credit – The Irish Economy

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.

The end of one quarter and the start of another sees the usual slew of economic reports and the start of Q4 is no exception. Today sees the launch of the Q3 Daft.ie Report. In line with other reports in the last week or so, and indeed with the last few Daft.ie Reports, there is evidence of strong price rises in certain Dublin segments. What is new this quarter is the clarity of the divide between Dublin and elsewhere: all six Dublin regions analysed show year-on-year gains in asking prices (from 1.4% in North County Dublin to 12.7% in South County Dublin), while every other region analysed (29 in total) continues to show year-on-year falls (from 3.1% in Galway city to 19.5% in Laois).

The substantial increases in South Dublin over the last 12 months have led to talk of “yet another bubble” emerging, with internet forums awash with sentiment such as “Not again!” and “Will we never learn?”. To me, this is largely misplaced, mistaking a house price boom for a house price bubble. Let me explain.

Firstly, I should state that, unlike “recession” which is taken to mean two consecutive quarters of negative growth, there is no agreement among economists on what exactly constitutes a bubble, in house prices or in other assets, but the general rule is that prices have to detach from “fundamentals”. For example, the Congressional Budget Office defines an asset bubble as an economic development where the price of an asset class “rises to a level that appears to be unsustainable and well above the assets’ value as determined by economic fundamentals”. Charles Kindleberger wrote the book on bubbles and his take on it is that almost always credit is at the heart of bubbles: it’s hard for prices to detach from fundamentals if people only have their current income to squander. If you give them access to their future income also, through credit, that’s when prices can really detach.