Why falling house prices will pull at employment (not the other way around)

Why a housing downturn would hurt employment

This is a topic I discuss often on this lowly blog.  It’s a source of confusion for many people as most see employment as buoying house prices, not the other way around.  I take a decidedly different view on this.  The argument typically runs along the lines of, “house prices won’t fall until there’s a fall in unemployment”.  Let me suggest that one of the problems with credit bubbles is that they mask the true employment picture, which becomes clear as day the moment the credit binge dries up.

The reality is that it is rising house prices that have created a great deal of employment gains over the past half decade.  A drop in house prices and the accompanying withering of housing starts and resales will significantly pull at employment numbers in Canada.  The connection between real estate prices and employment in our current economy is a significant and under-appreciated one.  Rising real estate prices create jobs in several ways.  Of course the flip side of that statement is also true…..falling real estate prices destroy jobs.  How exactly?

1)  Rising home prices create additional demand for new construction.

Rising home prices create demand for more homes, both new and existing…..oddly enough.  Falling home prices and sales tend to be correlated with lower housing starts.  While it would make sense that periods of falling asset prices would be met by more buying activity, Bob Farrell reminds us that few people buy as prices are depressed while most pile in close to the peak.

CMHC has calculated that the construction of 10,000 homes in Canada creates over 19,000 jobs across all sectors, with 46% being created outside the residential construction sector.   With housing starts averaging 200,000 annualized over the past decade, this has been a huge driver of employment growth in Canada.  The construction industry currently employs some 1.3 million Canadians and has significantly outpaced job growth in the rest of the economy.

As the US experience has shown us, when house prices and housing starts fall, employment follows.

Furthermore, MLS resales created over 200,000 additional positions in 2008 alone according to the same CMHC report.  It’s hard to see how this area will not come under pressure as new mortgage rules, eroding affordability, and a dwindling buyer pool will weigh on sales.

2)  Home renovations have a surprising impact on employment

The same CMHC report indicates that, “Residential renovation activity between 2006 and 2009 generated annually over 250,000 jobs in the construction industry and over 210,000 indirect jobs in other  industries.”  That’s not small potatoes.

In fact, home renovations (spurred on by house porn on HGTV) has risen from a long-term trend line of less than 2% of total GDP to 2.8% of GDP in 2010.  This is not an insignificant rise as the correlation with construction sector job growth is very strong.

Furthermore, this can be seen in the total dollar volume of renovation expenditures, which have risen at an 11% annualized rate since 2000.

The bulk of these renovations are not for needed repairs or maintenance, but overwhelmingly to update, add value, or prepare to sell (68%).

This can further be seen in the types of renovations that are most popular:

How did most households pay for these renovations?  According to a recent CAAMP report, 43% of people who have tapped into their home equity have done so to complete a major home renovation.   Now this doesn’t tell us how many paid for their home renovation from savings, but it should be evident that HELOC extraction is a significant source of funding for home renovations.  We know that lines of credit are the fastest growing form of debt, now accounting for 12% of total consumer debt outstanding.

Yet we also know that HELOC growth very closely parallels house price appreciation.  This is the US experience.  Can you find the peak in their real estate market?

On this very topic, Scotia made the following observations in a report released just today:

Looking ahead, the economic and financial landscape is becoming less conducive to continued strong expansion in renovation spending. This includes moderating home sales and prices, a leveling off in homeownership rates, high household debt loads, rising interest rates, and more stringent mortgage refinancing rules in effect since April 2010.

Indeed, should a protracted real estate slump occur, as I predict, it will have significant repercussions on home equity withdrawals and renovations, and by extension it will weigh on employment.

3)  Consumer spending will slow as the wealth effect goes into reverse

The wealth effect created by rising real estate prices is well documented.  In a 2006 paper, Michael R. Donihue and Andriy Avramenko described the increase in consumer spending associated with residential real estate appreciation:

“Real estate wealth is shown to have a positive effect on long-run consumption; at 6 cents per dollar, the marginal propensity to consume associated with real estate wealth is larger than the 4 cents per dollar associated with liquid stock market assets.”(p.16)

David Rosenberg, chief strategist at Toronto based Gluskin Sheff and Associates calculated that every dollar increase in Canadian housing wealth translates to 7 to 9 cents of incremental spending in the GDP accounts.

A 2008 Bank of Canada paper described the dynamics of house price wealth effect:

Movements in house prices can affect consumer spending in two ways: through a direct wealth effect…or through a collateral effect, by allowing greater access to credit. …Households perceive their houses as wealth, and base their spending decisions in part on movements in net wealth positions.

As well, if access to credit for some consumers is contingent on their housing wealth or equity, these credit-constrained households will be able to borrow and spend more, based on an increase in the collateral value of their homes.

There’s little debate that rising house prices fuel consumer spending.  Depending on the measure of GDP, consumer spending accounts for between 58 and 65% of economic activity in Canada, up markedly in the past two decades.  The question remains, what happens to this spending in the event of a housing market correction?

In a report earlier this year, CIBC calculated that, “Even a modest 5% additional drop in average price in 2011…will lead to a negative wealth effect of $10 bn, stripping growth in consumer spending by more than a full percentage point.”

For those more visually-oriented readers, Scotia prepared this lovely graph for us.  Note the strong directional correlation between house prices, consumer spending, and employment.

