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Looking Beyond The Fiscal Cliff: Commercial Real Estate Hopes and Prays Jamie Dimon Is Correct

The C.E.O. of J.P. Morgan Chase Jamie Dimon was widely quoted December 12th as saying the U.S. economy could be “booming” in a couple months if the Fiscal Cliff were resolved.  In support of his optimism he went on to say, “The Table is set very good right now” and “Housing has turned a corner”.  According to Mr. Dimon, “Let’s just keep it going and bring back confidence and stability.” So, there you go – confidence and stability.  That is what we need to keep “it” going.  But is he correct?  Will a budget agreement that averts the Fiscal Cliff really result in a booming economy?  I don’t believe so based on the transitive property of equivalence: 
If a = b, and b = c then a = c
Consider this, if the spending cuts and tax increases associated with the Fiscal Cliff, “A”, would result in reduced economic output and any budget Republicans and Democrats could agree on, “B” would also include spending cuts and tax increases then the budget deal, “B”, would also logically result in reduced economic output.  Said another way, if the spending cuts and tax increases associated with the Fiscal Cliff would reduce economic growth, at least in the near-term then the spending cuts and tax increases likely to be contained in a budget deal would logically also reduce economic output.  So how can Mr. Dimon be so certain the economy will be “booming” as a result of averting the Fiscal Cliff?  If “Fiscal Cliff” means spending cuts and tax increases then aren’t we just trading one Fiscal Cliff for another Fiscal Cliff in the form of a budget deal and thus still facing an economic slowdown at least in the near term? 
In the remainder of this paper I will first quantify the spending cuts associated with the Budget Control Act (“BCA”), often referred to as the Fiscal Cliff.  In the same section I will examine the assumptions underlying the commonly held belief that the spending cuts associated with the BCA would result in reduced economic output.  In the second section I will use the Bowles-Simpson (“BS”) plan as our budget to compare the spending cuts of a potential budget deal with those contained in the BCA.  In the same section I will examine how spending cuts associated with a budget deal could impact the current housing recovery, one of Mr. Dimon’s key points in supporting his claim.  In the third and final section of the paper I will examine how a budget deal could impact the “confidence and stability” Mr. Dimon also cites in support of his claim.
BCA Spending Cuts and Economic Impact
The terms of the BCA call for $984 billion in spending reductions from the current baseline over a nine year period.  This equates to $109 billion annually.  Many economists believe these spending reductions combined with the tax increases in the BCA would reduce economic output at least in the near-term.  To put this $109 billion “drag” in perspective consider the following:
  1. 2011 expenditures on spectator sports totaled $21.3 billion1
  2. 2011 Household appliance expenditures totaled $46 billion2
  3. 2011 expenditures on gambling totaled $101.5 billion3
  4. 2011 Expenditures on dental services were $114 billion4
This means that the BCA’s spending cuts in pure dollar terms would be equivalent to Americans not attending an NFL game, NBA game, NHL game or any spectator sport until 2018.  Americans would delay purchasing a new household appliance for 2.4 years, not gamble for over a year or not go to the dentist for nearly an entire year.  The point is that the impact of BCA associated spending cuts would be very real and sizable.
Some may ask whether government spending cuts really matter that much to the U.S. economy?  These are government spending cuts after all so they don’t count or if they do they only impact the defense industry, right?  Consider the table below.  It lists a few of the companies that sold products and/or services to the U.S. Government.  A number of companies sell a substantial amount of goods and services to the U.S. Government.  And notice that they are not just military contractors. 
Source:  Washington Technology
Earlier this year Microsoft was awarded a $617 million contract with the Department of Defense to provide its new Windows 8 software.  But it’s not just a few, large corporations that are impacted by federal spending.  According to Washington Technology the top 100 government contractors received more than $126 billion in government contracts in 2011 alone. So how would specific industries fare under the BCA spending cuts?  A study by Regional Economic Models, Inc. estimated the revenue impact on specific sectors.  According to the Regional Economic Models study the BCA would reduce manufacturing sector sales by $400 billion while professional and technical service revenues would be reduced by $600 billion over a ten year period5.  The role of government spending in private sector sales is clearly significant and reaches well beyond the defense industry.
Before we move on let’s briefly look at the BCA impact on taxes and specifically personal taxes.  According to the Tax Policy Center the BCA calls for an estimated $115 billion increase in annual payroll taxes.  Disposable income would be reduced by $115 billion annually under the BCA.  Here we do not have to speculate on the impact as the payroll tax increase went into effect earlier this year.  According to a widely cited survey of mall store managers conducted by Merchant Forecast, one-third of store managers surveyed said shoppers were reducing spending as a result of the payroll tax increase.  How much less?  If consumers cut back on spending as opposed to reducing how much they save then $115 billion less.  This is an amount equal to the annual sales of Procter and Gamble, J.C. Penney and McDonald’s combined6.
BCA VS Budget Deal
Having quantified the spending cuts associated with the BCA as well as briefly examining a few of the potential impacts on company revenues and consumer spending let’s now compare and contrast the BCA’s spending cuts to the terms of a possible budget deal. 
While it is impossible to know exactly what the spending reductions will be in the budget deal that averts the Fiscal Cliff we have been given a clue.  The previously mentioned Bowles-Simpson plan is widely cited as a reasonable framework.  Because the BS agreement will likely be used as the starting point for a final budget deal it is reasonable to use the spending cuts contained in BS when comparing the BCA terms to the potential terms of a budget deal.
Below is side-by-side comparison of the spending reductions associated with the BCA and the BS plan. 
Source:  CBRE
A few highlights from the table above:
  1.  The spending reductions proposed under BS are $635 billion greater than under the Fiscal Cliff
  2. The spending reductions proposed under BS are nearly 65% greater than under the BCA
  3. On an annual basis BS would reduce spending $71 billion more than the BCA

