What do the US budget squabbles mean for your money?

published 1 March 2013

Try as it might, Europe doesn't have a monopoly on dysfunctional politicians.

Over in the US, squabbling politicians can't agree on how to run the country's budget. Because of the way the US system works, that means we can expect any amount of disruptive brinksmanship in the year ahead, as each of the two parties tries to paint the other as the baddies.

It also means that you're going to be hearing a lot about the sequester' over the next few weeks (maybe months if we're really unlucky).

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So what is it? And more importantly, does it matter for your money?

The US needs to cut back but how?

The story of the sequester starts in 2011. The Democrats and the Republicans were trying to hammer out a way to bring the US government's finances back onto a sustainable path. Like many developed nations, the US is spending more each year than it makes in taxes. Its current deficit the annual overspend - is over $1 trillion. Its overall national debt is around $16.6 trillion.

As Robert J Samuelson notes in the Washington Post, depending on how you measure it, the debt-to-GDP ratio could be anything from 73% (if you take the most common measure) to more than 200% (if you include various government guarantees to the financial sector).

To put that into some perspective, sovereign debt experts Carmen Reinhart and Kenneth Rogoff suggest that an economy starts to run into real problems when a debt-to-GDP ratio rises above 90%. This is a very rough and ready theory. But the basic point is that the US like lots of other economies needs to start living within its means more.

But how do you do it? To cut a long story short, the Democrats would prefer to make ends meet by raising taxes. The Republicans would prefer to cut spending. And within the overall budget, there are lots of areas that are sacrosanct to one side or the other (like defence, or entitlements' spending)

In the end, they couldn't reach a deal. So instead they put together a package of automatic cuts the sequester that would kick in if they didn't reach a deal.

The idea was that the cuts would be so indiscriminate and uncomfortable for both sides, that politicians would feel forced to find a better way. This was always a long shot. Perhaps if the sequester had included a clause that would cut their own wages in half, they might have been more motivated. But oddly enough, that sort of measure never made it into the package.

As it is, they still haven't reached a deal. Unless they do so by midnight in the US tonight, the cuts will start to bite. $85bn is set to be cut from government spending this year. Over the decade, the cuts add up to $1.2 trillion.

So how much does this matter, if at all?

This is just the first of many arbitrary deadlines

Markets certainly seem quite relaxed about all this. The Italian election rattled them, but there's been no obvious panic about sequestration'. There are a few good reasons for that.

Firstly, these cuts don't happen all at once. This isn't like the fiscal cliff'. The last minute panic over that was to avert tax rises that would have taken effect immediately. The cuts will take place over several months. So there's plenty of time for politicians to keep arguing.

Secondly, it's not entirely clear what the eventual impact of the cuts will be. Both the Democrats and the Republicans have every incentive to lie about the scale of the disruption, to make the other side look bad. Also, the departments affected by the cuts might change if a new deal is reached.

Thirdly, and more importantly, there's a bigger deadline looming. On March 27th, the US needs to agree a budget for the year ahead or else the federal government could shut down altogether. The current optimistic hope is that both parties will be able to use this much more obvious deadline to come to some sort of compromise.

So markets probably won't start to fret until closer to the end of the month. But as the March 27th deadline approaches, and it becomes clear that politicians will be arguing down to the wire, you can expect to see another fit of the jitters.

And then, beyond that towards the summer, there's the whole argument over the overall debt ceiling again. Which is what kicked the whole sequester deal off in the first place back in 2011.

What this means for your money

There is unlikely to be a single catastrophic blow-up over the US government's finances in the near future. And all the fighting just gives Ben Bernanke more of an excuse to keep the quantitative easing taps open.

However, it's possible that individual sectors might end up running into trouble depending on where the cuts fall. Also, the latest US economic growth figures have been on the disappointing side. With more political gridlock ahead, it's quite possible that companies and consumers will be feeling less upbeat in the months to come. There might be further growth shocks to come.

This might not be an issue if US stocks were pricing in the potential bad news. But they're not. While European and Japanese stocks look cheap enough to discount many of the risks facing those regions, US stocks aren't indeed, they're almost at record highs. So as usual, we'd suggest you stick with the cheaper markets, and if you're looking for US dollar exposure, get it via some of the UK-listed big blue-chip stocks who make most of their sales in the US currency.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.