Fiscal Cliff Diving Can Be Hazardous to Housing’s Health

I remember the Saturday afternoons in the 1980s spent watching ABC's Wide World of Sports where, once a year or so, they would cover the cliff diving competition from Acapulco, Mexico. Like many of the things covered on this show (do you remember the demolition derby?), it was different and dangerous.

Our nation now faces something equally different and just as dangerous — falling off of the fiscal cliff.  The outcome of our trip to the edge of or over the fiscal cliff has wide ramifications for our economy, yet the impact on the housing market could be among the most significant.

Quite simply, the fiscal cliff is the combination of automatic spending cuts and automatic tax increases that take effect either at the end of 2012, or the very beginning of 2013.  It was a gimmick, known as the Budget Control Act of 2011, which was put in place by Congress and President Obama to attempt to force a budgetary compromise.  It represents a "kick-the-can-down-the-road" approach to policymaking.

Unable to reach an acceptable compromise by the deadline, our elected representatives on both sides chose to vote for something they did not entirely support largely because it contained policies that their opponents also found intolerable.    

Among the changes to current law set to take effect at midnight on December 31, 2012 are the end of last year's payroll tax cuts (2% for most workers), the end of certain tax breaks for businesses, modifications to the Alternative Minimum Tax that would impact far more people, the end of the so-called "Bush Tax Cuts," including capital gains and estate tax cuts, and the initiation of taxes related to the Affordable Care Act.

Concurrently, spending cuts that were agreed upon as part of the debt ceiling deal of 2011 would commence.  Estimates are that over 1000 government programs will face steep cuts, including $1 trillion from defense alone.

It is vital to remember the recent rebound in the housing market is a function of two primary factors.  First, historically low interest rates served to prop up the ailing market. Second, the market has benefited from the sense that it has finally bottomed out, which buoyed consumer confidence.

What impact might a failure to avoid the fiscal cliff have on interest rates?  In a word: disaster. 

Let's not forget the reason such massive spending cuts and tax hikes are being contemplated during this time in history is the existence of our nation's $16 Trillion debt. According to figures from the U.S. Treasury from August 2012, approximately 53% of our current debt is owned by foreign investors. China accounts for 10% of U.S. debt ownership, but  —  and this is key  —  China appears to be reducing its holdings of U.S. treasuries.

The reason for China's reduction in Treasury holdings is a belief on their part that the value of U.S. denominated debt will fall over time based on the inability of U.S. officials to put a credible debt reduction plan in place that does not compromise economic growth. China and other foreign investors could be tempted to sell more U.S. debt and reduce their future purchases if it appears a responsible plan will not be adopted. When U.S. debt loses its appeal, interest rates have to be increased to lure purchasers.  If that happens, our current period of historically low interest rates will end.