Free exchange – Housing was the business cycle | Finance & economics


AMERICANS HAVE long understood the link between the state of the housing market and the health of the wider economy. When Paul Volcker, then the chairman of the Federal Reserve, raised interest rates to eye-watering levels in the early 1980s, furious builders sent him lumber in protest, and the unemployment rate soon rose to nearly 11%. In 2007 Edward Leamer of the University of California, Los Angeles, wrote that “housing IS the business cycle.” The Great Recession soon seemed to prove his point. The trauma of the global financial crisis has left Americans overly sensitive to wobbles in the housing sector. But in fact its role as the engine of economic fluctuations has diminished. Though the covid-19 recession will bring pain for many renters and homeowners, it may also demonstrate that housing woes are not the harbinger of doom that they once were.

Mr Leamer’s description of the importance of housing for past economic ups and downs is no exaggeration. Residential investment represents a small slice of GDP—about 4.6%, on average, over the post-war era. But it has typically varied more wildly, and consequentially, than other sectors. Between 2007 and 2009, for example, real output in America shrank by about 2.5%. Over the same period, however, residential investment tumbled by 41%. In his study of America’s post-war recessions, Mr Leamer finds that GDP starts to deviate from its trend even before a recession begins in earnest and output starts to fall. Slumping residential investment typically acts as an early-warning indicator, accounting for about a quarter of output shortfalls on the eve of a recession, on average. By contrast, the consumption of durable goods is responsible for about a fifth, and the consumption of services contributes only a tenth or so to economic weakness. The housing market has generally been both a reliable predictor of downturns and, frequently, a proximate cause. Serious housing troubles preceded nine of the 11 recessions between the end of the second world war and the start of 2020. One exception is the dotcom bust, which was preceded by only a modest housing slump. The other is the recession of 1953, which was triggered by demobilisation after the Korean war. Here housing was a completely innocent bystander.

Still, over the period housing’s economic role has gradually weakened. Residential investment (ie, spending on new housing capacity) as a share of GDP, which peaked at 6.9% in 1950, has since drifted downwards (see chart). The surge in construction in the early 2000s broke with that trend, only for the downward slide to resume thereafter. Investment in housing as a share of GDP was just 3.9% in 2017, the lowest cyclical peak since 1945. As the share of residential investment in GDP has fallen, its contribution to recession-inducing economic weakness has also declined: from 32% before the…



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