When does a housing bubble start?

Yesterday, former Minister for Finance Charlie McCreevy appeared before the Oireachtas banking enquiry. His refusal to answer whether or not he believed Ireland suffered a property bubble that burst in 2007 was not only great TV, it also brings up some important issues. For example, the Irish Independent reports:

The conflict arose when Mr Doherty asked the former minister if he believed there had been a property bubble in the previous 15 years before the financial crisis. Mr McCreevy insisted he would only answer for his time in office and there had been no property bubble during that time… [after legal advice] Mr McCreevy said from 2003 to 2007 house prices grew at an extraordinary rate. He supposed that was a bubble. But he said: “I don’t believe the policies I pursued helped to create that bubble.”

The clear implication is that Mr McCreevy believes that, if there was any housing bubble at all, its roots do not lie in decisions made in the period 1997-2004, and that in reality there was no bubble at all. Given the title of my doctorate at Oxford was called “The Economics of Ireland’s Housing Market Bubble”, you might not be surprised to learn that I disagree.

First, I think it is important to note that there are two ways of diagnosing bubbles. They can be thought of as statistical bubbles and economic bubbles. A statistical bubble is one where the growth rate in the price of an asset, such as housing, grows at a rate that is unsustainable for any reasonable period of time. Between 1995 and 2007, house prices in Dublin increased by 300% in real terms (i.e. stripping out inflation), or 12.2% a year. Between 1997 and 2004, McCreevy’s term in office, the increase was 136%, or 13.1% a year. (Nationwide figures are comparable, although slightly lower for the period as a whole, although not necessarily in every year.) Thus, by any statisticians metric, it was a bubble – put another way, if 12% growth had continued for 25 years, a house costing €100,000 in 1995 would have cost €1.7m by 2020.

Economists like to get at causes, though, and a 10% increase due to – for example – a lack of supply has very different implications for what policymakers should do than a 10% increase due solely to first-time buyers needing a smaller deposit and thus being lent more. To economists, a bubble in asset prices is not just any old increase in prices, it’s an increase in prices due to excess capital/money. In the housing market, this means too much mortgage credit. Of course, to sustain people borrowing and lending too much, you need expectations. So the two ingredients for an economic bubble are over-optimistic expectations and excessive credit.

The graph below is, in effect, the one-chart summary of one of my D.Phil. chapters: what drove real house prices in Ireland during different market cycles (measured in changes per annum). Falling income (measure here relative to supply), pushed down house prices in the 1980s, together with higher real interest rates (a term that includes house price expectations). This reversed somewhat during the period 1987-1995, which income, as well as demographics (fewer people per household) pushing up prices by nearly 5% a year. Note, however, that credit conditions – measured by the ratio of mortgage credit to deposits – were not pushing up house prices as this time.

Irish annual house price growth, by driving factor, 1975-2012

The period 1995-2001 saw very strong house price growth, driven by a combination of tailwinds, including incomes growing proportionately faster than housing supply. By the time these supply constraints were removed – through the follow-up to the Bacon reports and other measures – borrowers and lenders now expected rapid house price growth. These unrealistic expectations were facilitated by rapidly easing credit conditions. Crucially, almost all house price growth from 2001 to 2007 was driven by a relaxing of credit conditions.

What this means for Mr McCreevy is that it is simply not credible for him say that there was no housing bubble on his watch. Bubbles, driven by asset factors in particular expectations and credit, grow out of booms, when demand outstrips supply. The 1995-2001 boom created the 2001-2007 bubble. A Minister for Finance in 2004 could have tried to burst the bubble, but not prevent it. To do that, the Central Bank mortgage rules would have had to have come in not in the mid-2010s but in the late 1990s.

A post-script. Mr McCreevy has come to be known as a man who strongly believes in pro-cyclical fiscal policy. As he clarified yesterday, as Minister, he believed “When you have it, you spend it.” Exhibit B below is a graph I show my first-year Economics students. It is the average all-in tax rate paid by a household on an average income, by country and year from 2000 to 2007 (source: OECD). At a time when the Irish economy was growing more rapidly  than ever before, the state took a declining share of these higher incomes. I think a strong case can be made that much of the austerity undertaken by Ireland in the period since 2007 would not have been necessary if tax rates had been in line with other developed countries and that Ireland sorely missed a Minister for Finance able to spot that Irish fiscal policy was increasingly unsustainable and take the steps necessary to correct the path.

