Housing IS the Business Cycle?

Interesting new paper here from UCLA’s Ed Leamer in which he argues that housing is the business cycle:

“Of the components of GDP, residential investment offers by far the best early warning sign of an oncoming recession. Since World War II we have had eight recessions preceded by substantial problems in housing and consumer durables. Housing did not give an early warning of the Department of Defense Downturn after the Korean Armistice in 1953 or the Internet Comeuppance in 2001, nor should it have. By virtue of its prominence in our recessions, it makes sense for housing to play a prominent role in the conduct of monetary policy. A modified Taylor Rule would depend on a long-term measure of inflation having little to do with the phase in the cycle, and, in place of Taylor’s output gap, housing starts and the change in housing starts, which together form the best forward-looking indicator of the cycle of which I am aware. This would create pre-emptive anti-inflation policy in the middle of the expansions when housing is not so sensitive to interest rates, making it less likely that anti-inflation policies would be needed near the ends of expansions when housing is very interest rate sensitive, thus making our recessions less frequent and/or less severe.”

I’d have to dive a bit deeper into this, but I do have to wonder if there isn’t a bit of recency bias in this data as real estate has disproportionately driven the US economy in the last decade.  My thinking:

  • Private residential real estate is only about 20-25% of private investment and only provides a narrow slice of the US economy.
  • Being a rather small component of private investment, there’s not much one can decipher from residential investment data.  Broader investment data is a FAR better indicator with many fewer false positives.
  • Home prices, with the exception of the last 10 years, are extremely stable in the USA.  Therefore, the activity in real estate tends to work with a long lag period making it far more stable than the business cycle itself.
  • The last 10 years were truly a period of “it’s different this time” and I think researchers and pundits are falling victim to this bias.

BUT, with the epicenter of the balance sheet recession being real estate, we’re likely to see a good multiplier effect coming from the recent positive activity in real estate.  So maybe the recency bias is warranted….FOR NOW.


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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • http://compoundingmyinterests.com Elliot

    FYI that paper is from 2007 and was presented at Jackson Hole in August 2007. I first heard of it from Bill Miller’s Bloomberg TV interview in October 2012, where he was revealed as a massive housing bull (http://www.bloomberg.com/news/2012-10-15/legg-mason-s-miller-redeemed-as-housing-bull-mortgages.html).

  • Andrea Malagoli

    I am not sure this is good news. Housing is a relatively unproductive form of investment, largely fueled by government sponsored leverage. Of course housing has been rebounding, thanks to all the US government stimulus actions. But is it rational to extrapolate the recent trends on a straight line?

    I guess my general feeling is that the US economy is too tilted towards unproductive consumption and much less on investment. This is ok in the short term, but the long term can be a problem.

  • Mr. Market

    No, I don’t think housing drives the business cycle. But housing is a MAJOR source of emplyment in ANY economy. Demographics drive the demand for housing. And with an againg US population demand for new housing WILL drop.

    The housing boom (& bubble) from 1995 up to 2008 also can be explained with demographic developments in the US.

  • Geoff

    Housing may not be a huge part of the economy, but it is a significant source of money creation from an MR perspective, is it not? Loans create deposits, and most loans are backed by real estate (at least in the household sector).

  • EconFan

    not sure why a house is less productive than a car which sits idle 90% of its life. I agree that housing hasan outsize impact due to government sponsored leveraging multiplied by the sheer number of people ‘investing’ in it – this makes it fertile ground for bubbles.

  • Andrea Malagoli

    Cars are the same. It is just that housing is so much bigger in terms of total value that it dominates everything else. The auto industry has also been propped up unabashedly by the US government via expansion in sub-prime car loans (see the components of consumer credit expansion in 2012).

    To be sure, an economy is also made of consumption, but at some point investments must play a role. We are $16Bn in debt, and our infrastructure is as obsolete as ever.

  • Andrea Malagoli

    It is a “huge” source of endogenous money creation via the shadow banking system.

  • Andrea Malagoli

    And loans are backed by real estate until they are no longer …

  • TruthNotPropaganda

    Another MASSIVE MISNOMER, and a case of confusion over correlation equaling causation.

    What came first, the chicken or the egg? I’m not sure, but I do know that homes purchased (new OR existing) more often than not require a buyer who already has and is confident that they’ll keep their job or a buyer who has landed a job that will allow them to (at least temporarily) pay the mortgage on said purchase.

  • EconFan

    I agree with need for public sector to pick up demand in recessions (like the recent balance sheet one) but it is not easy to define infrastructure e.g. some third world countries have skipped wired telephone infrastructure with the advent of wireless.
    on the other hand invisible hand has trouble investing in infrastructure also e.g. in Texas gas producers and distributors cannot come up with a model for funding new pipelines.

  • Geoff

    You mean until the loan is paid off? The value of the real estate is stil there and can be relevered. If real estate prices really are on the rise, it has major and probably underappreciated implications for potential money creation. Yes, this may not be the most productive use of money, but it will filter into useful places. The construction worker, the furniture maker, the lawyer etc. will all spend their well earned dollars on various goods and services. The money will make its way around, no doubt.

  • Adam

    This is an important paper, but it’s not new. Ed presented his analysis back in 2005 at the Federal Reserve conference in Jackson Hole–with Ben in attendance. Ben wasn’t interested. True macroeconomists like Ben don’t think sectors are important–there’s only one type of output in their models, GDP; one type of labor; and one interest rate. Sectors like housing just don’t show up in standard macro.

    Ed’s analysis isn’t based on a macro model. It’s an analysis of data and the relationships between sectors and GDP. Pretty compelling. It might have changed our recent history if Ben had taken notice, but he didn’t as recently released FR minutes show:

    “Federal Reserve officials in August 2007 remained skeptical that housing foreclosures could cause a financial crisis, just days before the Fed was jolted into action, according to transcripts the central bank published Friday”.

    Read more: http://www.mysanantonio.com/business/article/Federal-Reserve-transcripts-open-window-into-07-4206993.php#ixzz2IiHO6ayV

  • JB

    I don’t agree that housing is good for money moving. Actually, it can turn to be the same bubble as anything else, being produced just to make profit and not satisfy life needs of the people. If you check on the Vancouver housing market, you can see this pattern. People invested in the housing, it is no longer “making money” in terms of increasing housing prices, they have to pay their mortgage, which takes liquidity from them and the consequence is obvious = no additional consumption for them. But thanks to our marvellous banking system, they can still borrow money. The outcome is an outrageous level of household debt, which will be paid sooner or later by next generations.

  • JB

    I feel you, JB. Debt based money is certainly not without its problems. Vancouver is a good example. But US real estate has had a healthy correction and appears to have room for a fresh round of money creation. I’m not saying this system is ideal, but its the one we’ve got. Personally, I’d rather see productive companies do most of the borrowing rather than homeowners.

  • Geoff

    Sorry, that was me.