Impact of Real Estate Bubble on Economic Recovery

December 20th, 2011
in econ_news

Econintersect: Arguments over and analysis of the causes of the Great Recession will continue long after all of us are dead.   What seems obvious at this point is that it was caused by several causes including demographics, excessive leverage, and declining employment to population ratios.

In the December 2011 edition of the St. Louis Fed's Monetary Trends, a strong case was made that the recovery itself was constrained by the bursting of the real estate bubble.

Follow up:

From the report:

As the real estate bubble burst, the U.S. economy [found] itself with a stock of residential and nonresidential structures higher than desired. Under these conditions, economic theory predicts investment in structures should collapse (just as observed in the data) and stay low until the desired level is attained (either by natural depreciation or by actively restructuring the housing stock to more desirable uses). Moreover, this adjustment process is expected to be slow, given the relatively low rate of depreciation of residential and nonresidential structures.

The current slow economic recovery may therefore be, at least in part, the natural result of the burst of the real  bubble. Further research is required to determine what role monetary policy can play under these circumstances.

The explaination of the above chart (click on chart for larger view):

The left chart below displays the trends in private investment and consumption since 1995 after adjusting for the effects of inflation. Consumption expenditures have actually surpassed their previous peak levels of 2007 and are therefore higher than ever. Government expenditure and net exports (not shown) display similar trends. Investment is the only component of gross domestic product (GDP) that has not yet recovered. Currently, it stands 20 percent below its peak level of 2006. This means investment is contributing negatively to GDP growth by 3.2 percentage points (the investment component represents about 16 percent of total GDP).

The right chart focuses on the individual components of private investment. According to the data, the low levels of investment are accounted for by a continuous decline in investment in structures (residential and nonresidential).  The only other component of investment—equipment and software—is already above its previous peak level.  What economic factors explain the depressed behavior of residential structure investment? Many commentators have suggested that real estate prices during 2000-06 were driven by unreasonably low risk premia or too-optimistic expectations. Asset prices during this period, including the market valuations of existing and newly constructed houses, plus many nonresidential structures, might have been too high.

Source: St. Louis Fed Monetary Trends

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