Clearly in this case not only does “B”, BS equal “A”, BCA, the BS spending cuts are greater than those contained in the BCA.

Budget Deal Impact on Housing
Now let’s return to one of Mr. Dimon’s supporting arguments for his belief that the economy will boom subsequent to resolution of the Fiscal Cliff. He correctly cites the improving housing market. And while low mortgage interest rates have been important in this recovery the housing market depends on more than just low mortgage rates, if it did not we would have had a booming housing recovery back in 2009. The housing market depends also on the ability to qualify for a loan which requires a job. 
Many economists have noted that under the BCA hundreds of thousands if not millions of jobs would be lost.  For every job that is lost that is one less homebuyer.  Additionally, when those job losses and the associated rise in unemployment as well as reduced gross domestic product (“GDP”) are widely publicized those with jobs will likely become less confident in their job prospects and may very well delay purchasing a home. 
Second, the housing market depends not only on the quantity of credit available but the availability of the credit.  Thanks to the Federal Reserve’s Senior Officer Survey we know that while banks have excess reserves sitting with the Federal Reserve they are not relaxing their lending standards.  Certainly an increase in unemployment and reduction in GDP would not cause banks to all of a sudden loosen their credit standards. 
Finally, it should be noted that while housing is improving the sustainability of its recovery is by no means guaranteed.  For example, 30% of the much ballyhooed construction starts were actually new apartments, not single family7.  While 2012 single family housing starts were 24% above 2011 levels they were still the fourth lowest since 19598.  My point is that while housing is clearly improving the recovery may not yet be robust enough to withstand the combination of substantial reductions in corporate revenues and a material increase in payroll taxes. 
Confidence and Stability
Finally, Mr. Dimon notes the importance of bringing back “confidence and stability”.  And he is not alone in this.  When most people discuss current tepid U.S. economic growth they identify uncertainty, the opposite of confidence and stability, as the primary cause.  The belief is that both businesses and consumers aren’t spending due to uncertainty surrounding fiscal and tax policy.  This implies that both businesses and consumers are ready, willing and able to invest and spend.  Corporate cash piles and pent up consumer demand are cited as proof.  If this is all true and we had a crystal ball that allowed us to be confident in how much federal spending would be cut and how much taxes were going to increase then would businesses actually invest more and consumers spend more tomorrow?  Because consumer spending is impacted by business investment and the related hiring I will focus on three questions:  How much would corporations have to increase their investment to offset just the spending cuts proposed under BS, do they have the capacity to do that and would they likely do that? 
As we saw previously spending would be reduced on average $180 billion per year or $1,619 billion over nine years under a budget deal if we use the BS plan as our model.  Offsetting this fully would require corporations to increase business investment by $180 billion per year for nine years.  Now for the second question, do they have the capacity to do this?  The estimated $2 trillion in corporate cash on corporate balance sheets could be cited as proof of this capacity.  However, it is important to remember that while this is an historically high number, corporations likely cannot reduce this by $1.6 trillion without violating loan covenants and/or unsettling bond and equity investors.  