Why The Sequester Is Not Crashing The Economy - Barro Ricardian Equivalence

Includes: DIA, QQQ, SPY
by: Josh Young

Much ink was spilled foretelling the impending doom, the "Sequester." Perhaps cynically, out of a hope that a one-sided solution would be achieved like in the last political/fiscal crisis. Or perhaps out of a Keynsian-driven concern for the GDP, as short-term GDP falls when government spending falls.

I am not much of a macro economist - I focus primarily on investing in small, value-priced oil and gas companies and assets. However, I did graduate with a degree in economics from the University of Chicago, where I learned just enough macro economics to be dangerous.

One concept I learned in school struck me as I was reading an article from Fortune Magazine from a few weeks back. The article was predicting a drop in the stock market (NYSEARCA:SPY), most likely driven by the Sequester. I looked back at stock market performance (NYSEARCA:DIA) over the past few weeks, which has been markedly positive, and thought, how is that possible? The answer, perhaps, is Barro Ricardian equivalence.

According to Investopedia: "The basic idea behind Ricardo's theory is that no matter how a government chooses to increase spending, whether with debt financing or tax financing, the outcome will be the same and demand will remain unchanged." What this means is that participants in the economy understand that government spending has to get paid for, whether it is with higher taxes now, or higher debt now leading to higher taxes later.

So how is this related to the Sequester? It's simple - the government just cut $50 billion in spending. This translates to a $50 billion tax cut, or at least $50 billion less in taxes that will be collected now or in the future. And perhaps it will lead to further spending cuts, which imply further tax cuts now or in the future.

This is a different way of looking at government spending than is usually represented in the news, but it is perhaps one of the best explanations for positive stock market performance (NASDAQ:QQQ) since the sequester has taken hold.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.