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Talking to an economist about the sequester clears everything up - sort of

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John Easterwood, of Virginia Tech University. John Easterwood, of Virginia Tech University.

(RNN) - Trying to understand sequestration and all it entails is not easy. If economics were easy to understand, anybody could do it, even politicians. Obviously, that is not the case.

The effects of the massive budget cuts mandated by the sequester could be devastating to the economy for years to come, but the lack of alarm over this seems to come from the short-sightedness of politicians and the lack of understanding by the public.

I spoke to an economist friend of mine, John Easterwood, who is an associate professor of finance in the department of finance at the Pamplin College of Business at Virginia Tech University.

He knows all about this stuff and plays a mean saxophone.

I don't know if this manages to clear things up or makes it even more confusing, but here's the gist of our email exchange.

Is it really urgent that we reduce the deficit right now, and this fast?

Callers to talk radio and doomsday preppers believe we are on the verge of economic collapse. But are we really facing a full-blown debt catastrophe, like the one in Greece? Are we teetering on the brink of financial oblivion?

Easterwood says NO, and he capitalized the "N" and the "O." The deficit is too high, but it's not at such a crisis point that we have to make all these massive cuts right now.

The U.S. Treasury is still selling plenty of bonds to investors to raise money, at a really low rate of return. The Treasury is currently only paying 2.02 percent interest on 10-year notes, which is very low. Despite that, investors at home and abroad still snap them up, because they feel U.S. Treasury notes are the safest investment out there – they know in 10 years, they will get their money back, plus interest.

If that were not the case, the mess would be a lot worse. The Treasury would have to offer much higher rates of return to get people to buy their notes. And yeah, maybe we would be forced to implement these massive cuts.

Record deficits

Yes, we are running record deficits. But that's not necessarily because the government is handing out fat stacks of cash needlessly.

There are cyclical and short-term influences at work that force increases in government spending.

Count on it: when the economy is bad, the government spends more. There are several reasons why.

First – more people get laid off and go on unemployment. Thus, more people qualify for social safety-net programs.

Why should government even supply these programs? Those who favor them cite humanitarian grounds – people are in trouble so we should all chip in to help them out. Opponents contend that people who could work won't because it's easier to just sit on the couch and take money from the government. There is some merit to both arguments.

But as an economist Easterwood said it's better to keep as many people spending money as possible, especially in a recession. During a recession, people spend less money, and that makes the recession worse.

People who have lost their jobs obviously spend less than they used to. People who do have jobs spend less because they are scared, and they hold on to their money instead of buying new TVs, iPods and things.

Government programs can keep the drop off in consumer spending from being even worse.

It should be noted that government spending is not increasing right now. It peaked in the second quarter of 2011 and has been going down a little since then. Here's a graph from the government that shows that.

Government spending is not always a good thing. During light or moderate recessions, Easterwood said it's bad. But this past recession was a really, really bad one. So the government had to do something to stop the bleeding.

Easterwood said the stimulus money, on the whole, was doled out pretty effectively.

To wit:

  • A tax cut for middle income households,
  • Infrastructure spending, such as improving roads and bridges. These are things that are hopefully beneficial as the economy recovers.
  • Research and development programs run by the Department of Energy, National Institutes of Health, the National Academy of Sciences, and others.
  • Tax breaks for businesses that hire new employees - whether this did any good in the 2008-09 situation is questionable. But it may work well in other situations.

The spending associated with the stimulus bill was mostly completed by the end of 2010. The effects it is currently having likely include:

  • More revenue from taxes if the stimulus led to people making more money
  • More expenditures if the stimulus created more debt that we have to pay off now. If this is the case, the cost is probably low because interest rates are low and we likely are seeing more tax revenue.

In all, government expenditures increased by 26.5 percent over 10 quarters, ending in the second quarter of 2011 – that means all of 2009 and 2010, and half of 2011.

The deficit went up during this period because with all that extra spending, tax revenues went down. Tax revenues always go down in a recession.

That's because most federal revenue comes from the personal income tax, payroll taxes, corporate income taxes, user fees and import charges. The first three are the most important.

Personal income taxes, where the government gets most of its money, fell 20 percent from the beginning of 2008 until halfway through 2009, with the biggest drop coming in the first three months of 2009.

These combined forces are what caused the huge deficits we are now seeing. And looking at short-term numbers create misperceptions about where the economy is going.

A quick review: Government spends more and collects less in taxes during a recession. We had a whopper of a recession.

The deficit has already started to narrow, if you look at that chart. It's dropped by 17.5 percent from June 2010 until September 2012. If the economy continues to improve, the deficit will continue to shrink.

Everything is not OK

Things are not all roses, but at least the economy is behaving the way you'd expect it to, given the cyclical forces. There are always ways to improve taxing and spending, but the general pattern is improving.

Easterwood said it's better to look at a 20-year pattern than to focus on the last few years. We ran deficits during the good economic times of the late 1980s, which was a bad thing. We ran surpluses during the late 1990s, which is a good thing. We ran deficits again during the strong period from 2004-2007, and that, too, was a bad thing.

Second and most important, we should look at how much Medicare, Medicaid and Social Security are going to cost us in the future.

You can predict what Social Security will cost in the long term. It's not as simple as what I'm going to show you, but it can be done.

The primary factors in it, for our purposes are:

  • The Social Security tax rate
  • The ceiling on earned income [maximum income level subject to Social Security taxes]
  • The absence of an Social Security tax on investment and other unearned income
  • The level of current benefits
  • The rate at which taxable incomes and benefits rise over time and the retirement age
  • The average age of the work force.

The Social Security problem is one that could be addressed if both sides would negotiate in good faith. You could use Central Budget Office models to develop a plan.

Easterwood said he doesn't think that's going to happen, because the Republicans and Democrats have been unable to reach any kind of compromise at any point during this whole mess.

Back in the 1980s, guys like President Ronald Reagan and Speaker of the House Tip O'Neill would have probably hammered out some kind of deal, Easterwood said. That sort of working together has not been happening.

For what it's worth, Easterwood laid the blame at the feet of the Republican Caucus, because it could get a compromise if it would allow one.

The other big expenditure going forward is Medicaid, which depends heavily on economic activity. If the economy is good, spending can be held in check. If the economy tanks again, we're going to be in a lot of trouble.

Medicare spending is a highly charged political subject, and not much is getting done to address the problem. Things are probably going to get worse unless healthcare costs in the U.S. go down. This is a huge problem in the long run, and neither party is suggesting viable solutions.

The sequester hurts now, and can really hurt later

If we think past the current election cycle, the effects of sequestration are scary.

Sequestration could happen in several different ways, and none of them are good.

If the government gradually reduces spending, in the short run it will be a drag on gross domestic product , and will hurt things like retail sales and housing prices that are affected by GDP.

A year from now, we'll likely see slowed growth or even lowering of GDP and higher unemployment. That will probably decrease tax revenue and put more pressure on government spending.

You can make a case for ending some government programs and cutting others, but the heavy cuts to multiple programs caused by sequestration may damage useful programs.

The biggest problem with sequestration is that it is short-sighted. It focuses on the current budget without looking forward. The long-term health of the economy depends on a long-term budget plan that addresses more than this quarter's deficit.

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