Commute-Time Thoughts: Meditating on the Construction Bust
In the mid 2000s the United States had a construction boom.
Over the four-year period 2003-2006, annual construction spending rose to a level $150 billion above and then fell back to its long-run trend. Thus by the start of 2007 United States was overbuilt: about $300 billion had been spent building buildings in excess of the long-run trend.
When this construction was undertaken these buildings were expected to more than pay their way. But the profitability of these buildings depended on two shaky foundations: a permanent fall in long-term risky real interest rates, and permanent optimism about real estate as an asset class. Both these foundations collapsed.
By 2007, therefore, it would have been reasonable to expect that construction spending in United States would be depressed for some time to come. Since construction spending had run a cumulative amount of $300 billion ahead of trend, it would have to run $300 billion behind trend over a number of years in order to get back into balance. So everybody in 2007 was expecting a slowdown to be led by construction. But we were expecting a minor one: a fall in construction spending below trend of $150 billion a year for two years or $100 billion a year for three years or $75 billion a year for four years.
And starting in 2007 construction spending did indeed fall below trend. But we were expecting a minor one: a fall in construction spending below trend of $150 billion a year for two years or $100 billion a year for three years or $75 billion a year for four years. Instead, it fell $300 billion a year below trend. And it has so far stayed down for four years. And there is no prospect of rapid return to anything like normal levels.
Therefore when this construction cycle will have run its course, the United States will have first have spent an excess $300 billion, and then fallen short of trend by a cumulative $2 trillion of construction spending not undertaken. The net effect will be an at least $1.7 trillion construction shortfall in the United States: $1.7 trillion of houses, apartment buildings, offices, and stores not built.
This is a truly radical disproportion between the size of the boom and the size of the bust in construction. This radical disproportion makes nonsense of all claims that the current distressed state of the overall economy is in some sense necessary, deserved, or an inevitable consequence of the overexuberance that led to all the excess construction in the desert between Los Angeles and Albuquerque in the mid-2000s.
Now there is an alternative universe in which the irrational exuberance of the construction boom did indeed forth its deserved nemesis, and did lead to an economic slowdown led by construction. But that slowdown is not the $1.0 trillion per year of production lost that we now see. That slowdown is 1/10 of the size of ours. That slowdown is largely confined to the construction sector. And that slowdown is now over--in that alternative universe, we are now back to trend levels of production and employment and demand because we have worked off the entire burden of overbuilding.
There is one silver lining as we contemplate our macroeconomic wreckage.
When incomes, production, and employment in the United States return to their trend levels, Americans will demand an extra $1.7 trillion worth of buildings to live in. And those buildings will not be there. And demand for construction will come roaring back. The next decade will be likely to see--if we do recover to the previous long-run trend, that is--a construction boom to put the mid-2000s construction boom in the shade. But that is not now. And that is not for some years to come.
There is another lesson here. Rogoff and Rinehart argue that recovery after a financial crisis is almost always slow, and that powerful forces make it slow. There is at least one important aspect in which our current construction boost suggests that they are wrong. One channel making post-financial crisis recovery slow is that after a financial crisis nobody knows how the division of labor is to be re-knit. But right now we know a lot about how the division of labor will be re-knit. We know that when Americans become confident again--when they believe that they could find new jobs if they lost their current ones, and when they become thoroughly sick of doubling-up with their in-laws--Americans will want to demand more in the way of dwelling places than we have today. If incomes and demand were normal, we would want to be building a lot more new construction then we are now.
But even though we can do the math and see the magnitude of the underbuilding and understand how large the construction shortfall will be when recovery is complete, that does not help us right now. Right now incomes are slack, demand is low, people are doubling up with their in-laws, and we have not a shortage but a surplus of housing on the market--all because nominal demand is still far below trend.
In 20 years historians will be interviewing the then-aged monetary, banking, and fiscal policy makers of the 2000s. They will will ask them why they did not take more aggressive steps to return nominal incomes and demand to trend levels when they were sitting in the hot seats.
I do wonder what they will say.
