Managing Housing Bubbles in Regional Economies under EMU: Ireland and Spain


Today Thomas Conefrey and myself publish a working paper entitled “Managing Housing Bubbles in Regional Economies under EMU: Ireland and Spain”. It is available here .

With the advent of EMU, monetary policy can no longer be used to prevent housing market bubbles in regional economies such as Ireland or Spain. However, fiscal policy can and should be used to achieve the same effect. This paper shows that the advent of EMU relaxed existing financial constraints in Ireland and Spain, allowing a more rapid expansion of the housing stock in those countries to meet their specific demographic circumstances. However, the failure to prevent these booms turning into bubbles did lasting damage to the two economies, damage that could have been avoided by more appropriate fiscal policy action.

The failure to tighten fiscal policy in Spain and Ireland in the early years of this decade laid the ground for the housing market bubbles in the two economies. The Stability and Growth Pact proved a distraction: government budgetary balance was not an appropriate fiscal target for those two economies. By contrast, Finland, having learned from its mistakes twenty years ago, ran substantial government surpluses to prevent domestic overheating. Specifically in relation to overheating in the housing market, we consider that a temporary tax on mortgage interest payments (first suggested in 2001) should have been used to target overinvestment in housing, investment which seriously crowded out the traded sector of both economies. This tax would have mimicked an increase in interest rates. Obviously it will be a very long time before such a tax might be needed in either Spain or Ireland to limit overinvestment in housing.

The paper shows that demographic circumstances in both Spain and Ireland meant that it was appropriate that investment in housing in those two economies should have been somewhat higher than in their neighbours. Even after the housing bubbles have burst, the relatively low endowment of housing infrastructure in the two economies (relative to adult population) means that there will be a need for additional investment in the next decade, when the current excess supply has been worked off.

In the paper we also include a graph taken from our paper “Recovery Scenarios for Ireland” published in May  which, inter alia, considered likely housing demand over the coming decade. Our model included estimated 2009 population numbers which were quite close to the latest estimates published by the CSO. We assume that between 2009 and 2015 there will be cumulative net emigration of up to 120,000. Our analysis would suggest that the underlying population increase would lead to somewhat higher demand for housing than Brendan Walsh has estimated in a recent post for the period to 2015. In addition to the pure “demographic” effect we also factor in some increase in headship on the basis of the recent rise in the number of households, which possibly reflects falling rents.


Living with the Euro

Cormac Lucey has a piece in Saturday’s Irish Times on the implications of EMU membership for Irish macroeconomic adjustment: you can read it here.

Clarification:  There is an important typo in Cormac’s article. “In January 2005, Rossa White of Davy Stockbrokers used the Taylor rule to estimate that European Central Bank interest rates were appropriate for Ireland.”  This should read: “In January 2005, Rossa White of Davy Stockbrokers used the Taylor rule to estimate that European Central Bank interest rates were inappropriate for Ireland.”    You can read Rossa’s original note here.