The Decline in Construction Employment, Infrastructure Investment and the Davis Bacon Act

Reihan Salam has a smart piece in National Review Online and provides some good insights about how the construction sector is changing and why construction employment has not rebounded as it has in prior recoveries.  He notes that modular construction and technological change is likely to change the labor intensity of construction projects.  So even when construction activity rebounds, construction employment may never regain the share of total employment it reached during the housing boom of a decade ago.  Salam is correct; trends in construction employment may begin to look a bit more like manufacturing.  In U.S. manufacturing it has been quite common to see output increase despite stagnant or even declining employment because of technological change.

Salam writes that construction projects in the U.S are often inefficient and I agree, especially when it comes to infrastructure investments.  The federal regulations make public sector projects far too expensive to taxpayers even at a time when a record downturn in construction employment should mean much lower costs.  The federal government has not taken enough advantage of the considerable slack in construction employment to build and repair infrastructure.

By law, federal government projects must pay the prevailing wages of construction workers, and these wages are often union scale.  This regulation, known as the Davis Bacon Act, has artificially inflated the price of construction labor on public sector projects.  Even in states and counties  where construction employment has been depressed for the past five years, government contractors are sometimes required to pay wages in construction trades that exceed the average in the area by at least $10 per hour.

Davis Bacon wages do not rely on carefully designed samples of workers, such as the Bureau of Labor Statistics (BLS) Occupation Employment Statistics (OES) Survey to determine the wage distribution in construction trades in a local area.  Instead, Davis Bacon wages are determined in the Labor Department’s Wage and Hour Division which over-samples unions and obtains much higher construction wage estimates.  Only 6.6% of private sector workers are union members so the special treatment of unions in Wage and Hour Division surveys leads to unrepresentative prevailing wage estimates.

As an example consider Riverside County, California where the unemployment rate in July was 11.1%.  The most recent OES survey reports that the average wage for a carpenter is $27.25 per hour and 75% of carpenters earn $36.39 per hour or less in Riverside.  Yet the Davis Bacon Act mandates that federal contractors pay at least $48.43 per hour to carpenters in Riverside, in wages plus fringe benefits, on government construction projects.  The Davis Bacon prevailing wage for carpenters is $37.35 per hour and prevailing fringe benefits are $11.08 per hour.  (The BLS National Compensation Survey reports that the average cost of fringe benefits is $10.52 per hour nationwide.)  Similarly inflated compensation is required for brick masons, electricians, plumbers and equipment operators.

Although reasonable economists can disagree about the level of public spending on infrastructure, ideally we should make more public investments in infrastructure during a downturn when opportunity costs are lower.  The Davis Bacon Act interferes with such a common sense policy.  Conservatives should have proposed a repeal of Davis Bacon in the waning months of the Bush Administration or early in the Obama Administration as a way to more efficiently utilize slack resources during the recession.

Requiring taxpayers to pay inflated prices to construction labor makes as much sense as paying inflated interest rates to government bondholders even though market interest rates have declined.  The federal government currently pays lower interest rates on government debt because it pays market rates on new debt issues.  Fortunately there is no equivalent to the Davis Bacon Act requiring that the federal government pay inflated non-market interest rates to protect retirees and pension funds that hold government bonds.  It is time to change the law so that taxpayers can also pay market wages on construction projects.

2.8 Million Construction Jobs Are Missing

In Saturday’s Wall Street Journal Timothy Aeppel wrote an interesting article noting that manufacturing employment has recovered only 22% of the nearly 2.3 million jobs lost during the 2008-2009 recession.  While this is true the U.S. economy and labor market can flourish despite declining manufacturing employment.  In fact, declining manufacturing employment has been the norm in the U.S. for decades.  Manufacturing employment peaked at 19.5 million jobs in 1979.  Since then the manufacturing sector has lost 7.5 million jobs as 53 million jobs were created outside the manufacturing sector.

The decline in construction employment over the past five and a half years, however, is troubling and atypical of recent economic recoveries.  Normally investment in residential housing by households and structures by businesses increases rapidly in recoveries as these investments were deferred and delayed during the recession.  A comparison of the pattern of construction employment in this recession and recovery to comparable periods during and after the 1981 and 2001 recessions reveals some clear patterns:

• Construction employment declined more than three times as much (26%) during the 2008-2009 recession as it did during the 1981 recession and more than 11 times as much as during the 2001 recession.
• Construction employment is about 1.7 million (22%) below its pre-recession peak five and one half years after the recession began.
• Five and one half years after the beginning of the 1981 and 2001 recessions construction employment had increased to about 15% above its pre-recession peak.

The following chart compares construction employment across the 1981, 2001 and 2008-2009 recessions normalizing employment to be 100 at the start of each recession.  The chart tracks construction employment in each recession/recovery for the subsequent five and one half years.

