RGE Chairman Nouriel Roubini and the RGE Macro Strategy team discussed the near-certain sequestration beginning on March 1 and it's uncertain subsequent fate. Sequestration is an unfavorable outcome for both sides. Democrats will seek to avoid the sharp reduction in discretionary spending and replace sequestration with some revenue increases alongside spending cuts, since only part of their mandate to boost revenues was achieved in the fiscal cliff mini-deal. Meanwhile, Republicans will want to avoid the cuts to defense spending implied by sequestration, and will be averse to discussing revenue grabs so soon after the cliff deal, instead pushing for cuts to entitlements spending.
In our call, we discussed the prospects and details of four possible scenarios for sequestration beyond March:
1) The amount of spending cuts implied by sequestration could remain in place through the year if there is continued gridlock in Congress. Despite the cuts to defense spending, Republicans could hardball on sequestration to push for entitlement reform while Democrats could avoid deflect, pointing to room for more revenue increases. Across-the-board sequestration could be replaced by more targeted spending cuts.
2) Both parties could agree to go back to some version of the Plan A that was negotiated by both sides in late 2012, in which Democrats agreed to replace sequestration with back-loaded spending cuts to the tune of $1 trillion over a decade, in return for Republicans agreeing to $350 billion in additional revenue increases, on top of the $650 billion achieved via the fiscal cliff mini-deal.
3) Both parties could agree to pare back sequestration to about $600 billion over a decade, bringing spending cuts close to the magnitude of revenue increases under the cliff deal. A dedicated bipartisan commission could be appointed to find the remainder of the targeted $1-1.2 trillion deficit reduction, and possibly more, in coming months.
4) Both parties could agree to cancel sequestration for 2013, buying time to find $1 trillion in deficit reduction via alternative means. This could occur if Democrats are willing to put meaningful entitlement reform on the table, and provided Republicans agree to discussing tax reform that raises some net revenue. The specter of sequestration kicking back in 2014 would remain in place, to spur both sides to come to an agreement.