Over the past few days, I’ve read numerous articles from economists regarding the overall state of the economy. (Haven’t we all?) One of the recurring themes in these articles is the concept of “economic output” and “economic production.” As I considered this broader economic concept, there seemed to be specific implications for the housing market and homebuilding industry.
Greg Mankiw’s Wednesday blog post refers to a recent piece by Oliver Blanchard, IMF economist, where Blanchard discusses the long-term results of the banking crisis looking at 88 banking crises over the last 40 years:
“While there is large variation across countries, the conclusion is that, on average, output does not go back to its old trend path, but remains permanently below it.”
Nouriel Roubini (“Dr. Doom”) tells people to Stop Asking When the Recession Will End in today’s Forbes.com article. Regarding the economy’s recovery, Roubini writes:
Growth will remain well below potential in 2010, while the shape of the recovery will be closer to a U.
But, as with many economic arguments, there are two sides to the story. In their Economic Letter from August 14, John Fernald and Kyle Matoba of the Federal Reserve Board of San Francisco (FRBSF) state that:
“Going forward, capital is unlikely to contribute meaningfully to potential output growth over the next year. This weakness is likely to reduce potential output growth by about a percentage point compared with its recent history. If sustained efficiency gains continue, however, the weakness in potential output growth will be muted.”
What does all of this economic jargon about “output” mean?
An economy’s output is based on two main factors (there are other factors, but I want to keep it simple…):
- Capital - The level of factories, equipment, and machinery
- Labor - The available labor (and their relative skill using the “capital” described above)
In measuring “economic potential,” economists are looking at the total capital (factories and equipment) and the total amount of labor available to operate that capital, then determining the maximum possible output if the capital was utilized 100% of the time by all available labor. In reality, no economy can reach it’s full potential since factories sit idle sometimes, workers go on break or vacation, etc. However, in measuring an economy’s health and output levels, it’s important to know how much of the total possible capacity is being utilized in that economy. The more capital and labor is employed in an economy, the more economic output there is (measured as Gross Domestic Product, or GDP).
Here’s a graph that illustrates this point:
Over time, it’s clear that the United States (and all economies) utilizes less of its economic potential during recessions. During growth periods such as the 1990s, economies expand their overall economic potential because suppliers build new factories and buy more equipment to produce more goods. It’s clear that there was a dramatic rise in economic capacity during the 1990s as actual production crept towards economic capacity especially in the second half of the decade. Additionally, the current economic recession (the wide gray band) is wider (more prolonged) that any other periods since 1965 and the economy’s utilization of economic capacity has turned sharply downwards.
So what does this have to do with the housing market?
Referring back to the respective Blanchard and Roubini articles, I originally mentioned there are potentially significant affects to the US housing market as related to overall economic production levels. If Blanchard’s statement is true – that the banking crisis has permanently impaired the output trends across the country – there are certainly residual effects for the housing market.
1. Lower overall output trends mean that industries, homebuilders included, will struggle to reach previous production levels in the intermediate term. While the National Association of Homebuilders (NAHB) reported an increase in housing starts again this month, their own press release exercises caution about the long term viability of housing start growth because the short-term increase may be caused by factors such as the homebuyer tax credit and low interest rates.
2. Lower output trends will dampen the ability of employers to rehire those available for work, even as the economy grows. There will be excess capacity in the intermediate term, even while the economic is turning around and starting to grow again. This is more commonly known as the “jobless recovery.” (Roubini discussed this subject last week…) Lower employment levels mean fewer buyers (and more sellers in the existing home market…). This becomes a self-perpetuating cycle and and will contribute to the oncoming existing home inventory glut.
3. Lower output trends mean that there will be a prolonged period of economic slack. This is the concept that Roubini discusses with the “U-shaped” recovery he suggests. Companies will not only be under-utilizing their existing capacity but they will have less reason to expand capacity by way of business fixed investment. Referring back to the graph above, the precipitice fall of output in 2008-2009 puts the US economy far below capacity.
As a corollary, study the graph closely and you can see that the economic production trend line from 2001-2007 is noticeably flatter compared to the growth periods in the ’80s and ’90s – the gap between capacity and production from 2001-2007 was much larger than the gaps in 1980s and 1990s. This means the US economy was already operating with considerable slack. This explains why overall economic capacity did not grow as quickly in the 2001-07 period as it did in the 1990’s – there was already capacity in the system to utilize.
What about views expressed in the Economic Letter from the FRBSF?
The counterpoint that Fernald and Matoba make is that technological developments will increase the total productivity of labor, thus overcoming the downward shift in total output trends. The problem for the homebuilding industry is that its output is far less based on technological developments than total demand for it’s product. One would be hard-pressed to argue that technological developments can supercede lower demand levels for new homes and support the industry’s output growth.
The challenging economic fundamentals facing the United States are well-documented and examining the potential-output gap over time reveals structural challenges facing the economy and its recovery. These effects may have striking effects on the housing market and homebuilding industry over the next few years. While a look at these data might not offer exceptionally new viewpoints on our economy’s condition, it’s important to consider the longer term implications and trickle-down effects to the housing market, and it leaves one wondering if that rumors of the housing market’s demise may not be greatly exagerrated.