Investment in Structures Is Still Depressed
The current business cycle has been atypical along many dimensions. The recession was one of the most severe, and the recovery has been one of the slowest. (Click here for more about the comparison.) One of the striking features of this cycle has been the behavior of private investment in structures, both residential (new houses) and nonresidential (new factories, plants, office buildings, stores, etc.). The percentage drop in private investment in structures has been the largest ever in the last 60 years, and investment in these long-lived assets remains depressed, showing no sign of recovery.
The behavior of residential investment has been particularly unusual. Residential investment grew rapidly during the 1990s and early 2000s and then plunged 59 percent from its 2005:Q4 peak. While residential investment typically bounces back as recessions end, in this recovery the level is still depressed nearly two years after the recession ended. Investment in nonresidential structures dropped 35 percent from its 2008:Q2 peak and continues to decrease.
In contrast, the behavior of the other components of GDP has been more typical. For instance, although private investment in equipment and software dropped by a sizeable 20 percent during the financial crisis, it has since rapidly recovered and is now at pre-crisis levels.
Real estate prices go a long way toward explaining the unprecedented swing in investment in residential and nonresidential structures. Investment in structures responds to the price of these long-lived assets. As the price of structures increases, the anticipated profitability of investing in structures increases, and investment increases and new structures are built. Real estate prices were relatively high before the crisis, plunged during the crisis, and remain at a depressed level. In response, investment in structures was high before the crisis, dropped sizably during the crisis, and remains depressed.
Indeed, some evidence suggests that the collapse in real estate prices was a major factor behind the severity of the last recession and the slowness of the current recovery. In other work, we found that shocks that depressed household balance sheets had played an exceptionally large role in generating the last recession, and we showed that these shocks tend to have long-lasting effects. Since these shocks can be interpreted as unanticipated drops in the price of long-term assets, and of real estate in particular, our results suggest that unanticipated drops in real estate prices contributed to the severity of the recession and the slow pace of the recovery.
In turn, the weakness of the current recovery is one reason real estate prices remain low. It is constraining household income and households’ demand for houses. The weak aggregate demand is also discouraging firms from investing in nonresidential structures. Another reason behind the low real estate prices is the large overhang of unused and underutilized structures and the excess capacity present in the economy. The relatively high level of real estate prices before the crisis likely gave overly optimistic signals about the profitability of future investment, encouraging households and firms to overinvest in structures. This generated an overhang of structures, which is now weighing on current real estate prices and investment.
The capacity utilization rate, for instance, dropped to 67.3 percent at the end of the recession. Since then it has been increasing, as firms utilize the excess capacity rather than adding to it by investing in new structures. Likewise, the housing vacancy rate recently reached a record high level of 14.5 percent and is still very close to that level, which is evidence of a large overhang of unoccupied houses.
In addition to low real estate prices and the low profitability of investment, credit supply constraints could be another factor restricting investment. Some profitable investment projects may exist but not be undertaken because banks do not fund them. How big a role credit supply constraints are playing in this recovery is not clear though. While lending still shows no sign of growth after falling by approximately 10 percent during and after the recession, it could be entirely due to low investment profitability rather than a constrained credit supply. Bank capital ratios are currently at record-high levels, which could suggest that bank balance sheets are strong enough and are not a constraint on the credit supply. However, part of the reason banks are maintaining higher capital ratios is to satisfy higher required capital standards, current or anticipated under Basel III. This may be limiting the amount of credit that they are willing to extend.
Overall, the weak and uncertain profitability of investment projects seems to be the main reason behind the depressed levels of investment in structures. The large overhang of unused and underutilized structures needs to be absorbed, and a more robust recovery needs to take hold before we will start to see real estate prices picking up, making investment more profitable, and encouraging businesses to increase their investment in structures.