The same scenario played out in the US as consumers retrenched amid falling house prices.  Consumption declined, pulling employment with it:


Many economists have suggested that we will not see significant pressure on house prices until unemployment rises.  I’m not so convinced.  As I’ve noted before, I believe that this line of thinking has put the cart before the horse and has significantly under-appreciated the role that Canada’s credit bubble has had in buoying employment.

The question remains, what then might cause the housing market to correct.  I’ve suggested several possibilities ranging from a realignment of consumer expectations to a shift in mass psychology to demographics to credit-induced deflation.  The fact remains that asset bubbles pop under their own instability……they don’t necessarily need rising unemployment to cause a realignment.  Indeed, if history is a guide, the unemployment better serves as a lagging rather than leading indicator of house price weakness.




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11 Responses to Why falling house prices will pull at employment (not the other way around)

  1. TS says:

    An economy based on the wealth effect and debt,whether it be the housing market or the stock market. This is a result of Banking Institutions merging with Investment Banks. We had more stability when the two institutions were kept seperate. The investment banking thinking is based on short term profits. Lots of people gambling now a days. I understand some people are even using there own money. What a novel concept!

  2. Dmitri says:

    I think that either scenario is plausible. In fact I think that the opposite is likely to happen (i.e. weakening of employment drags housing down). There are a few reasons for this.
    1. Price of Oil (consumer gets squeezed and some of the ‘nice to have’ things drop in demand.
    2. Price of food (see above)
    3. China slows down => demand for commodities drops.
    4. High CAD => demand for exports drops.
    5. Low interest rates (we need something on a border of 7% after the inflation to have capital formation for future investments => job creation)
    6. Housing market becomes saturated => no need for construction crew.
    7. Consumers become exhausted (credit wise).

    I don’t see how any of these will have a direct effect on the housing market other then through the employment as a proxy.

    • ATP says:

      Agreed. I think it’s important to understand factors that influence the public’s (esp. RE investors) PERCEPTION of how the economy is doing. In this regard, headline unemployment rate is seen by a lot of people as the barometer and thus constitutes an important basis behind their optimism or pessimism.

  3. jesse says:

    In past recessions it could be argued that rising unemployment causes lower house prices because house prices used to be more sensitive to cash flows. These days that relationship has been partially broken as assets are in a bubble.

    Dusting off the old “infrastructure spending” playbook and dumping money into an asset class that was already inflated has likely turned out to be a bad move. Canada is now at significant risk of being caught 180 degrees out of phase with prevailing interest rates.

  4. Out_sider says:

    The experience in Iceland was a huge rise in employment during the bubble, unemployment rates were below 2% (as a matter of fact Iceland had almost no unemployment for decades). But during the bubble, lots of immigrants arrived to Iceland, mostly people for the building industry. In short, the day the housing bubble busted, there was 8% unemployment and rizing. Now it’s 7% but mind you, thousandsa of those immigrants (from Eastern-Europe mostly) have returned to their home countries. Couple of thousand Icelandic families have also moved to Norway and other neithbouring countries (few to Canada though because of complicated immigration laws).
    So, short, then the housing marked slows (or collapese), huge problems with unemployment and ….actually have you looked at the depts of the companies? Havent the companies also invested heavily in new and better housing? Their going to collapse also if they have high depts.

  5. Vince says:

    Excellent piece Ben! i especially liked the chart showing the trends in construction and manufacturing jobs. Funny thing with our manufacturing is that I wonder what portion of it is tied to housing?

    Spoke to a few real estate agents over the past few days. The second half of Feb, which should have been more active than the first, fell substantially. Don’t know how much is weather related, but could be the start of something.

    • Jordan says:

      The stats from the major RE boards will be out today (or within the next couple of days) so it’ll be very interesting to see what the numbers look like.

  6. jesse says:

    Leith Van Olsen highlights analysis on China’s prospects: http://macrobusiness.com.au/2011/03/puru-saxena-on-china-commodities-and-australia/

    Why is this relevant? Note how he cites housing prices to GDP ratios as a key statistic. A ratio of 350% currently exists in China, close to Japan’s peak 22 years ago. Where does Canada stack up using this ratio?

  7. Howdy There says:

    Two thoughts.

    1) The wealth effect shouldn’t exist. It’s a shame the financial industry tricked people into focussing on the wrong side of the balance sheet. They want us to look at the asset side, and a house certainly is asset. It has value by providing shelter. But the liability is more important. It’s the part you pay interest on. I propose a new definition for the wealth effect: ‘The effect on bank profits and executive compensation from people voluntarily sending them greater amounts of money through interest payments.’

    2) With regards to which is the horse and which is the cart (employment & housing prices), they are self reinforcing. House prices falling will cause greater unemployment, which will in turn put pressure on housing prices, which in turn will put pressure on employment…..

    You can replace ‘housing prices’ in the para above with ‘car sales’, ‘retail activity’, ‘demand for services’, etc. It’s called a deflationary spiral and it can spread across the economy. A big part of it is the psychological effect. You don’t have to lose your job to cut back on spending, you only have to witness coworkers, neighbours, friends and relatives getting laid off to decide to cut back. The money you don’t spend isn’t income for the next guy, who in turn is forced to cut back and so on.

  8. Brian says:

    Well, you’ve certainly convinced me Ben!

    Well all the economic activity involved in the real estate industry, there’s no question that house prices, consumer spending and employment in construction and trades are all positively correlated. I’m not sure which one if any is a leading indicator.

    But if we can learn anything from south of the boarder, falling house prices will begin with slowing sales, and increasing inventories.

  9. Norm says:

    Great post. Thanks!

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