20/07 Checking in on the coming boom

Housing markets

Jul 20th 2011, 18:19 by R.A. | WASHINGTON

KARL SMITH continues to argue that a housing boom lurks around the corner:

Lots of people said we are not going to see booming construction for a long time and seemed to feel the fundamentals backed that up.

Yet, over the beginning of 2011 lots of data series have started to turn in the same direction. We are seeing growing consensus that this is simply not sustainable and something is going to have to give.

Moreover, just like a price bubble, this housing shortage is a growing phenomenon. The longer it goes unaddressed the bigger the correct will be. And, quite frankly there is no reason to think actual housing supply will begin to tick up in the next 12 months. The lead time on home building is just too long.

So we are probably looking at 2 years minimum before we get a significant reduction in pressure. All the while shadow households are still forming. Couples are still getting married or waiting to get married. Babies are still being born, etc.

When housing corrects, I have to guess that it will correct hard.

The context for this argument is an American economy in which the decline in home construction has apparently overshot dramatically relative to the prior boom. The decline in home construction from 2006 has been unprecedented, and it continues; at the current pace, 2011 would see a record low addition to the housing stock. Meanwhile, the population of working age adults has continued to grow. Pressure in some housing markets (rental markets especially) is beginning to build, translating into rising rents and (in some markets) prices. 

That process will eventually spur new construction. Indeed, we saw a nice increase in housing starts in June. But starts, while up, remain at historically low levels. More importantly, construction occurs on a long lag. If rents start soaring tomorrow, supply can't respond immediately. Builders have to scope out new land, go through design and permitting procedures, and then build. Pressure for a boom may therefore be building.

But Scott Sumner provides a note of caution: household formation has also fallen dramatically in recent years. He attributes this drop, in part, to a crackdown on immigration, but he also credits falling demand for immigration and simple economising among natives, both associated with the weak economy. Reduced construction makes sense, in other words, because demand is lower, because people feel poorer.

I don't see that this rules out the boom Mr Smith has in mind. It simply means that America's housing market is stuck, for the moment, in a bad equilibrium that is vulnerable to an increase in expected growth. First-half GDP growth of (roughly) 2% is consistent with a low level of household formation, in line with a low level of construction. But if growth should accelerate in the second half, as expected, to 3% or more? Well, the pace of household formation will increase. Construction will increase, too, but on a lag. As household growth outpaces construction prices will rise, spurring more construction, employment, and growth. That will lead to still more household formation in excess of lagging new construction, and the boom is on. We would expect the number of households to snap back to a level near the pre-recession trend (near, because demographics are becoming ever less favourable for household formation). To meet that demand, we'd need to see a substantial recovery in construction activity.

There are other factors that are likely to temper a construction boom, not the least of which is tight lending standards. Nevertheless, the odds of a strong turnaround in housing over the next year seem to be fairly good to me and getting better.