Housing plays a major role in the growth of the United States economy, contributing to Gross Domestic Product (GDP) through residential construction (residential fixed investment) and the services provided by existing houses (personal consumption expenditure).
The close relationship between housing and GDP is reflected in the cycles of residential fixed investment (RFI), personal consumption expenditure and GDP growth. The recent exaggerated economic cycle provides an example of this relationship.
In the middle of the first decade of the 21st century, the United States economy was growing strongly, with GDP increasing at a rate above 4% in the first half of 2004. Housing demand was also growing strongly over this period, with housing construction well above the long term average rate of the two decades prior and residential fixed investment increasing at a rate of over 10% per annum in the second half of 2003 and first half of 2004.
Then at the end of 2005, as housing was becoming progressively less affordable, house prices began to decline. This undermined the key assumption driving the strong demand in the housing market that house prices never go down. With the decline in house prices, housing construction plummeted and RFI fell almost 75%. The fall in house prices led to a sharp increase in mortgage delinquencies and foreclosures. This put significant strain on financial markets, leading to the near collapse of the banking sector. With the financial sector in turmoil and confidence draining from the economy, economic activity slowed sharply, and the United States began what would be the worst recession since the Great Depression of the 1930s. At the trough of the cycle in the first quarter of 2009, GDP growth shrank by 6.4%.
Since housing was at the epicenter of the financial crisis that caused the recession, it is timely to consider the contribution of housing to economic activity and the role it plays as a leading indicator of economic growth. To explore housing’s role in the economy, this paper initially reviews how GDP is calculated and the components of GDP where housing contributes. It will then observe the contribution of housing to GDP over the past five years, before considering the housing sector’s role as a leading indicator of economic growth.
Gross Domestic Product
In the United States, the Bureau of Economic Analysis (BEA) is responsible for producing the national income and product accounts (NIPA). These accounts provide a detailed picture of economic activity at a given time. While GDP is the most widely reported measure, the NIPA consists of seven accounts which show the contribution of each sector (households, business, government and overseas transactions) to the output of the economy, their income and outlays, savings and investment.
GDP measures the market value of the goods and services in the United States. It is calculated as the sum of final expenditure components:
• personal consumption expenditure;
• gross private domestic investment;
• government consumption expenditures and gross investment
• net trade in goods and services (exports less imports) (Chart 1.)
Housing contributes to both the investment and consumption components of GDP, through residential construction (investment) and the services provided by existing housing units (consumption). The following sections detail the contribution of housing to the gross private domestic investment and personal consumption expenditure components of GDP.
Residential Fixed Investment
Gross Private Domestic Investment includes fixed investment in structures, equipment and software that contribute to production, as well as private business investment in inventories. It is fixed investment in residential structures, or residential fixed investment, that we are interested in when considering housing’s contribution to GDP.
Residential fixed investment includes the construction of new single-family and multi-family houses, manufactured housing (or mobile homes) and home improvements. Also included in residential fixed investment are the brokers’ commissions on sales, net purchases of used structures and residential equipment.
In the national accounts, fixed investment in new residential structures is accounted for as the construction occurs, not when the structure is completed or sold. While inventory is a component of Gross Private Domestic Investment, inventory typically is not included in the calculation of the value of residential fixed investment. Builders rarely invest in inventory unless they accumulate materials for future use. The unimproved value of raw land is not included in the value of investment in new structures, as appreciating land values are not a component of production. However, all of the work done to develop the land and then turn it into finished residential lots is included.
Residential fixed investment is calculated at its gross value, therefore it is not adjusted for depreciation. Residential property is a very durable asset relative to other assets, such as motor vehicles, computers and industrial equipment. With proper maintenance homes can be made to last indefinitely, although there are factors that make the lives of residential structures finite - functional obsolescence, competition for land on which the structure sits and natural disasters. For housing, the durability of the stock means that a larger proportion of the stock of capital is a net addition to the stock rather than the replacement of worn out capital. Over the past decade (2000-2009) an average of 1.5 million new housing units were added to the housing stock each year, this represents around 1.2% of the number of existing homes.
Housing Services Provided by Existing Units
Personal Consumption Expenditure is the largest component of GDP contributing around 70% of the total value. It includes all private household expenditures in the economy and is divided into three categories: durable goods, non-durable goods, and services. It is the contribution of existing houses in the services component of personal consumption expenditure that we are interested in when considering housing’s contribution to GDP.
The services provided by existing housing are primarily rent. It includes expenditure on rent of tenant occupied housing, the imputed rent on owner-occupied housing (an equivalent rent), the rental value of farm dwellings and other housing services. Under its recently revised classification system, BEA groups spending on utilities in this category, as in rental property utility costs are often included in the rent paid by the occupant to the property owner. Housing services do not include the purchase of new housing, as this, as we have just seen, is investment.
When a landlord provides housing services to a tenant in exchange for payment (rent) the transaction appears on the accounts side as personal consumption expenditures for housing services and on the income side as rental income.
The imputed value of owner-occupied rent is calculated using the rental equivalent method, which equates the change in owner-occupied rent to the change in the market rents charged for similar tenant occupied housing. This ensures that the housing services component of personal consumption expenditure is based on the number and quality of housing units available and will not change if a housing unit switches between being rented by a landlord or lived in by its owner. If owners imputed rent were not included, an increase in the home ownership rate would cause GDP to decline. On the income side of the account, the owner occupant is treated similar to a business. Expenses associated with owner-occupied housing, such as depreciation, maintenance, and repairs, property taxes and mortgage interest, are deducted from the value of the housing service, leaving a profit-like remainder of income.
