Sonntag, 8. März 2009

What does a real-estate bubble mean for the standard of living?

There is a tendency to equate per-capita GDP with "standard of living". Many things can be criticized about GDP. In this post, I discuss one specific aspect that strikes me as important in the context of the various real-estate bubbles currently unwinding around the world:

One indirect result of the bubbles is the current crisis leading to a sharp contraction of GDP. Most commentators seem to think that this is the "price" for the bubble, i.e. the "economic damage" they create.

However, that's far from the complete story.

To understand why, we need to look at the components of GDP:

GDP = Consumption (this year) + Investment (this year)

Standard of living = Consumption (of goods made this year) + Consumption (of long-lived goods you made in the past)

For instance, if people say that "China grew by 10 %, whereas India grew by 8 %, therefore China performed better", this is potentially misleading. As is well known, China has one of the highest investment rates in the world. Therefore, a comparatively low percentage of GDP goes to consumption, and today's standard of living is much lower than indicated by today's GDP.

This obviously doesn't mean investment is bad: It all depends on the future results achieved by making an investment. If they are good investments, they increase future standard of living. If they are bad investments, they are (partially) wasted.

As far as GDP is concerned, there are two kinds of investments:

1. Investments in long-lived consumption goods (houses, cars)
2. Investments made to increase future production (factories, machines, human capital)

Let's look at a simple two-period model, and compare two countries with different investment rates:

Country A has a GDP of 100, consumes 50, and invests 50.
Country B has a GDP of 100, consumes 100, and invests nothing.

Obviously, present-day standard of living in country B is much higher than in country A, in spite of identical GDP.

Now let's look at period 2 (as everything is assumed to end after period 2, there is no more investing going on; but obviously we could extend the model to as many periods as we like):

a) Country A invested wisely in consumer goods

Period 2 GDP is still 100. Consumption is now 150 (incl. 50 carried over via long-lived consumer goods from period 1). Standard of living is now much higher in country A than in country B, which still consumes 100.

So both countries had the same GDP in both periods, and the same overall standard-of-living (but spread differently over time).

b) Country A invested wisely in productivity increases

Period 2 GDP is higher due to higher productivity, let's say it is 150. So the result is the same as before: Country A consumed less in period 1, but is rewarded by higher consumption in period 2.

In this case, country A has a much higher GDP in period 2 compared to country B. But its people are not better off (nor are they worse off): Total consumption over two periods was identical, but spread differently over time.

c) Country A invested badly

Now let's assume country A didn't invest wisely. Instead, half of the investment went into real estate that nobody needs. The other half went into productive investments that increased period 2 GDP. What does that mean for standard of living?

- Year 1 GDP and consumption are unaffected
- Year 2 GDP and consumption are both 125
- Total consumption over both periods is 175

In other words: Country A sacrificed standard-of-living in year 1, but did not achieve the hoped-for increase living standard in year 2. In comparison, country B achieved aggregated consumption of 200, i.e. was better off.

Now you might say: Isn't that totally obvious? Well, yes.

But the thing is: You don't see it in GDP figures.

Even if Country A's real estate investments turned out to be totally useless, GDP would still be the same as Country B's GDP, even though average standard-of-living is lower due to the wasted investments.

In the example, country A had a higher GDP (100+125=225) compared to country B (100+100=200), even though standard of living in country A (50+125=175) was lower than in country B (100+100=200).

That's the thing about overinvesting:

Investments in productive capacity increase future GDP even if their return is negative (GDP is gross of amortization, i.e. unless the investments are 100% wasted, GDP will go up as result of investing).

Investments in long-lived consumer goods leave future GDP growth unchanged, but they may reduce present-day standard-of-living more than they increase future standard-of-living (if houses are built that nobody lives in, this has no effect on future GDP and future standard-of-living, and it has no effect on today's GDP either. But it does decrease today's standard-of-living, because the work that went into erecting useless buildings could have been used for today's consumption instead).


It's highly misleading to assess the economic impact of real estate bubbles by only looking at the subsequent economic crisis (i.e. drop in GDP). While the subsequent adjustment crisis is certainly a part of the story, it is far from the only one.


Of course it's open to debate how much of the real estate stock built in the US, China and Spain is really "useless". People have talked about excessive Chinese real estate investments for at least the last two decades (I remember a newspaper article from 10 years or so ago that called Pudong a "Potemkin village of empty office towers"), but as it turned out, most of those buildings did fill up eventually. The same thing can be said about US residential housing: There may be a lot of overbuilding and a painful adjustment process, but most of those houses will eventually find some sort of productive use. At least I hope so...


  1. I cannot follow u in this statement:
    Country A has a GDP of 100, consumes 50, and invests 50.
    Country B has a GDP of 100, consumes 100, and invests nothing.

    Obviously, present-day standard of living in country A is much higher than in country B, in spite of identical GDP.

    For me it is not so obvious that if I can spend 100% of my income in consumption (B) I have a worse present-day standard of living of somebody who consumes only half as much and invests the rest in boring factories (A).
    For me the opposite is more obvious!

  2. Indeed. I mixed up "A" and "B" in the text. I had meant to say that standard of living in country B is higher, because it consumes more.

    Thanks for pointing it out, I'm editing the post to correct the mistake.