Saturday, January 15, 2011

Residential Investment vs Construction Payrolls

There's some disagreement out there between those who see the recession as a "reallocation" shock resulting from a change in the composition of output (with the implication that a significant proportion of unemployment is "structural," because workers have the wrong skills and are in the wrong locations), and those who see it as primarily a phenomenon of aggregate demand (AD).  The two stories are not mutually exclusive, but I'm with those who would put more weight on the AD side.  After all, the economy is continually reallocating resources, creating and destroying firms and jobs, and usually manages this without an aggregate downturn; as Brad DeLong puts it:
"Reallocation" occurs when people are pulled out of unemployment or jobs in which their marginal product is low by opportunities in expanding businesses. "Reallocation" does not occur when people lose their jobs and pile up as unemployed. "Reallocation" occurs not in depressions but in booms.
Arguing against the reallocation story, Scott Sumner points out that most of the decline in housing occurred prior to the recession:
Yes, housing output was low in 2009 and unemployment was high.  But is there a causal relationship?  I say no.  Housing starts peaked in January 2006, and then fell steadily for years:
January 2006 — housing starts = 2.303 million, unemployment = 4.7%
April 2008 — housing starts = 1.008 million, unemployment = 4.9%
October 2009 — housing starts = 527,000, unemployment = 10.1%
So housing starts fall by 1.3 million over 27 months, and unemployment hardly changes.  Looks like those construction workers found other jobs...
You can see this in a graph of real residential investment (red), which falls from nearly $800bn to $500bn (in 2005$, at annual rates) from the beginning of 2006 through the end of 2007.  Most of the increase in the unemployment rate (green) occurs later, in 2008 and early 2009.
That seems to suggest that the economy was smoothly managing a significant reallocation of resources out of construction until the end of 2007.  However, while residential investment was falling like a rock in 2006-07, the decline in construction payrolls comes later, and really gets going in 2008-09.
My hunch is that what is going on here is an example of "labor hoarding" - the tendency of firms not to adjust inputs immediately when output changes, because it is costly to do so.  Initially, construction companies may not have been sure whether the decline was temporary or permanent; it may therefore have made sense to keep people on the payroll so that they would be ready to respond if business picked up.

That doesn't validate the reallocation hypothesis, but it is true that there were alot of construction workers among those losing their jobs in 2008 (but there were job losses throughout the economy, not just construction, of course, as an AD decline implies).


Alice Cook said...

Relocation versus aggregate demand? You might find it useful to look beyond the US to see whether other country experiences might help adjudicate the question.

At the moment, the Bank of England is rather perplexed by the surge in UK inflation. They had thought that the UK output gap remained large and therefore inflation would remain subdued.

The November inflation data proved to be a real shock, when indices beyond energy and food were also rising sharply. This strongly suggests that the financial crisis has done something nasty to UK potential output.

I wasn't to be convinced by your story on employment. I think if you have a closer look at construction employment in the US the mystery will grow deeper.

When the housing bubble finally burst, and housing starts collapsed, construction employment hardly changed. The reason, I suspect, was the high proportion of illegal migrant workers employed in the sector. Employment fell, but it wasn't fully reflected in the data.

Finally, I think it is about time that you had some UK economics blogs on your blog roll. You can start with mine:


Bill C said...

Thanks for your comment.

I think the UK situation raises some interesting questions about the "inflation targeting" concept. I would assume that one of the major differences with the US is that the UK is far more open, so the depreciation of the pound may be showing up in the price level (but I haven't verified this in the data).

If a significant proportion of employment in construction is undocumented workers, and those workers are shed first in a downturn, and not captured in the statistics, that would help explain the data. I'm not sure on those points - here's what the BLS says in the FAQ on the employment situation report:

Are undocumented immigrants counted in the surveys?

It is likely that both surveys include at least some undocumented immigrants.
However, neither the establishment nor the household survey is designed to
identify the legal status of workers. Therefore, it is not possible to de-
termine how many are counted in either survey. The establishment survey does
not collect data on the legal status of workers.

Alice Cook said...

Personally, I think the Bank of England stopped targeting inflation once the financial crisis exploded. Monetary policy is now guided by the needs of the financial sector.

Judging by recent speeches from MPC members, they appear to be unpleasantly surprised by the strength of inflation. They didn't expect the exchange rate passthrough to be so strong. They were also taken aback by the strength of indirect tax hikes on inflation. It appears that retailers past the bulk of the tax increase on to consumers.

They also thought that the output gap would ensure a reasonably benign inflation environment. In fact, they seem to have misjudged most things over the last four or so years.

Turning to your other issue, I'm sure that the BLS did capture some of the undocumented migrants. Nevertheless, the US housing starts data points to a vicious downturn in construction activity. Yet, one doesn't see quite the same thing in construction employment data. If it is not undocumented migrants, then one is forced to think of other less plausible hypotheses.

As an aside, I was uncomfortable with the phrase illegal migrants, but couldn't think of anything better. I like your phrase undocumented migrants. I will use in future.