Whilst investment spending on both dwellings and other buildings has been quite volatile over the whole period, it is particularly volatile for dwellings. Furthermore, if you compare the level of spending on these two related assets with the periods of recession shown in the first diagram, you'll notice that it is spending levels on dwellings that are most closely correlated with the business cycle.
This is quite surprising, and not consistent with the Keynesian macroeconomic model of short-term demand management. Why is that? Because in periods of strong house price increases, demand is quite resistant to interest rate rises because any extra cost of mortgages is usually far exceeded by potential losses from missing out on potential property price increases in the next period.
The volatility of investment in dwellings is most clearly evident in the run up to the 2007-08 financial crisis, and its aftermath in the following years. Intuitively this makes perfect sense, because it was a housing boom with excessive bank lending for mortgages that led to the crisis. I will further investigate this in the next diagram.
Government, Consumer, and Business Investment
In the diagram above I've illustrated the breakdown of investment expenditures by sector:
- HH represents household, or consumer, investment
- GG is general government investment
- CORP is investment by business corporations.
As can be seen by the red line in the graph above, it is household investment that most closely aligns with spending on dwellings, which confirms the earlier intuition that it is the spending of regular people rather than businesses that led to the house price boom and resulting collapse in 2007-08.
This is not to put the blame on people, a competent economic reaction to the booming house price market would have delivered significantly higher interest rates before the boom even got going, but as I've explained on my page about inflation, the government does not even include housing and real estate in its estimates of inflation - much less the central bank's monetary policy.
This is one of the most inexcusable in failures of western governments, and as I've further evidenced in my article about fractional reserve banking, the housing market really has been at the heart of the economic business cycle in recent decades. Its treatment by policy-makers is akin to the treatment of Cassandra in Greek mythology i.e. always right, and always ignored.
Tobin's Q Theory of Investment
The Q Theory of Investment relates the stock market valuation of a firm to the amount of investment that the firm will engage in. Intuitively we can imagine that since a firm's stock market valuation can be higher or lower than the actual accounting value of its physical assets, the difference should matter in some way.
For example, if the stock market valuation is higher, then the firm could simply invest more in order to expand its physical size, and then sell more shares on the stock market to cover the cost of that investment. If the high stock market valuation holds then the firm should be able to raise more money from the share sale than the cost of the new investment.
The Tobin Q Ratio gives a simple estimate of the relationship between stock valuation and accounting valuation, and anytime that this ratio is above 1 should imply more investment spending.
Of course, the real world is much more complicated, and the studies that have been conducted on the Q theory of investment have not been overwhelmingly conclusive regarding its efficacy.
Other Types of Investment
The main type of investment that is not captured at all by the official figures shown here is that of human capital i.e. investment in education and skills. Some estimates regard this type of investment as being equally important to economic output, and in an increasingly complex job market it would seem likely that its importance will continue to grow in future years. For more information on this, see my article:
Whilst the main thrust of my argument on this page is that it is household investment spending in the housing market that has been the most influential driver of the business cycle in recent decades, business investment is still important, and for more information on that, have a read of my article:
Finally, the remaining type of investment that I have not discussed here is inventory investment, i.e. stocks and unsold output held by businesses, and for my thoughts on the economic impact that this sort of investment has on the business cycle, see: