Overheard on the Economy

Overheard on the economy

A recession can come from reduced demand, i.e., less people are buying things, but the things are available to buy, so prices decrease (deflation or disinflation).

Or it can come from reduced supply, i.e., there are less things being made, but there are people wanting to buy them, so prices increase (inflation).

The Covid restrictions reduced supply. For example, the tire plant was shut down because the government thought its workers would be too close for Corona comfort. Once they were able to return to work, there was a delay in receiving the raw materials for the tire plant because the rubber plants and steel plants had been offline, too. Hence there were no tires for the new cars so the new cars couldn’t be made or sold. Therefore, the price of new cars spiked.

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Supply was suppressed by covid restrictions, so we had a supply recession. Adding fuel to the inflation fire was that everyone had money in their pockets with their stimmies and not being able to spend it on restaurants, entertainment, and travel.

With the Fed now raising rates, demand should decrease, and we could transition to a demand recession. This would be painful but could cure high inflation.

Things had changed, though, once businesses returned to work. Those workers had received their stimmies and had gotten comfortable living a different daily life. They no longer had to commute each morning and night. They worked from home. Perhaps they learned to garden, cook, or speed walk the neighborhood. Maybe they frequented Zoom happy hours or birthday drive-bys. Their preferences for how to spend their day and how they work changed and it might not reverse as quickly as everyone thinks.

This could lead to something just as concerning with the economy. If people don’t go back to the office like they used to, then commercial office space could be in trouble. How so?

The way buying an office tower typically works is that a company buys one via financing from a bank. The company leases the office space out to businesses for anywhere from three to seven to ten years or longer – so long-term leases.

If workers are not coming back to the office like they used to – meaning instead of coming in 9-5 everyday, perhaps they come in three days a week per new company rules (issued so its employees don’t flock elsewhere). Because offices and cubicles will now be treated more like shared temp spaces, the business doesn’t need as much space anymore. Because the business is on the hook for the long-term lease, we currently don’t see the lagging effects. Once those leases end, the renewal will be for less space and less price per square foot.

With businesses needing less office space, the price for office space will decrease. What happens if the building owner is forced to reduce the rent and lease payments below the amount needed to service its debt to the bank who helped finance the building purchase (i.e. it cannot make its loan payment)? Well, what happens if someone can’t make their mortgage payment? The bank forecloses on the home and becomes its new owner.

The same happens here. At that point, the bank would become the owner of the building. And the building will not be worth what it was pre-covid; it will be worth less because it has lower revenues. What does that do to the bank balance sheet? It reduces it. And how does that affect the value of the bank? It decreases it. Which are the main banks who finance these buildings? Is there contagion?

Hopefully this is not the case and doesn’t materialize, but what if?

Surely then a capitalist, free-market buyer will come in on the fire-sale and buy the building from the bank. But then what? Lease it for less? Convert it to alternate uses like apartments or a hotel? That is expensive and lengthy.

(The term "fire sale" flared up in the late-19th century as the name for a sale of items damaged by fire. As you can imagine, much of the merchandise at a fire sale was sold at very low prices, which fanned the flames of the use of "fire sale" for any sale with discounted or low price tags.)

One of the tallest office towers in St. Louis lost 96% of its appraised value. Denver’s former World Trade Center complex faces foreclosure. An oil company’s vacant Houston workplace sold this year at a $67.4 million loss to lenders.1

Other wild things running around this economy are a surplus of jobs. With all these businesses competing for workers, wages will increase. When wages increase, people make more money. Since companies pay higher wages, either they increase prices or make less money. People now with higher wages spend more money since prices are higher, driving up inflation further.

But perhaps they won’t spend as much with rates increasing. With rates increasing, money is more expensive. The latest from home builders is that a lot of new home buyers are cancelling. Price cuts are becoming common. Construction cost pressures are cooling finally because of a drop in demand. Builder layoffs are also happening. A few excerpted quotes are below.2

Perhaps people will hold off on buying stuff because they expect the price to decrease. This could help cure higher inflation, too. Back to the car market: if you think high inflation will be cured in six months, then you will hold off on buying one now. This is why controlling inflation expectations is so important to the Fed and why they are so precise with their statements. They need to make people think they will get inflation under control. But can they? And are interest rates enough to cure high inflation? See the previous post on oil and inflation.

#StLouis builder: “Expecting to see opportunities for lower costs coming in the near future as demand cools and manufacturers and trades see backlogs shrinking.”

#Phoenix builder: “Some builders are already cutting staff. Cancellations are extremely high. Dismal traffic and sales climate.”

 

 

1 https://www.bloomberg.com/news/articles/2022-03-14/u-s-office-buildings-face-a-1-1-trillion-obsolescence-problem

2 https://twitter.com/RickPalaciosJr/status/1546500966349819905?s=20&t=ZKIvGtDCrncUQIELZe4B-A

https://www.nytimes.com/2021/04/08/business/economy/office-buildings-remote-work.html

https://www.merriam-webster.com/word-of-the-day/fire-sale-2008-07-19

https://www.allinpodcast.co/