Average all-in tax rates, by country and year

 

Comments

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19 thoughts on “When does a housing bubble start?”

  1. @Ronan Lyons

    V. useful.

    @X-Minister McCreevy

    Not to mention that lite-touch (sic) regulation report based on free-mawrket PD ideology that you pushed through with fellow travellers Mary and Michael with Bertie providing cover in the background and Brian Cowen quietly biding his time! It lit a hibernian bonfire under deutsche credit conditions … and brought the state to its knees.

  2. “Après moi, le déluge,” Louis XIV is reputed to have said but it’s common for politicians to claim full credit for a prosperity that coincides with their time in office without regard for what went before or bad news afterwards.

    McCreevy was operating in a system where the corrupt land rezoning system made development land scarce in a country with the lowest population density in the EU. There was no political interest in upsetting farmers and the IFA managed to get almost 25% of the national roadbuilding budget – double the 12% land acquisition cost in the EU.

    RICS, the UK surveyors’ group said in a 2009 report that the general type of housing built was land intensive and standardised in form. “This leads to spread-out suburbs, both around Dublin and in other growth areas further afield. This urban form gives rise to long commuting journeys on a frequently overstretched infrastructure network. Land supply constraints near the major cities have been encouraging spread out development and reports have called for a more economically and environmentally sustainable living pattern.”

    RICS cited a report by the UK’s Policy Exchange think tank, which had argued that the Irish planning system created too many ‘starter homes’, of often mediocre quality on monotonous estates, and allowed insufficient quantities of larger, better quality properties. The lack of better properties had fuelled house price inflation, it argued, so that the high headline housebuilding figures give a misleading picture of the true supply situation.

    Finland also a euro member, like Ireland by the mid 1990s was facing a housing catch-up after a severe recession in the early part of the decade.

    The economy with a similar level of GDP as Ireland’s in 2007, had no debt and a surplus of about 50% of GDP.

    Finnish housing prices rose 45% in 1995-1999; fell 7% to 2001 and rose 42% to Q2 2008.

  3. Excellent work Ronan!

    But does it really matter?

    It’s not as if the younger generation understand, know or care about Mr McCreevy or what caused the housing bubble.

    I met one young person recently…. they knew nothing of the Air India disaster (30 years ago), they did not even know where Austria is located! That is the utter truth… and this 32 year old is a Irish native… and lives in Ireland.

    Back on subject….Mr Cowen… on the other hand has at least apologised.

    1. Hi Sporthog,
      I guess it’s less about finger-pointing and more about making sure that, even if we can’t guess the exact nature of the next war, we understand what happened in the last one and thus won’t fall victim to the same mistakes again.
      R

  4. In the long run the value of an asset must be linked to the income that can be generated from it,rent in the case of property,dividends in the case of shares. It is quite possible for individual assets to shoot up in price since residential areas can become more fashionable and companies can have very successful products. But in aggregate,share and property prices are constrained by the real growth rate of the economy. Rents cannot rise faster than income for long before no one can afford to rent. On the same basis if house prices outstrip GDP,more and more of a home buyer’s income must go to service the mortgage. This cannot last.
    Of course in the short term,changes in interest rates,lending practices and the rest can cause house prices to overshoot.
    ” House prices should not outstrip inflation in the long term because,except for land restricted sites,house prices should tend towards building costs plus normal economic profit” Bob Schiller

    Property bubbles are difficult to stop, because they have many supporters while they are inflating. Banks are making money from lending,estate agents and valuers are making money from commissions on property transactions, and the broadsheet media property advertising revenues soar. Home owners feel richer because their home is worth more.

