Construction un-bust

The headlines have been screaming that the Israeli economy is in recession — as if anyone needed to be told that. The reason why this is a news item is because the data for GDP growth in the first quarter of 2009 (published on 17/5) showed, to no-one’s surprise, that this key measure of economic activity shrank at an annualised pace of 3.6% in January-March 2009. The fact that this was the second successive quarter of negative economic growth confirms that Israel (too) is in a recession – because two straight down quarters is the standard definition of a recession.

Beyond that statistical fact, there was no real news. The declines registered in all the main components of GDP had been presaged by the regular flow of economic data over the previous weeks and months. Thus we learnt afresh that imports and exports dropped sharply – with imports declining faster, so that the trade deficit actually improved – and also that private consumption and investment both fell. Investments were one of the sectors hammered hardest: ‘gross fixed capital formation’, as investment is termed in the GDP jargon, fell at an annual rate of 27.8% in the first quarter. That sounds horrendous, and it is, but it means that if the rate of decline from the previous quarter, of 7.8%, was maintained for four straight quarters, then investment would have fallen by 27.8% in a year. Fortunately, that is unlikely.

So what else is new? Apparently nothing, but even that is worthy of closer examination. I want to focus here on the investment data, not just because these are important in themselves but mainly because they actually contain some good news. This positive item was reported nowhere, but is nonetheless worth exposing.

The term ‘gross fixed capital formation’ relates to two areas of economic activity. One is ‘plant and equipment’, and encompasses all the capital equipment that is used to produce income. Given the massive drop in demand both at home and abroad over the last year, it is hardly surprising to learn that investment in plant and equipment, including cars, trucks, etc, and productive machines of all sorts, has been a major victim of the recession. And even if you should want or need to invest, it is very difficult to obtain the financing necessary.

But there is another component of capital formation, namely ‘buildings and other construction activity’. Construction activity is itself divided into residential and non-residential – and residential construction in turn divides into that undertaken by the private sector (over 90% of the total in recent years) and the shrinking amount of public sector activity in this area. Non-residential construction also sub-divides, into buildings – whether factories, office blocks, schools or whatever — and ‘other construction activity’, which is mostly infrastructure construction.

So much for the structure of the data, now for the data themselves – and this is where it gets interesting. As everyone knows, the origin of the financial and economic crisis, in the US and then elsewhere, was and is the housing sector and the cycle of boom-bubble-bust that took place in America, Britain, Ireland, Spain and many other countries. Following the bust, the level of activity in residential construction has collapsed in these countries. Just this week, data from the US showed that new housing starts fell in April to a record-low level – confirming that the housing bust is still alive and well.

Because the residential construction sector in the US et al grew so large, its collapse had a major impact on the whole economy so that, since mid-2007, it has been a major factor dragging down growth. But by now, the level of construction activity has fallen so low that even if it falls further, its impact on overall GDP has become marginal.

In Israel, however, there was no housing boom – there hasn’t been one since the mid-1990s. So there was no bubble and no bust. Without a deflating bubble, the residential construction sector can have no negative impact on GDP. As it turns out, GDP is managing to fall sharply even without that factor. More correctly, GDP is now falling sharply DESPITE the positive contribution of residential construction.

Yes, that’s right, residential construction in Israel is a positive factor – albeit a minor one — in GDP growth. This was true in January-March 2009, and in every previous quarter since mid-2007. The last negative quarter here was April-June 2007, which is about when the crisis in the US blew up. Even prior to that, for most of 2006, the level of activity in residential construction had been inching up, after the long slump that began in 1996 and didn’t really end until 2004 or so.

But the very small rises in residential construction activity in Israel in 2006-2007 were highly UNimpressive against a background of rapid growth in all other areas of the economy. In those years, what distinguished the Israeli economy was that it was among the fastest-growing in the world – DESPITE the absence of a housing boom. In fact, other than Germany and Holland, it was the only developed economy to experience rapid growth WITHOUT the benefit of a housing boom.

The world is now on the down escalator. In Israel, we have a very different situation, in which the gradual rise in residential construction activity is continuing DESPITE the sharp swing in the overall economy over the last year from rapid growth to rapid decline. The level of construction activity in the private sector has risen fast enough to offset the further shrinkage in public sector building activity.

This development is interesting, remarkable and potentially very important. It confirms my basic position that the domestic Israeli economy is anti-cyclical with respect to the global economy. It suggests that the potential for economic recovery lies primarily in the domestic economy and that the construction sector can play its traditional role in leading the domestic economy out of a slump and back to rapid growth.

Since there is no excess supply in the Israeli residential construction sector, the only downside risk is of a collapse in demand. Demand is indeed weak, thanks to the impact of the global recession, but the underlying factors determining long-term demand – namely demographics and affordability – are positive.

If there were to be a positive demand-side shock, meaning a sudden increase in demand, the initial response would be a sharp rise in prices, because the elasticity of supply in housing is zero – you can’t provide more houses next week or next month. But the steady, quiet, gradual rise in private-sector residential construction is laying the foundations for a much larger surge in supply, which will occur when the positive demand-side shock takes place.

That will happen when the recession in Europe bites much harder and social tensions boil over, triggering large-scale anti-semitic violence (aka pogroms). The resulting emigration will translate into a massive aliyah wave which, in turn, will force Israeli economic policy to focus on absorption, via subsidies to buyers and benefits to contractors. Then, when the rest of the world is mired in a housing-led slump, we will have our next housing-led boom.

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