Built to Bust

BERKELEY – In the mid-2000’s, the United States had a construction boom. From 2003-2006, annual construction spending rose to a level well above its long-run trend. Thus, by the start of 2007, the US was, in essence, overbuilt: about $300 billion in excess of the long-run trend in construction spending.

When these buildings were constructed, they were expected to more than pay for themselves. But their profitability 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 foundations collapsed.

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By 2007, therefore, it was reasonable to expect that construction spending in the US would be depressed for some time to come. Since cumulative construction spending was $300 billion above trend, it would have to run $300 billion below trend over a number of years in order to return to balance.

So, in 2007, everyone expected a construction-led slowdown. And, starting that year, construction spending did indeed fall below trend. But we were expecting a minor decline: 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, spending fell $300 billion below trend in 2007 alone, and has remained depressed for four years. Moreover, there is no prospect of anything like a rapid return to normal levels.

Therefore, when this construction cycle has run its course, the US will first have spent an excess $300 billion, and then fallen short of trend by a cumulative $2 trillion of spending not undertaken. The net effect will be a construction shortfall in the US of at least $1.7 trillion. That is a lot of unbuilt houses, apartment buildings, offices, and stores – and it is a truly radical disconnect between the size of the recent construction boom and the size of the current construction bust.

Indeed, this radical disproportion makes nonsense of all arguments that the current distressed state of the overall US economy is in some sense necessary, deserved, or an inevitable consequence of over-exuberant building in the desert between Los Angeles, California and Albuquerque, New Mexico in the mid-2000’s. Otherwise, the construction-led economic slowdown would not be today’s $1 trillion in annual lost production. The slowdown would be one-tenth the size of the one the US is now enduring, and it would be largely confined to the construction sector. And, in that alternative universe, having worked off the entire burden of overbuilding, we would by now have returned to trend levels of production, employment, and demand.

There is one silver lining as we contemplate our macroeconomic wreckage: when incomes, production, and employment in the US return to their trend levels, Americans will demand an extra $1.7 trillion worth of buildings to live in. And, because those buildings will not be there, construction demand will come roaring back. If America does recover to the previous long-run trend, the next decade will likely witness a construction boom that puts the mid-2000’s boom in the shade. But that is not now. And it is not for some years to come.

There is another lesson here. The economists Kenneth Rogoff and Carmen Reinhart argue that recovery after a financial crisis is almost always slow. But there is at least one important sense in which America’s current construction bust suggests that they are wrong. One factor behind slow post-financial-crisis recovery is that nobody knows how the division of labor will be rearranged. But right now we know a lot about that.

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 can no longer tolerate doubling-up with their in-laws – they will demand more dwellings than the country has today. If incomes and demand were normal, we would want a lot more new construction then we do now.

But, even though we can see the magnitude of the construction shortfall and understand how large it will be when recovery is complete, that does not help right now. Right now, incomes are slack, households have become crowded, and there is a surplus of housing on the market – all because nominal demand is still far below trend.

In 20 years, historians will interview the then-aged monetary, banking, and fiscal policymakers of the 2000’s. They 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 already wonder what their excuses will be.