In the mid-2000s, the US had a construction boom. From 2003 to 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 US$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. However, 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.
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 US$300 billion above trend, it would have to run US$300 billion below trend over a number of years to return to balance.
So, in 2007, everyone expected a construction-led slowdown. And, starting that year, construction spending did indeed fall below trend. However, we were expecting a minor decline: a fall in construction spending below trend of US$150 billion a year for two years or US$100 billion a year for three years or US$75 billion a year for four years. Instead, spending fell US$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 US$300 billion, and then fallen short of trend by a cumulative US$2 trillion of spending not undertaken. The net effect will be a construction shortfall in the US of at least US$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-2000s. Otherwise, the -construction-led economic slowdown would not be today’s US$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 US$1.7 trillion worth of buildings to live in. And, because those buildings will not be there, construction demand will come roaring back. If the US does recover to the previous long-run trend, the next decade will likely witness a construction boom that puts the mid-2000s boom in the shade. However, that is not now. And it is not for some years to come.
There is another lesson here. Economists Kenneth Rogoff and Carmen Reinhart argue that recovery after a financial crisis is almost always slow. However, there is at least one important sense in which the US’ 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.