    The Irish Society of Chartered Surveyors are the Irish property professionals,and are self regulated. They engaged in three practices which inflated the property bubble;

    One,the property valuation error, unwittingly valuing all five euro notes as twenty euro.
    Two,they administered the Irish feudal commercial property lease law on behalf of a cartel.
    Three,ninety five per cent of all property sold in the state,is sold by surveyors/estate agents and they controlled where the property advertising money was spent. Almost all of this money was spent with the broad sheet media and the Irish Times,the owner of the property portal MyHome.ie, got the lion’s share. During the years the bubble inflated, the Irish Times revenue from property advertising was a substantial part of their gross income,and the surveyors/estate agents were allowed free rein with their puff pieces and property propaganda. Essentially this paper became the largest property market in the state with a newspaper bolted on. This fusion between the Irish Times, the paper of record and the estate agents was an important factor in creating the social contagion of boom thinking, mediated by the common observation of rapidly rising property prices.

    There were other useful idiots,like the soft landing economists etc.

  5. “A statistical bubble is one where the growth rate in the price of an asset, such as housing, grows at a rate that is unsustainable for any reasonable period of time.”
    I’m not familiar with the economics of housing but the US , South African and Australian stock markets have grown at >10% a year for the past 100 years , which would fall under the definition of a massive bubble according to this article . while i think that Irish property was a bubble, i don’t think its safe to say its a bubble by ‘ any statisticians metric ‘

    1. @chris c
      Perhaps you are thinking of nominal, not real, returns? Once you strip out inflation, I am not aware of an equity price index that has increased 10% per year on average for 100 years. Shiller’s long-run equity price index for the US shows real growth of 2% per annum since the 1870s and the US is widely believed to be by far the strongest equity market over the last two centuries. The mathematics of compounding never cease to amaze, by the way: 10% growth for 100 years would leave a $1 share in 1915 worth roughly $1,400,000 a hundred years later, which is clearly false.

      More generally, though, I am not a fan of statistical bubble-spotting for precisely the reason you point. There could very well be an asset for which demand growth outstrips supply growth substantially for prolonged periods of time. Hence my focus on economic bubbles.

  6. Judge Coughlan of the Naas District court presumably wasn’t on hand to provide an appropriate intervention…

    BTW is there, for the slightly less dedicated to Irish parliamentary internet streams, some sort of archive or youtubycloudthing where extracts from the Irish banking inquiry (many outsiders have more or less lost interest) can be viewed or listened to – or is there a transcript easily accessible.

  7. And those credit conditions 2001-07 are themselves linked to fiscal policy through the pay settlements which made the salarymen more credit worthy!

  8. In general, housing bubbles are driven by excessive credit. That much is clear and the banking enquiry evidence by and large endorses this view. However there are some people (including one member of the banking enquiry) who seem to think that rising house prices are caused by rising land prices and that all this is due to “speculation”.

    At a more micro level we should look at the role of the planning system. As Colm McCarthy has observed whereas there were once relatively small differences in house prices between Dublin and other urban areas before planning and zoning had much of an impact, during the bubble years (and perhaps in the lead-up to the bubble) very large Dublin price premia emerged. This has been blamed on restrictive planning and zoning decisions, although I would also say that basic infrastructural deficiencies may have contributed to the “scarcity” of available and zoned building land. The insane tax breaks given to building in the BMW regions contributed to this trend.

    It is somewhat ironic that critics of the activities of local authorities (especially in the Irish Times) railed against “excessive” and “corrupt” re-zoning, which would make one believe that zoning and planning was too liberal. Whatever about brown envelopes and lack of proper infrastructure in support of zoned areas, the idea that somehow “excessive” re-zoning can be blamed for housing problems seems to me to be absurd.

    A long time ago David Ricardo showed that the price of land was high because the price of corn was high, and not the other way around. People who blame land speculators for driving up price should remember this. After all Ricardo was much admired by Marx!

  9. @John Sheehan,

    David Ricardo was the first member of the Jewish faith to be elected to Parliament for an Irish constituency. He was elected to the Westminster Parliament in 1818 for the Borough of Portarlinton,Co. Laois(Queens County).

