If It Quacks Like a Lame Duck …
Dan Duray Nov. 18, 2010, 4:01 p.m.
Expectations are low for the final weeks of the 111th Congress, which convened yesterday for the first time since before the midterm elections. It is unclear how much legislative business will be brought to closure given the entrenched positions of the parties.
For Republicans, there is an advantage in delaying the most legislatively contentious battles until after the new year, when they take control of the House and the breadth of committee chairmanships. For Democrats and Republicans, however, there is urgent legislative business-relating to taxes and the budget, in particular-that requires immediate attention. Commercial real estate investors should be watching closely: Tax policy and federal spending priorities will impact the outlook for the sector through direct and indirect channels, as will global bond investors’ reading of our resolve in tackling the budgetary imbalance.
Foremost in the minds of voters and many businesses, the pending expiration of tax breaks has added to the prevailing environment of uncertainty that has distorted consumers’ and firms’ consumption and investment decision making.
Just as important as the unresolved question of tax rates, Congress has yet to pass a budget for the fiscal year that began more than a month ago, on Oct. 1. In a recurring ritual that speaks to the dysfunction in the political process, the government is currently operating by virtue of a short-term continuing resolution that holds expenditures at last year’s levels and that expires on Dec. 2. Positioning themselves as the party that will rein in government spending, Republicans are set to demand a durable extension of tax breaks and concessions on visible discretionary expenditures in the next round of budget arguments.
Deficit Management to the Fore
The negotiation of tax breaks and the current fiscal year’s budget will take place against the backdrop of a larger debate over government spending and the deficit. There is increasing agreement in Washington that the trajectory of fiscal policy in this country is unsustainable and that a serious reevaluation of long-term tax policy and spending priorities must occur posthaste. Acting on that recognition, a series of new proposals for curbing the deficit has come to the table in recent months.
The most visible assessment of policy options for addressing the deficit was released in draft last week, by the co-chairman of the bipartisan National Commission on Fiscal Responsibility and Reform. The report proceeds from the sound premise that unconstrained growth of public debt will limit the long-term growth potential of the American economy. On our current path, debt interest payments could rise to $1 trillion per year by 2020, we are told. In nominal terms, that is roughly equivalent to the current federal budget in its totality.
To stave off the real possibility of a crushing imbalance that would crowd out private investment, the report details nearly $4 trillion in cuts and adjustments to federal programs between fiscal year 2012 and 2020. No constituency is left untouched, as the proposal makes recommendations in areas ranging from national defense to Medicare and from the retirement age to the size of the federal workforce. Personal income tax reform measures include a call for lower marginal tax rates but a sharp curtailment of deductions, including for mortgage interest on second homes, home equity lines of credit and mortgages larger than $500,000.
Investors should not plan based on the specific measures included in the new report. Ultimately, each of the cuts that is large enough to make a difference in deficit management is also large enough to trigger fierce opposition from powerful interest groups. Whoever sees such a plan through will pay a heavy political price for their part in its success.
As with previous efforts to grapple with the deficit, that success will depend on elected officials’ willingness to alienate a part of their constituency. Absent that willingness, it will be left to external market forces, including the market for treasuries, to force the issue through the mechanism of market-clearing prices for our debt.
Battles on All Fronts
The parties’ failure to come to an agreement on a budget plan in the few weeks before the holidays will push the debate into January. That will send the wrong signal to the domestic and global investors upon whom we have become so reliant in financing public spending.
On the political stage, leaders from the emerging markets and from Europe are expressing clear dissatisfaction with the Fed’s most recent program of quantitative easing and its impact on currency exchange rates, let alone its distortion of interest rates and potential to foment destabilizing price bubbles.
If investors perceive that treasury issuance will continue to grow even after demand for treasuries’ safe haven has abated, the risk of rising interest rates becomes another more credible threat to the economy and commercial real estate. For our sector, those higher rates mean downward pressures on asset values because of adjustments in yield spreads and borrowing costs.
At this juncture, with pricing trends still foundering outside of major markets and with pending debt maturities rising, these are pressures that we are ill-prepared to internalize.
Sam Chandan, Ph.D., is global chief economist and executive vice president of Real Capital Analytics and an adjunct professor of real estate at Wharton.