The Housing Industry Association (HIA) has today released a paper examining the role and performance of residential construction during economic downturns and recoveries, namely:
A: The early 1980s
B: The early 1990s
C: The introduction of the GST [mid 2000]
D: The Global Financial Crisis [from 2008]
Prior to the early 1980s business cycle hitting a peak, the level of activity across most indicators grew strongly. When the downturn kicked in, new dwelling commencements were badly hit. Commencements fell by around 35 per cent relative to their peak within two years of the start of the downturn. Alternations and Additions (A&As) to dwellings also fell off sharply, although not as severely as for new dwelling activity.
Non-residential construction fell sharply during the downturn, although not as steeply as new dwelling construction.
Once the bottom had been reached, detached house construction and non-residential construction both bounced back very strongly and had recovered to their pre-downturn peak within four years. The recovery of A&As was much more hesitant; activity was still below its pre-downturn level a full five years after the onset of the downturn.
Employment plays a crucial role in determining disposable income levels in an economy as well as generating household confidence. Accordingly, major commitments such as home purchases and renovations will be strongly affected by labour market developments. It is worth noting that during the early 1980s business cycle, housing activity started to recover only when employment was again on the increase and after it had returned to pre-downturn levels.
Figure 2 below provides a comparison between housing activity and mortgage interest rates during the early 1980s downturn. It is interesting to note that detached house commencements began their strong recovery at almost exactly the same time as mortgage interest rates began to fall. Renovations activity bottomed out at around the same time as the interest rate easing cycle began.
Figure 3 below provides an overview of housing activity and other economic indicators during the early 1990s business cycle. Detached house commencements increased very strongly in advance of the peak in activity. When the downturn hit, activity eventually declined by over 30 per cent at its lowest ebb. Recovery was very slow, with activity still stuck below pre-downturn levels a full five years later.
In contrast, the rise of A&As activity was much more gentle prior to the downturn. Following the peak of activity, A&As fell by no more than 10 per cent and had recovered within two years of the downturn. This was a particularly incongruous outcome given how badly employment suffered during the downturn of the early 1990s; numbers employed fell by 3.5 per cent during the height of the downturn and the pace of recovery was extremely slow with employment taking over four years to return to its pre-downturn level. Non-residential construction also saw a very sharp decline during the downturn followed by a very slow recovery.
During the early 1990s cycle, it is interesting to see how mortgage interest rates interacted with housing activity. Interest rates rose in the run up to the start of the economic downturn. Once the downturn commenced, mortgage interest rates embarked on a significant downward journey, illustrated in Figure 4 below. The A&As segment of the market responded quite strongly to the lower interest rates being in place.
Detached house commencements also responded well to lower interest rates, although the recovery fell far short of pre-downturn levels. The weakness in new home building may be partly explained by the behaviour of real house prices which surged in the lead up to the peak, but then declined by up to 10 per cent before stagnating.
The GST Business Cycle:
…the introduction of the Goods & Services Tax (GST) in July 2000 resulted in a large amount of spending being dragged forward to the first half of 2000 and a sharp fall off in activity post July 2000. This is illustrated in Figure 5 below. The associated effects on economic activity were substantial: detached house commencements fell by almost 50 per cent in the immediate aftermath of the GST’s introduction, with a similarly sharp decline in non-residential construction. Motor vehicle sales also suffered to a lesser degree, while the reduction in A&As activity was also more muted.
A&As had returned to pre-downturn levels within three years, but new home building was still significantly lower five years after the start of the downturn. Indeed, detached house commencements have never fully recovered to pre-GST levels at any stage over the subsequent thirteen years. Interestingly, the GST downturn did not involve any significant decline in employment. Rather, activity in the labour market stagnated for a few quarters before resuming a growth trajectory.
The GST business cycle was also marked by strong housing price activity before and after the beginning of the downturn. This is illustrated in Figure 6 below. Real house prices declined very slightly before the economic downturn but quickly resumed a very strong growth path.
The GFC Business Cycle:
Figure 7 below shows the development of several key indicators for Australia during the GFC cycle. In the run up to the GFC, detached house commencements had largely been static. The beginning of the GFC downturn saw activity fall sharply but a strong recovery in detached house building was prompted by the government’s stimulus programme and record reductions in interest rates. However, the withdrawal of the stimulus and interest rate increases saw a second dip in detached house building. Similarly, A&As as well as motor vehicle sales saw smaller but significant reductions in activity, especially A&As.
Non-residential construction activity initially weakened during the onset of the GFC but subsequently recorded huge growth as the mining and natural resources (MNR) investment boom gathered pace. Non-residential construction activity in this area was also strengthened by large-scale investment in the education sector and in health infrastructure.
Interest rate and house price developments during the GFC business cycle are shown in Figure 8 below. It is worth noting that both detached house commencements and renovations activity recovered strongly from their initial falls and the era of low mortgage interest rates is likely to have played some role in this, in addition to some of the factors mentioned above. The close relationship between renovations activity and real house prices post-GFC is also worth noting. Declines in prices dampened the accumulation of home equity, therebyrestricting the scope for renovations financing.
The four business cycles examined here included phases of growth, contraction and recovery. Several common features are discernible: first, residential construction activity tends to take a disproportionately large hit during economic downturns, particularly new home building. Second, Alterations & Additions work tends to recover more quickly than detached house construction and the magnitude of its recovery appears dependent on house price growth. Third, new home building activity tends to take a very long time to recover once it experiences cyclical decline.
These observations underline the vulnerability of the home building sector during periods of economic weakness and demonstrate that strong policy support for the sector during cyclical downturns is warranted. The experience of the GFC shows that stimulatory policies in the sector are capable of lifting activity – but also that abrupt withdrawal of such measures has the potential to tip activity back into decline.
In addition to the weak economic environment, there are a range of structural factors currently obstructing a sizeable and sustainable recovery in residential construction, related to land supply, taxation, planning, regulation, and a squeeze on credit. A focus on reform measures to lift residential construction activity is a crucial area for policy development across all levels of government, and obviously needs to be led at a Federal level.
By and large, I agree with the HIA’s conclusions. Lowering interest rates and throwing stimulus at new home buyers is reasonably effective in producing a short-term (cyclical) uplift in construction from depressed levels. However, if the higher construction levels are to be maintained, then reforms must be made to the supply-side of the market to remove the barriers preventing affordable new homes from being supplied.
It is worth pointing out that the intensity of dwelling construction has been in structural decline since the mid-1990s as urban consolidation policies pursued by Australia’s various governments have taken hold (see below chart).
Therefore, while further cuts to interest rates and increased new home stimulus might lead to a short-term “sugar hit” to construction, they do not address the underlying structural problems and construction levels are likely to slump once the stimulus is removed.