  10. That last chart needs to be shown to anyone who claims (as many do) that the problem in the Celtic Tiger year was that government spending got out of hand. Government spending did increase from absolutely rock-bottom levels in 2000 (as pointed out in the 2008 OECD report on Ireland’s public service). But what really got out of hand were tax giveaways in successive budgets.

    And yet, when the crisis struck, the latter were reversed in only token ways while the public sector (and those who depend on them) were hammered.

  11. @Ernie Ball, note that the last graph shows average all-in tax rate paid by a household on an AVERAGE income. The same graph shown for households on higher incomes would (I believe – this is not my area) have a similar pattern but would not be as dramatic, due to the fact that much of the fall in tax take was due to lower income households being removed from the tax net altogether.

  12. @ Ernie Ball,

    ‘But what really got out of hand were tax giveaways in successive budgets’

    Ernie… it’s not just that simple.

    What about the massive inward flood of credit which occurred in the noughties from Asia?

    Fred Goodwin of RBS (sorry it’s Sir Goodwin) bought Ulster Bank, which began a reckless campaign of giving out mortgages in Ireland.

    Other Irish banks followed suit… otherwise they would have lost market share.

    In fact it was the British Taxpayer who bailed out Ulster Bank.

    Co-incidentally…. Greece also had a inward flood of credit during this time also.

    I think your ‘Manifesto’ requires updating… all tax breaks to be banned, along with free movement of capital.

  13. @ John Sheehan

    There is seldom one simple explanation for most things.

    In recent times land has become a popular investment asset in many countries and governments have been buying land overseas through wealth funds to increase food security.

    In the UK as an asset class land has outperformed shares in recent years.

    Irish agricultural land is among the most expensive in the world and it’s not related to the price of corn!

    http://www.finfacts.ie/irishfinancenews/article_1028856.shtml

    The low turnover may be related to CAP welfare.

    The price of arable land in France is about a quarter of the Irish level.

    As for development land, restrictions on high rise and the low ratio of apartments/ flats are factors as are the other issues of planning you referred to.

  14. Bob Schiller in his Nobel Prize Lecture defined a bubble as:
    “A situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases and bringing in a larger and larger class of investors, who, despite doubts about the real value of an investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement”.

  15. Newspaper Bubbles:

    I would say that a speculative bubble is a peculiar kind of fad or social epidemic that is regularly seen in speculative markets; not a wild orgy of delusions but a natural consequence of the principles of social psychology coupled with imperfect news media and information channels.

    At the center of this definition are the epidemic spread, the emotions of investors, and the nature of the news and information media. Bubbles are not, to my mind, about the craziness of investors. They are rather about how investors are buffeted en masse fron one superficially plausible theory about conventional valuation to another. One thinks of how a good debater can take either side of many disputes and, if the debater on the other side has weak skills, can substantially convince the audience of either side. College debate teams demonstrate this phenomenon regularly, and they do it by suppressing certain facts and amplifying and embellishing others. In the case of bubbles, the sides are changed from time to time by the feedback of price changes, with the proliferation, caused by price increases, of reminders of basic facts that a debater might use to defend the bubble. The newspapers are even better at presenting cases than are typical college debaters.

  16. The term “new era economy” did not have currency until a Business Week cover story in July 1997 attributed this term to Alan Greenspan, marking an alleged turning point in his thinking since the “irrational exuberance” speech some months earlier. It is a curious fact that the development of the “new era” stories around 1997 corresponds to the approximate date when the real estate boom began in the United States and other countries. The beginning of this boom started quite sharply around 1997 in Boston, Los Angeles, Paris and Sydney; it appears that London’s increases had begun more that a year earlier. David McWilliams had spotted the Irish property bubble in 1999 as the link below explains;
    ttps://www.youtube.com/watch?v=vzNO4u8AU3Y

    Mr McCreevy left the office of Minister for Finance in 2004, and at that stage the bubble was already well advanced. The greatest bank crash in the history of mankind started with one house–Leinster House.
    Attachments area
    Preview YouTube video David McWilliams Late Late Show 1999

    David McWilliams Late Late Show 1999

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