Despite the fact that our legislators in Washington are having a difficult time finding a way forward on a mutually acceptable agreement to raise the nation’s debt ceiling, almost everyone in Washington agrees that federal spending must be reduced.
After much posturing, the House and Senate appear to be pursuing separate plans that call for spending cuts ranging from $1.2 trillion to $2.7 trillion phased in over 10 years. Whatever the amount that spending ends up being cut, one question that commercial real estate brokers and property owners should be asking is, what impact will the reduced federal spending have on private sector employment, and by extension, on demand for commercial real estate?
Given the extent of private sector jobs supported by government spending, the impact could be very different from what some may think it would be.
Surprising Impact of Cuts
From 1969 to 2009 the federal budget increased from approximately $823 billion (on an inflation-adjusted basis) to an estimated $2.88 trillion.
Interestingly however, while the federal budget has been rapidly expanding since 1969, federal payrolls have actually been shrinking – yes shrinking – by more than 30% since 1969. According to the Office of Personnel Management, federal payrolls were reduced from 6.5 million in 1969, to 4.3 million in 2009. During that period, the federal government reduced its payrolls by more than 2 million people — a 33% reduction.
Conversely, during this same period, private-sector payrolls grew from more than 76 million in 1969, to more than 142 million in 2009 – an 85% increase.
If federal spending increased over the last 40 years, yet federal payrolls contracted, and private sector payrolls nearly doubled, it seems reasonable to assume that a material amount of the increase in federal spending went to private sector companies in the form of government contracts. It also seems reasonable to assume that, if the private sector benefitted from the federal budget growth, it may also suffer when that spending is cut.
Based on those assumptions, a reduced federal budget could have the largest impact on private sector payrolls, not federal payrolls.
How much would $1.2 trillion to $2.7 trillion in federal spending cuts impact private sector payrolls? While we can’t quantify this exactly because we don’t yet know where the cuts will eventually occur, we can get a sense of the potential scope of the impact.
Private Sector Payroll Cuts Could Be Widespread
According to the Office of Personnel Management, from 1969 to 2009 Uniformed Military Personnel payrolls shrank from 3.499 million to 1.591 million. Many former military positions likely were outsourced to companies contracted to do the work, as well as related positions at many defense contractors such as Lockheed Martin, Northrop Grumman, Boeing, Raytheon and General Dynamics among many others. This outsourcing, in combination with expected reductions in defense budget, would seem to result in a loss of private sector jobs as a result of federal budget cuts.
Private sector defense industry payrolls were not the only ones to benefit from increasing federal expenditures over the last 40 years. Other industries, including consulting, healthcare, engineering services, communications equipment, professional services, systems integration, telecommunications, information technology, construction and education, all received significant dollars through federal contracts.
For example, according to Washington Technology, the management consulting firm Booz Allen had $3.7 billion in government contracts as of 2010; Dell Inc. $2.2 billion; Verizon Communications $1.8 billion; IBM $1.6 billion; Deloitte $1.2 billion; Accenture $837 million; AT&T, $664 million; Xerox $428 million; Oracle $229 million.
And what if money for prescription drugs is cut from the federal budget as a result of the healthcare debate? The federal government buys a lot of prescription drugs. This supports drug company payrolls. From these and other examples it seems clear that federal spending cuts would have a far-reaching and material impact on private sector employment.
Corporate America To the Rescue?
The expectation among some is that Corporate America will offset the job losses associated with government spending cuts by investing in their businesses and hiring large numbers of employees. According to the Wall Street Journal, U.S. corporations stockpiled more than $1.84 trillion in cash and other liquid assets as of the end of March 2010 – a remarkable 26% increase, the largest such increase ever. It would seem from this that private sector corporations are well positioned to offset declines in federal spending.
Under an ideal scenario some have proposed, reduced government spending would result in a reduced tax burden on many American taxpayers, who also happen to be the economy’s shoppers, resulting in consumers having more of their income available to spend.
This scenario leads to two questions: First, will Corporate America increase its business investment and pursue expansion, and second, even if it does, can that private sector spending offset billions of dollars in reduced federal spending on an annual basis? Let’s start with the first question.
Up to this point in the economic recovery, U.S. corporations have been reticent to significantly increase their levels of business investment and, more importantly, hiring levels. This has puzzled many economists. Supply side economics posits that record corporate coffers should lead directly to increased investment, driving expanded employment and contributing to a sustained economic recovery.
While we have had record corporate profits, by and large, companies are still holding back on spending, waiting to gauge the strength of the current recovery. However, with flat consumer wages, Europe battling recurring sovereign debt issues and China working to slow its economy, it is the hiring and business investment of private firms that will determine the sustainability of the current economic recovery.
Still, many corporate executives report they are hesitant to increase production capacity at a time when there still appears to be excess capacity in the system. In that regard, it appears that the tenets of supply side economics i.e. production creates demand, at least in this cycle, are not working. This economic conundrum would first need to be resolved before federal spending cuts could be offset by meaningful increases in business investment.
Before attempting to address the second question, we should clarify that the spending cuts (once finally approved!) are expected to be phased-in over time, resulting in the uneven distribution of the cuts over the next 10 years. For the sake of simplicity in evaluating their impact, I am making the assumption that the cuts are evenly spread over the next decade.
Under this assumption, the total amount cut over 10 years, and thus the impact of the “gap” the private sector needs to fill, is theoretically the same. So, does Corporate America have the financial capacity to take up the additional slack that will be created by the expected federal spending cuts?
To answer that, we need to look at how much companies currently spend on business investment annually. Fixed, non-residential investment was approximately $1.4 trillion in 2010, down from its 2008 peak of approximately $1.6 trillion. The largest annual increase from 1995 to 2010 was 12.1%. Assuming a 12.1% increase from the 2010 level, that would equate to approximately $181 billion in corporate spending, squarely in the middle of the $102 billion to $270 billion per year in federal spending associated with the two proposed levels of federal spending cuts by the House and Senate. But will corporate America increase investment at the very time their government contracts are being cut as a result of the spending cuts? That again goes back to supply side economics and whether corporate America believes production creates demand.
Even if corporate America does change its current behavior and invest based on idea that increased production will create the necessary demand, such a “wash” in terms of investment level would leave us generally in the same economic position the U.S. is in today. However, that would most likely require U.S. corporations to dip into their $1.84 trillion cash reserves as one of their main customers, the U.S. Government, has cut back its purchases.
At some point, of course, one would think companies would eventually begin hiring in earnest and generate the type of economic growth expected to accompany this level of profitability, (and needed by commercial real estate industry to fill available office, retail and warehouse space.)
Impact on GDP and Commercial Real Estate
Assuming a $15.5 trillion US economy, $102 billion or $270 billion in spending cuts equate to .7% and 1.7% of Gross Domestic Product (GDP) respectively. Considering that GDP growth in the first quarter was 1.9%, these cuts in federal spending without offsetting increases from the private sector could present a material problem. They could move us further away from the levels of GDP necessary to generate the level of employment growth that the commercial real estate industry needs.
Commercial real estate (and the larger economy) certainly would appear to benefit if $102 billion to $270 billion per year of government spending was removed from the shoulders of American taxpayers, if it was accompanied by an equal rise in corporate investment. This could reduce taxes on those who shop at commercial real estate’s shopping centers, freeing up more of their income to shop at our shopping centers, increasing aggregate demand providing the increased demand that business leaders are looking for before moving forward with hiring.
Can and will Corporate America offset government spending cuts? That is the key question for commercial real estate and the larger economy surrounding the current federal budget talks. (credit c. macke, co-star)