Does the Market Care About the Sequester?

The sequester officially takes effect tomorrow and there has been almost zero negotiations between the White House and Republican leaders over avoiding the cuts. Instead, both sides have spent most of their energy blaming the other side. The media has done an excellent job covering this aspect of the sequester, but it has ignored another major part of it: market reaction.

Remember, the sequester was enacted in the summer of 2011 when Republicans took the debt ceiling hostage and we almost defaulted on our debts. In the immediate aftermath of the deal, investors were happy that the U.S. Congress had avoided creating an artificial economic crisis. However, part of that optimism stemmed from the sequester. If the Super Committee failed (as it eventually did), then Congress would have to find a way to either replace the sequester or accept the sledge-hammer cuts. For a while now, a number of serious people on Wall Street have been calling for deficit reduction. I don’t agree with their analysis, but that’s what many people on Wall Street want.

So, is it any surprise that as we get closer to the sequester taking effect, the market has soared? Here’s the Dow Jones over the past three months:

Dow 2.28Now, there’s a lot of other factors in there, such as the Fiscal Cliff deal and the recent mess in Italy. But look at the steep rise at the end. That’s in the last few days even as Italy cannot form a government and the Eurozone looks to be moving towards another crisis. At the same time, everyone in the U.S. wants to avoid the sequester, but we cannot agree to a deal so all these cuts that no one wants are going to be implemented tomorrow. Look at the market reaction over the past few days:

Dow 3 day
Does that look like the market is panicking about the sequester? Not at all. No one wants these cuts, our government is too dysfunctional to even negotiate over them and yet the Dow has almost reached a new high. Why?

One possible reason may be other factors. Fourth quarter GDP was revised upwards today and unemployment claims came in below expectations. But none of that explains the previous two days rising market. Of course, it is always tough to pin down a reason for why the market does what it does. No one knows for sure. But I’d hypothesize that the sequester hitting is actually reassuring markets.

The government is not just removing the sequester without replacing it. Although I would support such a bill, Wall Street would not. As I said above, Wall Street wants deficit reduction and the sequester cuts spending. It may not do so in a smart way, but it cuts it nonetheless and Wall Street is pleased that we are actually reducing the deficit.

It also shows that Congress can constrain future Congresses. This is always a tough thing for Congress to do. It can enact as many deficit reduction plans as it wants, but if future Congresses just repeal those spending cuts/tax increases, than any long-term plans that Congress legislates will be meaningless. Future Congresses will just undo them. But the sequester is demonstrating that future Congresses will not just ignore previous reduction plans. Part of this is a result of partisan gridlock, but if that’s what forces future Congresses to abide by the deficit reduction plans of the current Congress, so be it. That works just as well for the markets since that partisan gridlock doesn’t seem to be disappearing anytime soon.

Of course the impacts of the cuts, while unclear, will still hurt the economy and even if Wall Street is hoping the cuts take effect, it’s still bad policy. It also brings up a different question: if we were to just get rid of the sequester, would markets revolt? I’m not sure and it doesn’t look like we’ll ever find out. But it’s a question the media has ignored entirely and deserves more coverage.

 

Why Republicans Should Care Even More About the Sequester

The sequester officially hits on Friday and at this point, there’s no chance of avoiding it. If Congress and the President agree on a deal, when that deal is struck will determine how much damage the sequester ultimately causes.

The White House and Republicans have spent the last week not trying to avoid the cuts, but trying to lay the blame at the other’s feet. The GOP has ardently pushed the line that President Obama came up with the idea for the sequester and thus is responsible for it. The Administration has tried to scare the public and Congress into a deal by demonstrating how bad the cuts will be (cuts to teachers, airline delays, etc.). Yesterday, they released a state-by-state breakdown of how the cuts will effect different departments and programs in every state. The Washington Post has a nice interactive graphic of it here.Sequester state by state

As I read Wonkblog today, I came across a post detailing the states who receive the most in federal aid as a percentage of state revenues and thus are most exposed to sequester cuts. This wasn’t using White House data, though. It’s from a Pew Center of the States study from last December. That got me thinking: the senators of states more exposed to the sequester should have an even greater incentive to push for a deal to avert it. So, I went through Pew’s data and combined it with the partisan identity of the senators in each state. The result is to the right.

The states most exposed to the cuts are undeniably states with Republican Senators. Of the 20 states most exposed, 28 of the 40 senators in them are Republicans. In the 20 states least exposed, just 11 of the 40 senators are Republicans (28 are Democratic with one Independent). This isn’t a surprise though: Republican states receive a large share of federal funds and thus steep cuts to those dollars will hurt those red states the most. Given that, Republicans should have even greater incentive to cut a deal.

Now, let’s say that Republicans are worried enough about the deficit that they can swallow the cuts, even if they predominantly impact Republican states. What about the political prospects of senators in those states? The public is going to be upset with these steep funding cuts as polling shows that no one actually wants to cut anything outside of foreign aid. Senators in states who face deep budget cuts from the sequester are going to face a disgruntled constituency. Those up for reelection in 2014 will be at the greatest risk of voters giving them a one-way ticket out of Washington.

Thus, I went through and outlined each senate seat up for election in 2014 in bold. Here, neither Democrats or Republicans are in particularly good shape. In 2014, 36% (10/28) of Republican Senators in the 20 most exposed states are up for reelection while just 27% (3/11) of Republicans seats are up for grabs in the 20 least exposed states. The is true for Democrats as well. Of Democratic Senators in the most exposed states, half (6/12) are up for reelection, but in the least exposed states, just 39% (11/28) of Democratic seats are up.

What does this all mean?

While both Republican and Democratic senators are going to find themselves with a lot of angry constituents post-sequester, Republican senators are going to face even greater wrath. This should give them a further incentive to make a deal. Nevertheless, they have refused to consider any additional revenue thus far and without relaxing that demand, no deal is going to be struck. At this point, it looks like the GOP would rather accept the cuts and deal with angry constituents instead of cutting a deal with more revenue in it.

As for those up for reelection in 2014, they have significantly more incentive to make a deal as well, but this doesn’t seem to be having much of an effect on their decision-making either. Republican senators up for reelection in 2014 whose states will be deeply affected by the cuts still won’t agree to additional revenues and Democratic senators are not going to accept that, even if they are up for reelection in 2014 and reside in a state severely impacted by the sequester as well.

In the end, which states are most exposed to the sequester and how it affects different senators’ reelection prospects doesn’t seem to be impacting the negotiations at all. That’s not particularly surprising to me, but in 18 months, we may see some senators who wished that they’d advocated for a compromise harder.