The magnitude of the decline in construction employment during the 2008-2009 recession was unprecedented.  The absence of a recovery in construction in employment during the subsequent recovery is also unprecedented.  Had construction employment rebounded over the past few years as it had in previous recoveries, there would be 8.6 million workers in the construction sector instead of the current total of 5.8 million construction employees.  The net difference represents a shortfall of 2.8 million jobs in the construction sector.  Construction employment remains well below the levels of six years ago because businesses are investing less in structures than they did in previous recoveries and the residential housing market has not recovered as strongly as it has in other recoveries.

The shortfall of 2.8 million construction jobs is equivalent to the difference between the current unemployment rate of 7.4% and a 5.6% rate.  Of course, if the economy were strong enough to generate an additional 2.8 million construction jobs there would also be more robust growth in income and employment in other sectors of the economy lowering the unemployment rate even further.

The sharp decline in employment in the construction sector since 2008 and the fact that only 8% of construction jobs have been regained during this economic recovery is extremely troubling.  Construction differs from manufacturing because jobs can’t easily be outsourced to foreign countries.  While manufacturing’s share of total employment has declined steadily for decades, construction’s share of total employment grew steadily for three decades from 1978 to 2008 until the sharp decline over the past five and one half years.  The following chart illustrates the sharp drop in construction employment since 2008.

In my view the continued weakness in the construction sector underscores a failed opportunity for those who advocate public investment in infrastructure.  The past five and one half years have seen an unprecedented slowdown in construction activity and employment.  Over two million construction workers lost their jobs in the deep recession and have remained displaced through a tepid recovery.  At the same time we have not chosen to re-build and repair our roads, bridges and infrastructure while there is an excess supply of construction labor and interest rates are low.  Government expenditures have been diverted from infrastructure to other programs such as a record extension of unemployment insurance benefits (over one billion weeks worth of UI benefits have been paid since 2008).

More importantly, the fact that the recession officially ended four years ago yet construction employment remains in a slump is a clear indication of the weakness of this economic recovery.  As the recovery officially enters its fifth year households are still unwilling or unable to purchase new houses and businesses lack the confidence and demand for their products to invest in offices, factories, warehouses and other facilities.  Until the construction sector rebounds because households and businesses are willing and able to invest in structures this recovery will continue to disappoint.

Lessons from Elkhart, Indiana

In the 2008 presidential campaign then-candidate Barack Obama visited Elkhart, Indiana twice.  He visited again as president in February 2009 to make the case for his $800 billion stimulus package.  President Obama came to Elkhart three times because the city was in the midst of an economic freefall and seemed to epitomize the plight of the U.S. economy in 2008-2009.  Although Elkhart’s unemployment rate was 4.6% in 2007, by March of 2009 it would reach 20.2%.  Elkhart has bounced back from the recession much better than other cities.  Its unemployment rate is now 8.3%, slightly above the national average but dramatically lower than it was just three and a half years ago.

Indiana is the most manufacturing-intensive state in the U.S. with one of six private sector workers employed in manufacturing.  In addition, over 7 out of 10 manufacturing jobs in Indiana are in the durable goods sector.  Arguably, no city in the U.S. is more dependent on the production of durable goods than Elkhart, which has been called the recreational vehicle capital of the world.  While only 6.7% of private sector jobs in the U.S. are in durable goods manufacturing in Elkhart 43.6% of private sector workers are employed in the manufacture of durable goods, with the majority of those jobs in the production of recreational vehicles and motor vehicle parts.  Elkhart has been one of the top job creating cities in the U.S. since the recession ended.  In the past three years jobs in durable goods manufacturing have increased by 42.7% in Elkhart compared to 5.6% growth in the U.S. overall.

As a durable goods manufacturing center Elkhart’s downturn and recovery looks much more like the typical pattern for a deep recession followed by a brisk recovery.  Other cities hurt most by the recession (such as Riverside, CA and Las Vegas NV) suffered collapses in their residential real estate markets and residential investment.  These cities have not yet experienced the rebound seen in Elkhart.  The following chart indicates how the unemployment rate in Elkhart spiked much above the rates in Las Vegas and Riverside but has fallen more quickly since then.

There has been much discussion about why this recovery has been so slow and so weak.  Reinhart and Rogoff relied on cross-country and historical comparisons to argue that a slow and weak recovery is to be expected after a systemic banking and financial crisis.  It is difficult, however, to make consistent cross-country comparisons of unemployment rate fluctuations because of differences in the way each country measures unemployment.  Bordo and Haubrich limit their analysis to American historical data.  They find that “general recessions associated with financial crises are generally followed by rapid recoveries.”  They also conclude that one reason for the slowness of the recovery “is the moribund nature of residential investment.”

Another way to understand the 2008-2009 downturn and the subsequent recovery is by comparing unemployment rate fluctuations across U.S. cities.  Such a comparison shows that the unemployment rate has remained stubbornly high in cities where the housing bubble burst.  Durable goods manufacturing centers like Elkhart saw a big drop in the demand for the products they produce and a large increase in unemployment during the recession.  But manufacturing-intensive cities have recovered somewhat more rapidly – more typical of previous downturns.  That gives the edge, for the time being, to the explanations provided by Bordo and Haubrich.

