Edward Leamer on Housing and Macro
By Arnold Kling
He has a new book, which sounds very interesting (but expensive). I’ve been re-reading his 2007 paper. My comments follow. Leamer finds that a lot of cyclical variation in the U.S. economy is in residential construction, with some also in automobiles and in other consumer durables. Thus, he argues, we should call it a “consumer cycle” rather than a “business cycle.”
A key point that Leamer makes is that you cannot have more housing construction now without having less housing construction later. Thus, if policymakers push housing starts up in one year, they are sowing the seeds of a recession later.
From that perspective, he might view the current recession as an inevitable consequence of the overproduction of housing from 2003-2006. In fact, because that upsurge was so strong, the correction in housing starts will be much longer and deeper than normal. Moreover, there is not much that government policy can do about this necessary correction.
However, it seems to me that if all we had were a housing correction, the economy would have bottomed out already, because most of the drop in housing starts is behind us. Leamer does point out that in a typical recession other sectors, notably business fixed investment, start to decline later in the cycle and keep the recession going. So maybe we are just into that phase.
But I think there is more to it than that. In my view, the main downward driver since last fall has been the stock market collapse. Of course, one wonders how much of that collapse reflects lack of confidence in policy in Washington.
Another point that Leamer makes is that the housing cycle is a volume cycle more than a price cycle. He says that prices are sticky downward, so that transaction volume falls during a housing recession.
This is a longstanding puzzle about the housing market. When there is a decline, home sales collapse, and when there is an expansion home sales increase. In theory the volume of transactions could be independent of the cycle. Volume could be high in a downturn, with prices falling, and volume could be moderate in an upturn, with prices rising.
Leamer does not distinguish between sales volume and construction volume. Even if one can explain why individual home sellers are reluctant to cut prices in a downturn, what matters for GDP is new housing construction. Home builders should not have sticky prices.
Even if prices were flexible, I think there would be a cycle in housing construction. With flexible prices, if demand were to fall, then prices of land and of homes would fall. With prices low relative to construction costs, you would not want to build. It’s a Tobin’s q story.
We used to think that housing was a big component of cyclical movements in GDP because we thought that housing responded strongly to interest rates. In part, this was due to institutional factors–the way that savings and loans were regulated up to the 1980’s, the credit market for housing dried up when interest rates rose.
In the current situation, it was not so much a Fed tightening that wrecked the housing market. It was a speculative bubble that crashed, for the most part because the euphoria was unsustainable.
Overall, I am not sure that past recessions provide any strong lessons for this one. Without looking back at previous recessions, we know that housing was out of balance in recent years, and we know that housing construction has plummeted. That is the easy part of this recession to understand. The hard part to figure out is the dynamics among the financial sector, stock prices, government policy, developments in other countries, and economic activity.