Construction in the Economy

An interesting question in the air this week is this: to what degree is the US economy shifting resources out of other sectors of the economy and into construction projects? The graph below gives my best answer to this question, which is that the shift into construction is real, and substantial.

(Note that the two series are not exactly comparable, since the employment line shows all construction employment, while the GDP line shows only residential construction as a percent of GDP.)

Clearly the house-building industry is highly cyclical. In part it depends on interest rates – the sharp drops in construction activity around 1980-82 and around 1990-92 both coincided with interest rate increases. And at the other end of the spectrum, today’s boom in real estate (including new home construction) is widely attributed to extremely low interest rates.

But just as clearly, interest rates do not explain all of the movements of resources into and out of construction. The following chart shows the Prime Lending Rate and 10-yr Treasury yield in both nominal and real terms over the same time period as the preceding chart.

(Note: the real rate is calculated by subtracting the average inflation rate of the GDP deflator over the previous 24 months from the nominal rate, a technique that I’ve previously noted seems to provide a good proxy for inflation expectations.)

The relatively low interest rates of 1992-94 did not spark a major housing boom, and the relatively high interest rates of the mid 1980s did not quash a significant burst of construction activity. So while they certainly help, low interest rates seem to be neither a necessary nor sufficient condition for shifting economic resources into the construction sector of the economy.

So I’m left somewhat unconvinced that the low interest rates of the past couple of years are single-handedly responsible for the significant rise in construction activity in the US in recent years. I think there’s something else going on. Perhaps its just psychology: good old ‘animal spirits’. If so, then perhaps higher interest rates (when they finally do arrive) may cause construction activity to fall not so much because of their direct effect, but more because of how they may contribute to a shift in the psychology of builders. I suppose you could call this a ‘sunspot’ theory of construction activity…