Real Estate and Small Business

Start-ups and new businesses are extremely important for job creation and employment growth.  The strength of the economic recovery depends on the rate of new business formation and the employment gains from these start-ups.   Real estate is the primary asset for many small businesses and the collapse of residential and commercial property values devastated their balance sheets.  Declining real estate values have also reduced the net worth of entrepreneurs and likely slowed the rate of small business creation.

The latest Federal Reserve’s Flow of Funds Report, which was released last week, indicates that real estate is a substantial component of the assets of non-corporate non-financial businesses.  In 2007, prior to the collapse of real estate property values, the market value of real estate accounted for

• 69% of the assets of non-corporate businesses
• 33% of the assets of corporate businesses

Moreover, residential real estate accounted for the majority of the real estate holdings by non-corporate businesses and 41% of all assets of these businesses.

The sharp decline in residential and commercial real estate values during the Great Recession had an enormous impact on the balance sheets of non-corporate businesses.  The plunge in real estate prices accounted for 99.9% of the decline in the value of their assets between 2007 and 2009.  The value of real estate owned by non-corporate businesses has increased since 2009, but for each $8 decline in property values there has been only $3 in gains between 2009 and the end of 2011.  The recession has taken its toll on small businesses; the asset value of all non-corporate businesses is 10% below the pre-recession level, while corporate businesses are worth more than in 2007.

The decline in real estate property values devastated the balance sheets of small businesses and probably reduced the rate of new business formation and job creation.  The latest Federal Reserve data indicates that corporate businesses are worth more than they were prior to the downturn, while non-corporate businesses have declined in value.  Real estate is the primary asset for most small and new businesses, which account for much of new job creation.  Depressed real estate values remain a drag on small businesses.  Small and new businesses will not be an engine of growth until residential and commercial real estate values recover.

Location, Location, Location

This recession, with a weak job market and declining home values, has been especially tough on the middle class.  Two of the most valuable assets of middle class households are human capital and residential housing, which are poorly diversified.  Financial investments can be spread across many securities so that losses from one investment can be mitigated by gains from others.  You can’t trade shares of ownership in your home or human capital to diversify your investment.

Housing has been a poor investment relative to equities since the end of 2006.  The most recent Case-Shiller 20-city price index indicates that home values in these cities declined by 32% over the past five years while the Standard and Poor’s 500 index declined by about 5%.  To make matters worse property values are closely related to employment and wages in a metro area.  Cities hit hard by declining property values have experienced reductions in household wealth, lower consumer spending and falling employment and income.

A simple linear regression of home values on metro area employment (from the BLS) across the 20 Case-Shiller cities indicates that each one percentage point decline in an area’s employment is associated with a 3.2% decline in home values.  This significant positive covariance is statistical evidence that buying a home in the city where you work is putting the bulk of your financial eggs in one basket.

There are 8 Case-Shiller cities that have been hit particularly hard by the recession: Atlanta, Cleveland, Detroit, Las Vegas, Los Angeles, Miami Phoenix, and Tampa.  The following figure indicates that employment fell by 9% and home values by 44% in these cities between the beginning of 2007 and the end of 2011.

There are another 8 Case-Shiller cities where the recession has been somewhat less severe: Boston, Charlotte, Dallas, Denver, New York, Portland, Seattle, and Washington, DC.  The following figure indicates that employment fell by 1.3% and home values by 18% in these cities between the beginning of 2007 and the end of 2011.

For working class households the depth of the recession depends on location, location and location.  Job losses are concentrated in cities with the biggest reductions in household wealth due to declining home values.  Our tax code, with mortgage interest deductions and capital gains exemptions for owner occupied housing, encouraged the middle class to view their home as a means of accumulating wealth.  Decades of policies encouraging investment in residential housing over diversified mutual funds made middle class households especially susceptible to the risk of a housing price bubble.

Although the labor market started to recover over the past two years it is much weaker in cities where many houses are in foreclosure.  Job creation has lagged and the labor force is shrinking in cities with distressed real estate markets.  Will the just announced $26 billion mortgage foreclosure settlement involving five of the largest mortgage servicers and 49 of 50 state attorneys general help?  Critics on the right and left are skeptical. President Obama just unveiled his proposal to offer government assistance to homeowners who are underwater on their mortgage but not in foreclosure.  Critics of this plan fear that it could sink the taxpayer backed Federal Housing Administration and delay the inevitable and necessary process of market clearing.

Regardless of how we navigate our way through the current mess serious tax reform should address the home mortgage interest deduction and capital gains taxes on home ownership.  These reforms would not just broaden the base and lower marginal tax rates they could make working class households less susceptible to the risk of future housing price bubbles.