Another means to assess corporate capacity to increase business investment $1.6 trillion over a nine year period is to look at history.  Between 1980 and 2011 the average increase of business investment over a nine year period was $363 billion9 on a Chained inflation adjusted basis, well short of the $1.6 trillion proposed spending reductions contemplated under BS.  Even the greatest nine year period of business investment between 1980 and 2011 only saw business investment rise $1.054 trillion, nearly $600 billion short.  And with an average $363 billion increase in business investment over a nine year period, which includes some periods of unsustainable housing investment, it seems very unlikely that corporations have the capacity to offset proposed spending reductions under the BS plan. 
This leaves us with the final question:  Will corporations increase business investment as a result of averting the Fiscal Cliff enough to offset the proposed spending cuts likely resulting from a budget deal?  Even setting aside the magnitude of increase required I doubt whether corporations would even materially increase investment as a result of a BS type resolution to the Fiscal Cliff.  Many argue that because of the reduced uncertainty corporations will feel free to spend their cash hoards.  I find this argument puzzling and without merit when it is thought through. 
While uncertainty regarding fiscal and tax policy certainly has had a negative impact I don’t understand how corporations’ being confident they will have materially fewer sales from one of their key customers, the federal government, will make them more confident.  And this does not even take into account the negative multiplier effects so well documented by the IMF10.  Corporations may be more confident in the fact that their revenues generated from federal contracts will be less but I’m not sure that that certainty will make them more willing to hire and invest, especially when combined with reduced consumer disposable income as a result of the inevitable tax increases associated with any budget deal.
It sounds even more questionable when you imagine the following hypothetical presentation made in front of a corporate investment committee, “That is correct sir, because we are now certain that our sales from federal contracts are going to be less, our tax rate higher and the disposable income of our individual consumers less we are recommending increased hiring and increased investment in plant and equipment.”  And as far as the crowding out argument, namely that corporations are currently being crowded out by government spending, the Output Gap does not support that argument. 
Again, Mr. Dimon’s point is well taken, all the political infighting and uncertainty surrounding fiscal and tax policy is making matters worse.  The likely budget resolution to this however will most likely not result in a solution but rather at least a moderate diminution of our already tepid economic growth, at least in the near-term.  Perhaps Mr. Dimon’s comments were based on a final budget deal that pushes spending cuts and tax increases far enough into the future that the economy has time to build up enough momentum to overcome future spending cuts and tax increases.  Given the state of our politics however this may be more wishful thinking than reality. 

Bureau of Economic Analysis, Personal Consumption Expenditures by Function, August 2, 2012




5“It’s Not Just Defense Cuts:  Sequester Would Cripple Our Economy”, AOL Defense, Mackenzie Eaglen, November 2, 2012

6“Retailers Fear Payroll Tax Will Cut Consumer Spending”, Wall Street Journal online, January 13, 2013

7“Five Facts On The Housing Construction Rebound”, Wall Street Journal online, January 17, 2013


9Bureau of Economic Analysis, Real Private Fixed Investment by Type

10“Fiscal Multipliers and the State of the Economy”, Anja Baum, Marcos Poplawski-Ribeiro, and Anke Weber, International Monetary Fund

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