spending cuts

El-Erian: 6 reasons why the sequester hurts

March 1, 2013: 9:43 AM ET

Rather than be shocked into comprehensive action, look for Congress to come up with some temporary Band Aid for the sequester. While better than doing nothing, this is not a great solution.

By Mohamed El-Erian

capitol-building

FORTUNE -- My short trip to Europe this week served as a vivid reminder of how accustomed we have become in America to Congressional dysfunction. Back on U.S. soil, it took just a few minutes of listening to political commentary in the car ride from the airport to be reminded of the damage, and to worry about the evolution in some of the political commentary. All of this adds up to the risk, indeed probability, that Congress will fall further behind in dealing with the economic challenges of our time.

The latest illustration of Congressional dysfunction is the "sequester," the technical name for the blunt across-the-board cuts in discretionary spending that will likely be activated today. Think of them as yet another self-inflicted blow to an economy that is working very hard to recover from the devastating blow of the 2008 global financial crisis.

The sequester is the latest round in a seemingly-endless game of bickering and dithering on Capitol Hill. (Remember the drama over the fiscal cliff? That was just two months ago!)

Every round lessens trust between political parties, intensifies the ugly blame game, and erodes the standing of the traditional political order. With that, the probability of another slippage increases. Yet the general public becomes more indifferent and less engaged.

If the sequester were allowed to fully occur in 2013 -- and it probably won't, but that is for later in this column -- the economy would slow, job creation weaken, and income inequality rise.

MORE: Why the stock market will yawn at the sequester

These consequences were emphasized this week by the President and by Administration officials. To make them more concrete, they cited specific examples of how average Americans would be affected.

Yet rather than honestly assess these warnings, some influential commentators opted for disingenuous dismissals; and rather than hold Congress accountable and encourage more constructive behavior, they emboldened our politicians to be more irresponsible.

Some complained that the President was trying to "scare" Americans into supporting his position. Others sought to dismiss the sequester's likely impact by using inappropriate private sector comparison. (An example of this runs as follows: The spending cuts constitute some 3% of annual outlays; any well-run company would be able to handle such a situation without missing a beat; and, therefore, the risk comes from a badly-managed government rather than Congressional dysfunction.)

Yet for reasons detailed in several prior columns about the cumulative economic impact of Washington's unusual political polarization, it is correct to worry about the consequences of this latest example of political dysfunction; and the attempt at a private sector comparison misses the point.

Consistent with this view, here are six points that should feature front and center in the debate -- today, and during the inevitable next round(s) of political posturing on Capitol Hill:

1. Government activities have large multiplier and network effects; those of the vast majority of private companies do not. As such, the extended effects of blunt actions -- such as the sequester -- tend to be sizable and quite unpredictable.

This is particularly concerning at a time when the country has emerged from the global financial crisis still structurally impaired; when income and wealth inequalities have already worsened considerably; and when unemployment remains way too high and joblessness is getting embedded more deeply in the structure of the economy (particularly among the most vulnerable segments of the population).

2. The "3%" comparison is, well, analytically challenged.

Over the years, non-discretionary spending has assumed a much greater share of the budget. As such, the sequester has a disproportionate influence on key items, including national security. To add insult to injury, the negative impact could be avoided by sensible tax measures that have negligible detrimental effects on growth and are socially fairer and less threatening to national security.

3. After a series of self-inflicted wounds, most companies would have been forced to reform their governance system. Not Congress.

Politicians emerge from each political battle less eager to compromise. Moreover, as Nate Silver's analysis on polarized constituencies implies, every month that lapses until the mid-term elections means that politicians are more likely to put their individual re-election aspirations ahead of the national economic interests.

4. The endless fiscal battles provide an excuse for Congress to postpone action to remove structural impairments that undermine the most durable of all remedies for our economic challenges -- that of sustainable high and inclusive growth.

From a better-functioning labor market to re-invigorated infrastructure, and from enhanced education to a new housing finance system, the Congressional to-do list is already quite substantial. As noted in the President's recent State of the Union speech, the longer items languish on it, the greater the headwinds to private sector investment, competitiveness, job creation, and enhanced opportunities.

5. Economic debacles on Capitol Hill gradually undermine American soft and hard power around the world. This is particularly disturbing at a time of ineffective global policy coordination (witness the recent inadequate G-20 response growing risk of "currency wars"), evolving global development challenges, and high geo-political risks (in the Middle East, as well as Asia).

6. Congressional dysfunction is part of a wider global policy process that is taking hold in several western and emerging economies—that of a growing divide between citizens and the established political order. And as the recent Italian elections show, the risk of a further disconnect is material; and with no meaningful alternative emerging.

These six issues are real and consequential. Each individually, and certainly all of them together, should act as a catalyst for a more responsible and responsive Congress. I fear, however, that this is unlikely. Instead, expect a replay of what happened two months ago.

MORE: Chuck Schumer: Sequester shows we're 'tough'

Rather than be shocked into comprehensive action, look for Congress to come up with some temporary Band Aid for the sequester. It will most likely take the form of imperfect budgetary adjustments in the context of the continuing resolution that needs to be passed by the end of the month if we are to avoid a government shutdown.

While better than doing nothing, this is not a great solution.

Such patchwork implies yet more political bickering down the road. In the process, Congress will again waste the precious time that the Federal Reserve has bought our economy through a series of bold and untested measures. And, as Chairman Ben Bernanke reminded us this week, the benefits of these measures come with costs and risks.

Unlike Europe, the comprehensive solution to America's growth and employment challenges does not pose a daunting engineering problem. And resolution is not hampered by foreign influences.

The answers lie more in the political than economic domain. They are within the control of the House of Representatives and the Senate. And they can (and should) be urgently anchored by a medium-term growth and job vision, such as the one the President has proposed to Congress.

Let us all hope that a political "Sputnik Moment" occurs soon on Capitol Hill. In the meantime, I fear that the private sector -- both companies and households -- will continue to try to disconnect from a political process that is falling further behind the economic challenges of our time. The result of this ongoing fragmentation is greater inefficiencies, foregone opportunities, and a lowering in our longer-term growth potential.

Mohamed El-Erian is the CEO and co-chief investment officer of PIMCO. He also heads the U.S. global development council. 

  • Why the stock market will yawn at the sequester

    Profits have been relatively resilient during the decline in government spending over the past few years. Can that continue with the massive cuts coming?

    FORTUNE -- Despite all the doomsday-like scenarios we've heard that budget cuts could wreak havoc on the U.S. economy, investors won't likely sweat it – at least not in the short-term.

    To be sure, the cuts are indeed very deep. If Congress fails to strike a budget deal MORE

    - Feb 27, 2013 11:23 AM ET
Current Issue
  • Give the gift of Fortune
  • Get the Fortune app
  • Subscribe
Powered by WordPress.com VIP.