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Why the bright spot in housing won't save the economy

July 19, 2012: 10:34 AM ET

Since the 1970s, housing rebounds have served as reliable signs of brightening economic prospects. Not this time around.

FORTUNE – As economic recessions go, it was widely believed that once the housing market recovered, new construction, home sales, and the like would drive growth across the broader economy. This happened in the U.S. during economic downturns in the 1970s, 80s, and 90s.

This time around, don't hold your breath. "The recovery is going to work in reverse," says Paul Edelstein, financial economics director at IHS Global Insight. "The rest of the economy is going to have to pick up before housing does."

Over the last few months, the U.S. housing market, though still fragile, has outperformed expectations: Home prices have risen; spending on home construction and home improvements has picked up; in July, home builders' confidence took its biggest jump in nearly a decade, according to the National Association of Homebuilders.

Following most previous recessions, a rebound in the housing market signaled stronger economic growth ahead. Admittedly, home construction makes up only roughly 2% of the nation's economy, but it has typically been among the first sectors to pick up following a recession. An average of roughly 50 jobs are created for every home that goes up, says Edelstein, adding that construction stimulates other industries, from lumber to metals to retail.

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But as Federal Reserve Chairman Ben Bernanke testified before Congress this week, the economy hasn't gotten any better. And it likely won't for a while, even if the housing market shows signs of a turnaround.

In his second day of testimony to Congress on Wednesday, Bernanke reiterated the central bank's plans to keep its key short-term interest rate near zero until at least late 2014. This follows the Fed's move earlier this month in downgrading its economic outlook, as Europe's ongoing debt crisis rattles markets and a series of tax hikes and budget cuts set to kick in next year threaten to send the U.S. economy back into a recession. The Fed now expects growth of just 1.9% to 2.4%, half a percentage point lower than its April forecast.

Indeed, things look gloomy. And there are a few reasons that may explain why what some are calling an improving housing market isn't likely to translate into stronger economic growth.

For one, residential construction has picked up, but the vast majority of Americans are renting more than buying. In June, housing starts rose by 23.6% to an annual rate of 760,000 units over the same month the previous year, according to the U.S. Commerce Department. Barclays analysts called the increase a "post-crisis high" and the highest level since October 2008. Though a bulk of the increase reflects single-family homes, construction of multi-family units has consistently risen over the past year-and-a-half as more people rent rather than buy, according to Barclays.

Edelstein says this is significant because unlike homebuyers who view their purchase as not only a place to live but also an investment, renters don't exactly feel any richer when they sign a lease. So renting doesn't generate as large of a wealth effect. It remains to be seen if construction of single-family homes continues its upward trend.

And while home sales have picked up during the past year before existing home purchases fell to an eight-month low in June from May, that doesn't necessarily signal that the average consumer is feeling any better about the economy. Investors, particularly foreign buyers, motivated by the boom in the rental market, have been buying up distressed homes at bargain prices. It's unclear to what extent investors could support the housing recovery, as tight credit standards have continued to block regular would-be buyers from taking advantage of one of the cheapest times to buy.

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Perhaps it's really not that surprising that any rebound in the housing market won't be enough to drive America's economic recovery. After all, as Harvard professors Carmen Reinhart and Kenneth Rogoff argue, economies that have undergone systemic financial crises take much longer to heal than economies responding to normal recessions.

Perhaps we shouldn't read too much into recent news that the housing industry is doing better.

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About This Author
Nin-Hai Tseng
Nin-Hai Tseng
Writer, Fortune

Nin-Hai Tseng covers economics and finance. Before joining Fortune, Tseng was a reporter at The Orlando Sentinel and a public affairs associate at GE. She holds an MPA from Columbia University and a BS in Journalism from the University of Florida. She lives in New York City.

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