JUL 14, 2016
STEFAN GERLACH @ Project Syndicate
ZURICH – After having endured the collapse of its housing market less than a decade ago, Ireland has lately been experiencing a blistering recovery in prices, which already have risen in Dublin by some 50% from the trough in 2010. Is Ireland setting itself up for another devastating crash?
It’s no secret that the collapse of asset bubbles carries massive financial and social costs. With construction activity and investment spending grinding to a halt, sharp recessions – which cause tax revenues to fall, even as surging unemployment demands increased social spending – are unavoidable. Taxpayers may even be asked to shore up financial institutions’ capital base. The last time that happened in Ireland, it cost more than €60 billion ($67 billion), or about 40% of GDP.
Housing bubbles are not difficult to spot; on the contrary, they typically make headlines long before they pop. Yet they are far from rare. Bubbles in Ireland, Spain, the United Kingdom, and the United States collapsed after the financial crisis that erupted in 2008. After the Asian financial crisis erupted in 1997, property prices in Hong Kong, Indonesia, Malaysia, Philippines, South Korea, and Thailand sank by 20-60%. And a decade earlier, Sweden, Norway, and Finland experienced property-price declines of 30-50%.
The obvious question is why nobody stepped in before it was too late. The answer is simple: while the bubbles are inflating, many people benefit. With the construction sector thriving, unemployment falling, and banks lending freely, people are happy – and politicians like it that way.
The process is simple. Rising prices trigger a surge in building activity, which creates job opportunities for young, low-skill workers, whose employment options are otherwise limited, and generates large profits for property developers and builders. In fact, a telltale sign of a bubble is that second-rate developers suddenly are able to earn billions.
Banks’ profits rise too, because there is plenty of demand for mortgage lending, which is viewed as almost risk-free. After all, steadily rising property prices mean that, if a borrower defaults, the property can be resold at a profit. (The inevitable market correction remains too remote to be taken seriously at the height of the boom.) Taking advantage of this lending, ordinary people, from taxi drivers to hairdressers, can become millionaires by playing the market on the side.
All of this benefits elected leaders, who win the support of voters who feel wealthier, the formerly unemployed who find jobs, and the homeowners whose houses are rising in value. Endearing politicians to voters further are new spending increases and tax cuts that can be undertaken, as accelerating economic growth causes the debt-to-GDP ratio to fall.
Because bubbles tend to inflate gradually over a number of years before their abrupt collapse, letting them run a little further seems politically astute. No one wants to be the one to stop the party – especially if their job is at stake.
But the partygoers of the private sector cannot be counted on to stop themselves. In particular, banks, for which maintaining market share is crucial, cannot be expected to constrain risky lending, especially given the expectation that, if things do go wrong, the taxpayers will fund a bailout.
This leaves only the financial regulator or the central bank, which can use macroprudential tools – such as loan-to-value and debt-to-income ratios on new mortgage lending – to limit the deterioration of banks’ balance sheets during boom times. But this approach isn’t perfect, either, because the risky borrowers to whom lending is restricted tend to be first-time or low-income buyers.
This may not be a problem in countries with well-developed housing markets, where there are plenty of rental properties available from professional landlords. After all, in such markets, renters can find housing with security of tenure at price levels that are predictable, even as they evolve gradually over time according to market conditions, thereby ensuring that landlords have incentives to maintain the properties.
But in countries where rental markets are small and function poorly – often a result of a widely held belief that all families should own their homes – financial stability and access to mortgage financing are closely linked. By limiting the riskiest borrowers’ access to finance, rules on mortgage lending can trigger a fierce political backlash.
Ireland is a case in point. In January 2015, the central bank sought to protect financial institutions from another catastrophic bubble by restricting their lending to high-risk borrowers. As a result, annual growth in property prices fell from a little over 20% to just below 5%. But the construction industry, worried about its profits, has been harshly critical of the rules, as have ordinary people who have been denied credit, and thus must struggle to find suitable housing in a small rental market. Politicians, no surprise, have jumped on the bandwagon, to capitalize on the popular mood.
As the pressure on Irish regulators to relax lending rules intensifies, so do concerns that they will succumb to it. One hopes that they will continue to resist. Would-be borrowers do indeed face genuine challenges as a result of these regulations; but that is nothing compared to the pain that a collapsing bubble would cause.
In any case, Ireland’s experience with housing bubbles carries a deeper lesson – one that virtually everyone has missed. A housing system that can so easily produce such large and damaging bubbles is fundamentally flawed. While restrictions on lending may be useful, they are not enough to bring about an efficient and stable housing system.
Many in Ireland might find that conclusion overly pessimistic. Maybe they are simply hoping that, this time, the luck of the Irish will hold. Perhaps it will, and this time really is different. But there isn’t much evidence of that.