European Recession, the American Fiscal Cliff and Commercial Mortgage Lending

Investors’ natural response to the Greek results conveyed a sense of relief, echoed on the margins in easing measures of systemic financial stress in Europe and the United States. Leading up to the vote, monetary policymakers around the world had been positioning to brace financial markets against a Greek exit from the eurozone. Such a move would have disrupted any remaining notions of structural stability and driven borrowing costs in Spain, Italy and other large economies well beyond manageable levels.

Contagion across the eurozone is hardly theoretical. Italy’s short-term financing costs have doubled between May and mid-June, rising to four times their early 2012 low. The results of the most recent three-year bond auction suggest no relief as yields on those bonds increased to 5.30 percent. To put this in perspective, Americans can finance their homes at lower interest rates.

While the prospect of financial market seizure may have receded temporarily, the fundamental issues that imperil stability across the Continent remain unresolved. Absent consistent bank regulation and a European program of debt mutualization that can reduce the cost of sovereign finance—such as might be the case under the terms of a Hamiltonian redemption fund—resolution will remain elusive. The next moment of crisis will never be far off, whether it relates to banks in Spain or the threat of a continent-wide bank run.

Balancing political reality with the glaring need for a comprehensive plan to address Europe’s problems is a task that falls to German Chancellor Angela Merkel. As the crisis has spiraled, Chancellor Merkel has signaled provisional support for a bond program that would bring sovereign indebtedness back in line with Maastricht Treaty levels. But exactly what happens next is unclear. And therein lies the problem.

Commenting at the Group of 20 summit that followed the Greek vote, French President François Hollande offered that “in this permanent race between events, speculation and political decisions, political decisions must get ahead of the uncertainty.” It is obvious to everyone involved that the uncertainty fomented by a glacial decision-making process is taking a toll, both on the economic outlook and the costs of resolving the crisis. Bank of England Governor Sir Mervyn King echoed this view, saying that the impact of the “euro area crisis has been to create a large black cloud of uncertainty hanging over not only the euro area, but our economy too—and indeed the world economy as a whole.” That characterization of the crisis held water going into the Greek vote and it remains true in the vote’s aftermath.

The costs of exaggerated uncertainty are neither the realm of the anecdotal nor the ideological. For European investors and businesses, the chance that assets may be redenominated in a new currency—or in the euro of a fundamentally altered eurozone—has chilled activity to an extent that Europe has effectively fallen back into recession. The United States may not fare much better if the year-end Fiscal Cliff is left unaddressed until the 11th hour. Businesses and households will delay major expenditures if after-tax incomes are less predictable.

Seeking to quantify the intuitive relationship, current research by Scott Baker and Nick Bloom at Stanford University and Steve Davis at the University of Chicago suggests that political uncertainty takes a substantial toll on growth. Their foray into the difficult area of study puts the cost of uncertainty between 2006 and 2011 at 2.3 million American jobs. Conceding a wide confidence interval on the exact number, the results of their work still offer a sense of the magnitude.

While the Greek drama and the larger European crisis play out on center stage, the impact is being felt in myriad corners of the financial markets. Capital flows into the United States have pushed yields on the Treasury to new historic lows, below the prevailing rate of inflation. Lower Treasury yields are not a vote of confidence in the American economic outlook per se, but do reflect that Treasuries are still the safest haven for wanderlust global capital. For corporate bonds, spreads are higher and volatility measures have risen.

European headwinds represent a significant obstacle for real economic activity in the United States. The lending market is impacted as well. Given the special position of Fannie Mae (FNMA) and Freddie Mac (FMCC) in relation to the market for guaranteed bonds, lower Treasury yields generally mean lower apartment financing costs. That is a benefit and a potential challenge for apartment investors, inasmuch as borrowers are taking on undue interest rate risks. Although I am in the minority, I have argued that apartment investors and lenders are under-assessing these risks.

On the other side of the coin, MBS without a guarantee becomes less competitive as global conditions demand higher yields for risk investments. For borrowers outside of the apartment market, volatility in corporate bonds undermines CMBS lending and issuance. Inasmuch as the latter might be more attractive to investors if it was diversified into apartments and not consistently over-weighted to retail and hotel exposures, the strengthening of the Agency’s advantage impedes its progress towards recovery.

Sam Chandan, PhD, is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School. The views expressed here are his own. He can be reached at dsc@chandan.com.