The Contribution of Housing Construction to GDP
Housing construction is an important sector of the United States economy, considered to be a cyclical driver of GDP. With high volatility over its cycles, housing construction often accounts for a large share of the change in GDP, relative to most other sectors.
Between 2003 and 2006, housing starts surged to a historical peak of 2.27 million units (Seasonally Adjusted Annual Rate) in January 2006. They then fell sharply to a low of 488 thousand units at the bottom of the trough in January 2009, a decrease of almost 80 percent. While housing construction has recovered slightly to 591 thousand units in January of 2010, it is still at a level not seen since detailed records began to be collected in 1959. With the dramatic decline in housing starts, residential fixed investment fell sharply, down 54% from a peak of $775 billion or 6.1% of GDP in 2005, to a low of $359 billion (chained 2005 $) or 2.8% of GDP in 2009.
Single-family houses dominate this segment, contributing over half of the value of residential fixed investment. At the peak of the housing cycle, construction of new single-unit housing was valued at $434 billion, or 3.4% of GDP. This declined to $109 billion in 2009, following the collapse of the housing market, with its contribution to GDP falling accordingly to 0.8 %. (Chart 2.)
Multi-family dwellings vary widely, as they can include small structures of 2 to 4 dwellings or a very large apartment or condominium complex with hundreds of dwellings. The value of construction of multiunit dwellings peaked at $48 billion (0.37% of GDP) in 2006 and has since fallen back to $26 billion (0.2% of GDP) in 2009.
Home improvements, refurbishment and remodeling of residential structures are the second largest component of residential fixed investment, typically contributing around a quarter of its value. Despite the sharp reduction in housing construction, investment in home improvements has experienced only a modest decrease from $164 billion (1.3% of GDP) in 2005-06 to $148 billion (1.1% of GDP) in 2009. As a result its share of residential fixed investment increase to almost one third in 2009.
Brokers' commission on sales provides a further 18% of residential fixed investment, valued at $65 billion in 2009 or 0.5% of GDP. Other factors contributing to residential fixed investment, manufactured housing, dormitories and net purchases of used structures (negative) are small in comparison to the other sectors, valued at less than $1 billion in total in 2009.
The Contribution of Housing Services to GDP
Housing services are a major component of personal consumption expenditure and GDP. Total housing services were valued at $1.66 trillion in 2009, representing 18% of personal consumption expenditure and contributing 12.8% of GDP.
In the United States home ownership is high, with roughly two thirds of Americans owning the house in which they live. Therefore, owner-occupied imputed rent makes the largest contribution to the housing services component of consumption. In 2009, the imputed value of owner-occupied rents was calculated to be almost $1.1 trillion, representing 8.4% of GDP. (Chart 3.) Owner-occupied rent has grown at an average rate of around 2.5% over the past decade.
Rent from tenant occupied housing provides 18% of the housing services component of personal consumption expenditure (3.2% of total personal consumption expenditure). In 2009, tenant occupied housing rent was valued at $295 billion contributing 2.3% of GDP. Tenant occupied housing rent has been very stable over the past five years, and has consistently provided over 2% of GDP.
Household utilities, such as water supply and sewage, garbage collection, electricity and gas, account for around 15% of the housing services component of GDP. In 2009, household utilities were valued at $249 billion or 2% of GDP. Other household services, such as rental value of farm dwellings and group housing contribute only 1% to the housing services component of GDP, valued at less than $20 billion in 2009.
In comparison with residential construction, housing services are a very stable component of the economy. In the past three years, despite the boom and bust in the United States economy and housing sector, housing services have experienced only a small reduction in value and their overall contribution to GDP. The lack of volatility can be attributed to the size of the housing stock and the rate of expansion. The Census Bureau estimated the housing stock was 129.7 million units in June 2009. In an average year the housing stock increases by approximately 1.2% (new construction averaging around 1.5 million units per year). This combined with the method of calculation, which equates the housing services provided by owner occupied housing with rental housing through the imputed rent of owner occupied rent, ensures a relatively slow and consistent rate of growth for housing services. Therefore the housing services component of GDP is very stable over the long term and has very little impact on GDP growth.
Housing as a Leading Indicator
Housing construction acts as a lead indicator of the economy due mainly to its high sensitivity and responsiveness to interest rates. When the Federal Reserve raises interest rates to cool an overheating economy, home building quickly responds. This is due to the high reliance on mortgage lending to fund investment in housing. With higher interest rates the cost of capital to finance investment in housing increases, and with increasing cost, the amount of investment demanded declines. On the flip-side, when the Federal Reserve lowers interest rates to stimulate the economy, the cost of capital is less and the amount of housing demanded increases. Other sectors of the economy are not as sensitive to interest rates, so take longer to react to changes in monetary policy. Therefore, the impact of interest rate changes is typically not observed in the wider economy and GDP for several months after the policy/rate change.
The role of housing as a leading indicator is illustrated in the graph below (Chart 4.). Residential fixed investment led GDP in each recession period (grey shaded areas) over the past 50 years. The turning points in residential fixed investment typically occur around six months prior to the turning points in GDP. The only exception was the recession in 2001 that resulted from a collapse in technology stocks. The housing market continued to grow during this period, thus the changes in RFI at this time closely match the changes in GDP. There are indications that housing is providing weaker support to economic growth in this cycle, with RFI and GDP returning to positive growth in the third quarter of 2009. Further, housing starts are still at unprecedentedly low levels and will experience several years of recovery before returning to normal levels. Unlike past economic recoveries, housing construction will grow alongside other sectors rather than leading the recovery.
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