"The God of Economic Rationality"

It's fairly clear that there is something wrong within the construction industry of the U.S. The sum of existing and new homes for sale has just taken another leap upwards, and this should be seen as a natural warning sign that the Federal Reserve will be compelled to cut interest rates in the near future. Naturally, house prices are very close to falling year on year. At the same time, the low quality end of the lending market, the sub-prime market, has already received enough press for senators to be calling for reparations.

Meanwhile, curiously, there hasn't been a carry over into the all-important employment numbers that would naturally sanction interest rate cuts. As we have pointed out before, the U.S. Federal Reserve only really manages the economy for jobs; everything else is just a sideshow. So without a follow through into rising unemployment, the politics of interest rate reductions are all wrong for the Bernanke Fed. This is doubly true when we consider that headline inflation won't be falling until the summer months (because of the rebasing of the inflation indices).

So if jobs aren't being destroyed in the construction industry, are they being transferred or recreated elsewhere? There is some evidence that they are. If you look at the structure of the U.S. construction industry, then the lions-share (over 50%) goes on residential construction, the very area that is being worst affected at the moment. However, the reality is that the total spend peaked back in July 2005 (see first illustration). At the same time the amount of money being spent on residential construction has declined from about 57% of total construction expenditure to just 50% in February this year.

Miraculously, since the peak of the cycle there has been a transfer of construction expenditure from residential expenditure to things like schools, medical facilities and roads which has actually stabilised the total expenditure at a time when the residential area has been going to hell in a hand cart (see second illustration which shows the transfer of from residential to other parts of the economy). No wonder unemployment hasn't risen, the workforce has just moved to where the money and work are.

The god of natural economic forces and rational expectations is worshipped no more vigorously than in the U.S. Yet, even when we allow for this, this is a remarkable piece of timing by all involved, and it explains why there hasn't been a transfer of problems from the residential construction market into generalised unemployment.  

What's more important though, is the composition of this transfer. All of the things that are gaining expenditure are the areas that aren't necessarily tied to the economic cycle. If we restate the second illustration to show the split of this new expenditure, the areas that are picking up the slack can be seen; education, healthcare and infrastructure are all things that are not tied to the economic cycle, and as such, market expectations that interest rates are going to fall in the near future look somewhat overdone.

There is another consequence of this observation. A lot of emphasis for the 'coming chaos' that comes from sub-prime lending depends upon a localised phenomenon spreading to the generality. This only really occurs when 'can't pay, won't pay' is sponsored by the fact that individuals and families don't have jobs. Clearly, on this evidence, the U.S. economy is someway off generalised chaos. There may be things for the financial system to cope with, such as delinquencies and isolated repossessions, but the vast majority of people may well be unaware of this and quietly go about their day-to-day lives. All the while, the Bernanke Fed will mostly likely keep interest rates on hold.