The Congressional Budget Office estimates that the automatic spending cuts and tax increases outlined in the Budget Control Act of 2011, often referred to as the “fiscal cliff”, would decrease 2013 GDP by more than 4%. To put this in perspective, the average decrease in GDP during the five recessions occurring between 1980 and 2001 was 1.65%. With second quarter GDP increasing a meager 1.5% a 4% reduction in 2013 GDP would put the American economy squarely back into a recession, a deep recession.
Meanwhile, American businesses and consumers aren’t taking any chances of getting caught flat-footed by Congresses’ inability to avert the “fiscal cliff.” According to Bloomberg, bookings for non-military capital goods (not including aircraft, often considered a proxy for future investment) fell at a 3.1% annual rate in the second quarter. This was the first decline since 2009. Consumers, already insecure in their current jobs, have resumed saving more and spending less. The consumer saving rate has increased from 3.6% to 4.0%. Not surprisingly retail sales have declined for three months in a row, the first time since the recession ended. The mere prospect of going over the “fiscal cliff” is pushing American businesses and consumers closer and closer to the proverbial “edge”. So who would be impacted the most if Congress lives up to its reputation and watches the country go over the cliff? While some of the answers are to be expected, some are surprising and have very real consequences for the commercial real estate industry including likely more than a few of the tenants in your portfolios.
The most obvious group to be impacted by Congress’ inaction would be regions and cities whose economies rely heavily on federal payrolls. George Mason University recently estimated that more than 615,000 federal jobs would be cut as a result of Congress’ inaction. And our research shows that the impact would be uneven with some cities impacted far more than others. For example, Washington, DC’s government payrolls, including federal, state and local total 694,000. While all 615,000 federal payroll losses would not occur in Washington, DC it shows the magnitude of eliminating 615,000 federal payrolls all at once. I too want to see the government shrink over time. However, the idea of adding 615,000 people to the unemployment lines on January 1, 2013, when the private sector is already pulling back on hiring in anticipation of weaker demand, is less than an intuitive way to grow the economy at this point in the business cycle.
While cities and regions reliant on federal payrolls are obvious places to see the likely effects of going over the “fiscal cliff”, the impact on the private sector would be surprisingly significant as well. According to the same George Mason University study, while federal payrolls would be cut by an estimated 615,000 jobs the private sector would see more than 1.5 million jobs cuts – far more than the government sector. As the chart below shows this equates to more than 70% of the estimated job losses coming from the private sector.
The Budget Control Act of 2011 calls for $50 billion a year in defense cuts. Consider this: according to Washington Technology, Lockheed Martin, Northrop Gruman, Boeing, Raytheon and General Dynamics collectively had nearly $50 billion in government contracts for 2010. Lockheed Martin alone currently has more than $300 billion in total government contracts according to usaspending.gov. While Lockheed Martin’s $300 billion in contracts will be fulfilled over a number of years, the mere prospect of cuts to those contracts led Lockheed Martin’s vice president of legislative affairs to state that all of their 125,000 jobs could be at risk. While some of this is surely posturing, it cannot be denied that cutting $50 billion out of the military budget annually would have very real consequences on private sector defense-related employment. It is estimated that Virginia alone has more than 900,000 defense-related jobs – that is 20% of Virginia’s total, non-farm employment. Southern California, San Antonio, Colorado Springs, Tampa and other cities also rely on defense-related jobs.
What may be most surprising however to many is the significant impact budget cuts would have on non-defense industry company payrolls. The U.S. government does not manufacture pharmaceuticals, have a paving business, or IT consulting business. When the government makes cuts, it also impacts non-defense related companies including their payrolls. Consulting, healthcare, engineering services, communications equipment, professional services, systems integration, telecommunications, information technology and construction companies receive significant dollars through federal contracts. For example, the federal government buys a lot of prescription drugs which supports drug company payrolls. What if money for prescription drugs is cut from the federal budget as a result of going over the “fiscal cliff”? As the chart below shows, many non-defense related companies receive significant dollars from the government.
