All Commentary
Sunday, June 1, 2008

Construction Boom and Bust Between the World Wars

The Recent Housing Bubble Had a Spectacular Predecessor

Imagine a story about collapse of the real-estate markets that states: “Most of the millions piled up in paper profits had melted away, many of the millions sunk in developments had been sunk for good and all, the vast inverted pyramid of credit had toppled to earth, and the lesson of the economic falsity of a scheme of land values based upon grandiose plans, preposterous expectations, and hot air had been taught in a long agony of deflation.”

A story written in 2008? No, an extract from Frederick Lewis Allen’s 1931 book Only Yesterday. The real-estate boom and bust we are now experiencing had a spectacular predecessor during the 1920s and 1930s. History may not repeat itself exactly, but episodes composed of speculative mania, construction boom, financial misfeasance and malfeasance, and expansive monetary policy do recur from time to time.

When World War I ended, private construction activity, which had been substantially displaced in 1917 and 1918, resumed at a healthy pace. Even during the brief depression of 1920–21, construction did not decline greatly, and as the economy recovered, building activity grew smartly, approximately doubling between 1921 and 1925. During the second half of the 1920s, construction remained on a high plateau, though falling slightly after a peak in 1926, and gross private construction spending amounted to 62 percent of gross private domestic investment, on average.

Real-estate booms occurred in many parts of the country, affecting both residential and commercial construction. Skyscrapers sprang up in the downtown areas of many of the largest cities, and huge suburban developments appeared, catering to the rising middle class, whose members now possessed automobiles for commuting to work in the cities.

None of this activity could match the mania that propelled the development of properties in Florida. In the summer and autumn of 1925, wrote Allen, Miami “had become one frenzied real-estate exchange. There were said to be 2,000 real-estate offices and 25,000 agents marketing house-lots or acreage. . . . The warm air vibrated with the clatter of riveters, for the steel skeletons of skyscrapers were rising to give Miami a sky-line appropriate to its metropolitan destiny. . . . [T]he public utilities of the city were trying desperately to meet the suddenly multiplied demand for electricity and gas and telephone service.”

People’s wildest dreams were coming true. “Everybody was making money on land, prices were climbing to incredible heights, and those who came to scoff remained to speculate. . . . The whole strip of coast line from Palm Beach southward was being developed into an American Riviera. . . . The fever had spread to Tampa, Sarasota, St. Petersburg, and other cities and towns” on the state’s west coast. Millions of dollars were being made almost overnight.

In 1926 the frenzy of the preceding two or three years began to cool noticeably. Then, in September, a hurricane focused its fury on the Miami area, killing about 400 people, injuring more than 6,000, and leaving 50,000 people homeless. At this point, the bloom was definitely off the Florida real-estate rose.

By 1927 Florida presented a desolate scene. Henry S. Villard described his approach to Miami by road: “Dead subdivisions line the highway, their pompous names half-obliterated on crumbling stucco gates. Lonely white-way lights stand guard over miles of cement sidewalks, where grass and palmetto take the place of homes that were to be. . . . Whole sections of outlying subdivisions are composed of unoccupied houses, past which one speeds on broad thoroughfares as if traversing a city in the grip of death.”

Elsewhere the ascent was not so breathtaking, nor the descent so devastating. Yet many parts of the country experienced a similar boom and bust. By 1929, for the country as a whole, real spending for gross private new construction was already down 17 percent from its peak in 1926, but the bulk of the collapse was still to come—by 1933, real construction spending had fallen 84 percent from the peak.

Alexander Field notes that “[r]esidential construction alone exceeded 8 percent of the GNP in each of the four years from 1924 to 1927, and the subsequent downturn was severe. Real spending on new private nonfarm housing fell 89 percent from its peak in 1926 to the trough in 1933.”

Spending for private nonfarm commercial and industrial construction took a similar beating, falling in real value by 79 percent from its peak in 1929 to its trough in 1933. Allen wrote that “by the time the splendid shining tower of the Empire State Building stood clear of scaffolding [in 1931] there were apple salesmen shivering on the curbstone below. . . . [A]nd financiers were shaking their heads over the precarious condition of many realty investments in New York.” Financiers in Chicago, San Francisco, and many other large cities across the country took a similar beating.

The construction boom of the 1920s consumed a great sum of loanable funds. Development corporations issued real-estate bonds secured by new structures they were building—forerunners of the recently issued, and now infamous, mortgage-backed securities at the heart of the current troubles in financial markets. Nonfarm residential mortgage debt increased from $9.4 billion in 1920, to $18.4 billion in 1925, and $30.2 billion in 1930. Such vast increases in lending could take place only if a permissive monetary policy created accommodative conditions.

The Federal Reserve banks created such conditions, in part because their managers hoped that a “regime of cheap money,” as British economist Lionel Robbins described it, would ease the way for Great Britain to resume convertibility of the pound sterling in 1925 at its pre-war value relative to the dollar. This U.S. policy caused the money supply to grow faster than it otherwise would have grown, especially during the middle years of the 1920s, kept interest rates lower than they otherwise would have been, and thereby encouraged domestic investors to make more investments in structures and other long-lived, “higher-order” goods than they otherwise would have made.

Thus U.S. monetary policies had the effect of bringing about “malinvestments” in the United States and thereby distorting the structure of the capital stock in an unsustainable fashion because investments in structures and other long-lived capital goods will prove economically unwarranted when they are made in response to artificially low interest rates. Such projects ultimately will go bankrupt—as a great many did during the late 1920s and early 1930s, most visibly in the aftermath of the Florida boom.

Construction did not recover much in the 1930s. Despite some recovery in the latter half of the decade, the average real value of private construction during those years was less than 40 percent as great as it had been in the latter half of the 1920s, and investment in structures accounted for a substantially smaller fraction of total private investment, as investors, fearful for the security of their property rights under the New Deal, held back from making large long-term commitments. Only in the late 1940s, after the war had ended, were comparable amounts finally spent again for private construction.