Thursday, May 26, 2011

How Long Did the Housing Bubble Go On For?

Brad DeLong posts this on his blog
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.

He's basically describing this graph:

I don't know if I necessarily disagree with Professor DeLong, but I am curious about his trendline decision.  He justifies it here:
Now let me briefly turn to construction. We expected a construction slump after the mid-2000s boom. Take construction spending in the United States as it stood back in 2001--when nobody thought we were overbuilding or overbuilt--and project it forward at the 3% growth rate of the American economy. We should probably project the construction trend at a slightly higher rate than that, because as people grow richer they do want to spend a greater share of their larger incomes on housing in a way that they don't for, say, food.
I'm not totally convinced by this.  Post financial crisis "nobody thought" isn't very solid ground.  So I looked at the longer annual real residential investment series:

 I see basically three separate periods here.  69-81 looks like 2 business cycle driven very volatile periods with a little growth.  After the 82 trough the expansion seems sustained a little longer and the fall off doesn't seem so steep.  The red portion, which somewhat arbitrarily begins in 1992 is the beginning of an virtually uninterrupted climb in residential housing (even during the 2001 recession) that eventually became what everybody agrees was the housing bubble of the mid-2000s in which residential investment stays above the trend of the previous years until the collapse in 2006/7.

That chart reminds me of this chart:

Bubble run ups usually have a long period of above trend growth before you hit the "mania phase".  In the case of housing, that's still above trend investment and is part of the overbuilding that still needs to be "corrected".  

I think the case that the bubble had been a long time coming can be made.  For instance, if we take 2003-2006 as the mania phase then it makes sense that this is the period where subprime mortgages arise.  There are two stories people tell about subprime.  The first is "chasing yield" story.  That is, banks were lending to risky borrowers they said were safe but still paid high interest rates.  The other story is that subprime was the last place to go because all the good borrowers had already taken out mortgages and refinanced etc.  To the extent that the second story is true, how long did it take to make it all the way through the credit worthy borrowers?  Did mortgage lenders become instantaneously aggressive in 2003 or was there a slow push of the supply curve of mortgages out further and further?

This brings me to the next argument in favor of my new pet theory.  I'm a big subscriber to the "giant pool of money" theory of the housing bubble.  However, I tend to date the capital inflow bonanza from the Asian Crisis of 1997. In the late 90s there was a sudden shift from capital flow "excess" into government deficits to "private deficits" (Private Savings - Investment < 0).  Meanwhile, the current account balance continued it's historic decline.  The dot com bubble, of course, is what everyone thought about and thinks about but a stock market bubble is not mutually exclusive with a housing bubble's infancy.

So whats the point?  Well, I want to go back to Professor DeLong's idea that housing was only over built by $300billion and that we are "missing" $1.7trillion in residential investment that will eventually come roaring back.  The increase in prices above the my trendline if measured from 1992 adds another $1.4trillion dollars to the overbuilding total.  So if we think of the housing bubble as a generational phenomenon and not just a couple of years we had over $1.7 trillion in excess housing being built.  The "correction" so far according to the 67-92 tread line is also much shallower, only about $425 billion.  Suggesting we still have a long way to go before we come out even on residential housing.

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