Are any of these your tenants? For some of these companies, such as Booz-Allen which gets more than 70% of its revenues from military and intelligence related work, federal cuts would have a disproportionate impact on their revenues. Clearly federal spending cuts would have a far-reaching and material impact on non-defense, private sector employment in addition to federal payrolls.
In addition to the reduction in government contracts, non-government customers of your tenants would also be impacted. Government transfer payments are dollars that some of your tenants’ customers use to buy goods and services from your tenants. For example, cuts to cost of living adjustments for social security recipients would impact seniors, again, likely some of your tenants’ customers. Dollar stores, with customers that likely rely disproportionately on transfer payments, would see their customers dealing with reduced dollars to spend as well. If we go over the “fiscal cliff”, it is very possible that cuts to transfer payments would reduce the amount of commercial space needed by some of your tenants.
My point isn’t that cutting government spending is the wrong thing to do. My point is that unless an increase in business investment and hiring fills the spending and employment gap left by the cuts outlined in the “fiscal cliff” the impact will be felt by more than just federal employees and that may include more than a few of your tenants.
In addition to job losses, the “fiscal cliff” would negatively impact the economy through automatic tax increases on individuals that would reduce discretionary income. According to the Tax Foundation and as reported by Jeff Cox of CNBC, individuals could pay up to $5,700 more a year in taxes if the “fiscal cliff” is not averted. While Mississippi consumers would see the smallest average increase at $1,300 more than half the states would see a minimum $2,000 increase. Do your tenants sell to these consumers?
What if we avert the “fiscal cliff”? There seems to be a mindset that if we avert the “fiscal cliff” all will be okay. However, averting the “fiscal cliff” doesn’t mean your tenants would automatically be left unscathed. For example, if we avoid the “fiscal cliff” by adopting the Bowles-Simpson plan, nearly $600 billion in spending cuts would occur in just the first four years of the plan. For perspective, the total reduction in GDP during the last devastating recession was $500 billion over two years. Here again the impact of spending cuts would largely depend on whether the business community increases its investment and hiring enough to offset the government spending cuts and resulting reduction in both federal and private sector payrolls outlined above.
Even if business wanted to increase investment and hiring as a result of Congress taking deficits seriously, could business investment realistically offset the total spending cuts contemplated under the Budget Control Act of 2011 or Bowles-Simpson? The largest four-year increase in business investment since 1950 has been $598 billion, the equivalent of the cuts that would occur under a “fiscal cliff” or a Bowles-Simpson type budget reduction plan. However, the average increase in business investment over a four-year period was $338 billion, a significant gap.
Having determined that both the “fiscal cliff” and a Bowles-Simpson type plan would likely have a very real impact on your tenants, let’s examine whether a budget reduction plan is necessary right now or if waiting until the economy is in a stronger position to absorb the cuts as some have argued is an option. The most often cited reason for immediate deficit reduction is the United States’ debt-to-GDP ratio. However, as the chart below shows, debt-to-GDP ratio isn’t always an indicator of an immediate need for deficit reduction. If it was, based on 2010 debt-to-GDP ratios, Japan would have a credit rating today more similar to Spain or Greece while Spain would have a credit rating more similar to the U.S.
A reduction in credit rating is also often mentioned as a reason for cutting the federal deficit immediately. However, here again the evidence does not support this claim. An analysis by Bloomberg of 314 country ratings downgrades revealed that in 47% of the downgrades, the cost of debt for the downgraded country actually declined. So protecting a country’s credit rating is also not a reason for immediate deficit reduction. Do we need to reduce our deficits – yes. Do we have to right now – not necessarily.
Given the likely negative impact on the economy and commercial real estate demand as well as the questionable need for immediate deficit reduction, perhaps immediate, drastic deficit reduction should be replaced with a plan that neither kicks the economy while it’s down nor “kicks the can down the road”. I know, how novel in today’s environment, a moderate approach. A realistic, longer term deficit reduction plan would provide the economy with the breathing space it needs while providing corporations the certainty they want in order to increase private sector job growth and business investment. Of course none of this will happen until well after the November presidential and Congressional elections when everyone has had a chance to assess their political strength and what they think they can get. Ah yes, the political economy.