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Housing and the “R” Word


Daniel L. Thornton
Tuesday, July 1, 2008

There has been considerable discussion of the possibility that the economy could be heading toward recession-a sustained period (typically, two quarters or longer) of negative growth in real GDP (gross domestic product)-because of ongoing troubles in the housing market. The decline in housing alone is unlikely to cause a recession. Any recessionary effect of housing on the economy will be a consequence of the indirect effects that housing has on aggregate spending, primarily consumer spending.

Real GDP is a measure of the economy's current production. Sales of existing houses have no impact on current production because these houses were produced sometime in the past. The direct effect of housing on current economic growth comes through the residential investment component of GDP, such as current construction of single- and multi-family housing, for example.

Residential investment accounts for only about 5 percent of GDP, however. Consequently, the effect of residential investment on economic growth is relatively modest. This is illustrated in the adjoining figure, which shows quarterly GDP growth with and without residential investment (left-hand scale) and the quarterly growth rate of residential investment (right-hand scale) over the period 1970Q1 through 2007Q4. The figure shows that the direct effect of changes in residential investment on economic growth is small. For example, the difference in growth of real economic activity including or excluding residential investment since mid-2005 is very small despite the large negative growth of residential investment. Very large changes in the growth of residential investment have a modest effect on economic growth.

Since residential investment peaked in the fourth quarter of 2005, its decline has reduced growth of real GDP by an average of about 0.88 percentage points. This decline has largely been offset by nonresidential investment, which has continued to grow at a brisk pace.

If the troubles in the housing industry are to cause a recession, it will have to be because of the effect of housing on consumer spending. Consumers base their spending decisions not only on their current income, but also on their wealth. An increase in wealth, with other things the same, should induce consumers to spend more of their current income. Hence, a decline in wealth could generate a decline in consumer spending. For many people, the net worth of their home is the single most important source of wealth. Consequently, a decline in home prices makes people less wealthy and may cause them to consume less. Because consumption accounts for about 70 percent of GDP, even relatively small changes in consumer spending can have a relatively large effect on output growth.

Wealth effects are difficult to identify and measure. Consequently, how large a wealth effect housing has on output growth due to consumption is difficult to say. The wealth effect associated with changes in equity values appears to be weak. Evidence of a wealth effect associated with housing wealth is stronger, however. This suggests that the recent and continuing turmoil in the housing industry may adversely affect economic growth.[1] Growth of real consumption expenditures slowed somewhat in 2007 from its average pace of more than 3 percent over the period 2003-2006. The extent to which this represents a wealth effect of housing on consumer spending is unclear.



  1. See “Comparing Wealth Effects: The Stock Market vs. the Housing Market,” Karl E. Case, John M. Quigley and Robert X. Shiller, Advances in Macroeconomics, 2005, 5(1), pp. 1-34. [back to text]