The Lay of The Land

The U.S. economy will continue to be weighed down in 2010 by the after-effects of the bubble collapse in residential and non-residential real estate. This collapse, not the financial crisis that was sparked by the collapse, is the cause of the recession and the main factor suppressing growth. The fallout from the collapse of these bubbles virtually guarantees that 2010 will be a year of slow, and possibly negative, growth with 2011 offering little better prospects.

The impact of the housing bubble is fairly straightforward. The run-up in housing prices earlier in the decade led to record rates of housing construction. This led to enormous overbuilding. The country currently has an unprecedented level of vacant housing units.

With the collapse of the housing bubble, residential construction has fallen to less than 3 percent of GDP. The loss in annual demand from this drop in construction is close to US$ 500 billion. While construction has now stabilized and risen from the lows reached in the spring of 2009, there is no reason to expect a substantial increase any time soon. Levels should remain more or less flat through 2010 and most likely 2011. With the huge baby boom population reaching retirement age, and many looking to downsize their homes, the demand for housing will be growing slowly for the foreseeable future.

The collapse of the housing bubble also had an enormous impact on consumption. At its peak, the housing bubble created more than US$ 8 trillion in additional home equity. Standard estimates put the housing wealth effect at between 5 and 7 percent, meaning that an additional dollar of housing equity leads to an increase in annual consumption between 5 to 7 cents. Using this arithmetic, the US$ 8 trillion in housing bubble-created equity led to an increase in annual consumption between US$ 400 billion and US$ 560 billion. Now that much of this wealth has disappeared, consumption has fallen, exactly as would be expected.

There was also a bubble in non-residential construction that followed in the wake of the bubble in residential construction. At its peak in 2008, non-residential construction was more than 40 percent higher than in 2005. This boom led to enormous over-building in retail and office space. These sectors are now contracting as projects are finished, but no new ones have been initiated. There was also somewhat of a boom in the building of refineries for the manufacture of bio-fuels. This boom is now coming to an end, leading to another source of downward pressure on non-residential construction. The decline in this sector will subtract close to 2 percentage points of GDP, or US$ 280 billion a year, from annual demand compared to the 2008 peak.

The government sector is also likely to be a source of contraction going forward. The stimulus put in place at the federal level in 2009 was smaller than is generally recognized. While the sum often cited is US$ 787 billion, US$ 80 billion of this package was a technical adjustment to the tax code that provided no stimulus whatsoever. Another US$ 100 billion are expenditures that will be carried through in 2011 and later years, providing no near-term boost to the economy. This leaves just US$ 300 billion in stimulus per year in 2009-2010, a bit more than 2 percent of GDP.

This spending helped boost the economy in 2009, but the stimulus money is already being spent at its maximum pace. That means it will provide no additional boost to the economy in 2010. State and local governments are experiencing large budget shortfalls as a result of a plunge in tax revenue and increased demand for services. Most state and local governments are required by their constitutions to balance their budgets. Budget cutbacks and tax increases were put in place by many in 2009; governments relied on reserve funds or accounting tricks to minimize the pain.

As the impact of the recession continues, these governments are exhausting their reserves and running out of accounting tricks. They will have to impose larger cuts and tax increases to balance their budgets for the 2011 fiscal year, which in most cases, begins in July 2010. State and local government sectors will be a source of contraction in the next year, with spending cuts and tax increases likely totaling close to US$ 140 billion or 1 percent of GDP.

The only substantial source of growth in the economy in 2010 will be inventories. Inventories had been contracting at a rapid pace over the last year and a half. If inventories simply stabilized in a single quarter, it would add 4 percentage points to growth in that quarter. Alternatively, if inventories stabilized over the course of the next four quarters, it would add 1 percentage point to the growth rate over this period.

The flip side of inventory accumulation is the trade deficit. A large portion of U.S. inventories consists of imported goods. At least 50 percent of the growth implied by inventory accumulation is offset by higher imports. Therefore, the potential growth from a turnaround in inventories is much less than it first appears. The turnaround in inventories will provide more of a boost to the United States' trading partners than to the U.S. economy. Of course, foreign growth will provide some boost to exports, but even a large boost will only have a limited impact. Exports are only 11 percent of U.S. GDP. Even a 15 percent jump in exports would only add 1.6 percentage points to GDP.

The stimulus from growing exports, however meager, may prove the most important source of growth for the U.S economy in 2010. After previous recessions, the economy has enjoyed robust growth based on a surge in home buying, residential construction and soaring car sales driven by pent-up demand in the downturn.