leon Panetta, until recently Secretary of Defense, characterized the sequestration as a “meat axe” taken to Department of Defense budgets. The Bipartisan Policy Center claims a million jobs will be lost as a consequence, while the science and research community argues that long-term growth in the economy will be hindered, if not delayed for years, as a result of the automatic cutbacks.

Economists agree that a more thoughtful approach to reducing the debt by cutting government spending – revising the entitlement programs, for example, where unrestrained spending occurs, devising a more equitable tax code, and implementing programs that encourage economic growth with shared benefits – would be preferable and wiser than the actions forced by the sequestration. Thus far, however, Congress has proven incapable of a balanced approach to resolving the deficits and reducing national debt. Neither our history nor the current political environment provide any hope that an effective, bipartisan effort is likely to emerge in the near or medium terms.

The sequestration may be the only realistic way to correct our worsening debt problems and our practice of borrowing from future generations. Though crude, it will reduce government spending in the short-term and long-term if left in place. No one wins and everybody loses, but the pain is shared equally across all parties. If it applied to the big entitlement programs – Social Security, Medicare, and Medicaid – real progress could be made in eliminating annual budget deficits and returning our national debt to a manageable level.

Final Word

America is much like the morbidly obese patient who, after years of binging on cheeseburgers, fries, and super-sized soft drinks, learns he must lose weight to avoid deteriorating health, increased medical expenses, and premature death. To his chagrin, he learns that the only effective way to drop the excess pounds is reducing the daily calories consumed. There is no magic pill or surgery where he can maintain his old habits and lose weight. Weight loss is simply taking in less calories than one burns. Reducing our national debt is simply spending less than we take in from taxes.

What do you think of sequestration? Do you think your Congressman should compromise on taxes or cutting entitlement programs to reduce the deficits? Do you think a compromise is possible?

Michael Lewis
Michael R. Lewis is a retired corporate executive and entrepreneur. During his 40+ year career, Lewis created and sold ten different companies ranging from oil exploration to healthcare software. He has also been a Registered Investment Adviser with the SEC, a Principal of one of the larger management consulting firms in the country, and a Senior Vice President of the largest not-for-profit health insurer in the United States. Mike's articles on personal investments, business management, and the economy are available on several online publications. He's a father and grandfather, who also writes non-fiction and biographical pieces about growing up in the plains of West Texas - including The Storm.

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  • http://mydebtucation.blogspot.com/ Mario

    I understand the theory that would make #4 and #5 true, but can you point to empirical data that says as much? It seems particularly detached in these post-financial crisis days

    • MLewis

      Mario, I understand your questions and I am afraid there is no direct empirical data of which I’m aware proving that government debt squeezes out other lenders. Specifically. I cannot quantify the limit on Supply of credit (those people or entities willing to buy Government debt at any given time), but I suspect there is one out there, particularly as other alternatives approach the security of American Government debt. Since U.S. government debt is considered the safest possible investment, all others pay a premium over the government rate, the magnitude depending upon the difference in perceived safety. When U.S. debt rates increase, other have to follow suit.

      As far as #4, I believe allowing a little inflation is more palatable than diverting a greater share of future GDP to repay debt. In the final analysis, there are more debtors than creditors and raising taxes has been political suicide in the past. I don’t think the Fed is immune to such pressures.

      Thanks for writing.

  • John@TheMoneyPrinciple

    “The problem is that a dollar spent in interest, particularly to a
    foreign holder of national debt, has little multiplier effect on the
    economy, whereas a dollar spent on infrastructure (roads, bridges,
    sewers, airport runways) returns $3.21 in increased economic activity
    over a 20-year period, with $0.96 coming back in tax revenues to the
    government.”

    An interesting suggestion. A dollar spent on infrastructure returns $3.21 over 20 years with almost the dollar coming back as tax. So if you haven’t got the dollar in the first place, doesn’t it make sense to borrow it and, unless interest increases the dollar borrowed to $4.17, you are ahead of the game?

    The models used by many governments have been shown to be wrong in these times of extreme austerity. Nations with a sovereign currency can – and do of course – print themselves out of trouble. Too much is not a good thing but while it was believed that a 1% cut in government spending would lead to a 0.5% reduction in GDP, it has now been recalibrated to be more like a 1.5% reduction in GDP. Since governments have quite a lot of fixed costs the corresponding reduction in tax revenues leads to a much greater reduction in money to invest.

    I understand the comparison with a household but generally nations are not the same as families. While the UK government has been particularly silly in its response to the financial crisis and is still talking of cutting while we are heading for a triple dip recession, this doesn’t invalidate the essential economic truth that the only way out of the hole which we have dug for ourselves is growth. After the Great Depression, only part of the recovery in the US was down to FDR’s new deal – the rest was public investment in war when young men (mainly) were sent overseas to fight on (compared to their allies) good wages and then came home in 1945 with money to spend. After the Great Depression in the UK, we recovered by building houses, which is after the initial investment a self-financing operation.

    • MLewis

      John, While I am no fan of sequestration, I do believe it is the only way we will ever face our burgeoning debt problems. As evidenced by the ongoing talks this week, both parties have returned to their pre-election positions – the Republicans, all cuts and no additional revenues, and the Democrats, leave Medicare and Social Security unchanged.
      I agree that growth is the only solution – we need to kick it up from the anemic 1.5% to over 3%. That won’t happen without government investment. If it were me making the decision, I’d use the low interest rates available now to kick off a massive infrastructure program, subsidize education, and increase research & development sponsored by the government. At the same time, I’d eliminate loopholes in the tax code generally, raise rates on the highest payers, increase the FICA taxes to 9%, raise the age for Social Security, and do means testing among others.

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