Unluck of the Irish

Earlier this week, Alan Kohler wrote an article in Business Spectator on the misery created by the Irish housing bubble/bust and its lessons for Australia:

After 2002, when Ireland joined European Monetary Union and adopted the euro, the two things combined to create a massive property boom and, in essence, the government was able to replace corporate taxes with much more revenue from property taxes.

Between 2000 and 2008, the state pension doubled, average public service salaries increased 59 per cent, the standard income tax rate fell from 26 per cent to 20 per cent and the top rate from 48 to 41 per cent.

Despite this, Ireland, like Australia, entered the global financial crisis with low public debt. But its prosperity was built on the quicksand of a property bubble.

In 2007, stamp duty and capital taxes yielded €6.7 billion; this year that will fall to €1.6 billion. As a result, the budget deficit has ballooned to 11.7 per cent of GDP, even after big spending cuts in the past two years, and gross public debt is suddenly at 95 per cent of GDP, rising to 102 per cent in 2013…

The bigger problem was Charlie McCreevy who, as finance minister in two stints during the 90s and then again 1997, disastrously cut taxes and increased government spending.

Specifically, in 1997 he cut the capital gains tax rate from 40 per cent to 20 per cent and extended property tax concessions, which directly led to the explosion in property speculation, which in turn led to the collapse of the Irish banking system.

When the boom ended, government spending went from 28 per cent to an unsustainable 44 per cent of GDP.

Ireland thought the property boom would last forever and lived it up. Yes, the boom was created by out-of-control bankers and rich speculators, and the politicians took the government along for the ride, but in the end that doesn’t matter. Government spending now has to be cut even if bank bondholders are forced to lose their shirts.

Needless to say, the Australian government should learn from Ireland’s mistakes.

Indeed, in 2004 Ireland was the toast of Europe and one of the world’s wealthiest countries:

Ireland is one of the world’s wealthiest countries since its economy has grown nearly five-fold since 1973. It boasts one of the world’s highest levels of GDP per capita, some 20 percent above the European average—while 30 years ago it was 35 percent poorer than the average….

Ireland’s economic growth model has been hailed as an example of development done right, with everyone from professors in Pittsburgh to investment agencies in Armenia trying to figure out how to replicate the success of the Celtic Tiger.

And in 2005, The Economist judged Ireland to have the best quality of life in the world.

How things change. Once house prices began deflating, the world discovered that Ireland was not so special after all and that their economy was just another unsustainable credit bubble that burst violently.

The below chart shows the extent of Ireland’s housing bubble/bust:

 
 
 
 
 
 
 
 
 
 
 
 
 

And the below IMF Charts show the extent of Ireland’s dependence on property taxes and how these sources of revenue have dried-up:

Not surprisingly, given the spikes in stamp duty and capital gains taxes between 2005-06, Ireland’s public finances were looking pretty good prior to the onset of the Global Financial Crisis (see below IMF charts):

However, following the collapse of property taxes and the costly bail-out of its banks following the bursting of its housing bubble, Ireland’s net debt has exploded. In fact, the IMF forecasts that Ireland’s net debt will increase by around 50% of GDP over the period 2007 to 2015 (see below IMF chart).

Now Ireland’s economy is experiencing its third year of recession in which its unemployment rate has risen from under 5% to nearly 14%:

Ireland has been following a self-imposed stark austerity program for almost two years, cutting public spending and raising taxes. Despite this, the budget deficit remains at around 14 per cent of GDP, as the sharp contraction in the economy has caused tax receipts to collapse. At the same time, the Irish government faces a higher spending on social security benefits now that the country’s unemployment rate has climbed to 13.7 per cent. Fears that the Irish government will struggle to reduce its borrowings has pushed the interest rate that Ireland pays on its benchmark 10-year bonds close to 300 basis points more than comparable German bunds.

So what caused Ireland’s property bubble and what lessons does their predicament provide for Australia?

The usual suspects:

As is the case with all housing bubbles, Ireland’s was fuelled by two inter-related culprits: easy credit and speculation.

A recent article by Saul Eslake provides a nice explanation of how low interest rates and easy credit fuelled Ireland’s housing bubble:

Once Ireland joined the euro at the beginning of 1999, short-term interest rates in Ireland were no longer set in Dublin in accordance with Irish conditions, but rather in Frankfurt in accordance with conditions in the euro zone.

Thus Irish short-term interest rates fell from about 6 per cent, where they had remained during the second half of the 1990s (which the Central Bank of Ireland had deemed appropriate for an economy that had been growing at rates of 8-11 per cent a year) to 3 per cent (which the European Central Bank considered appropriate for an economy that had been growing at about 2.5 per cent a year).

From then until the onset of the financial crisis, short-term interest rates averaged 3.25 per cent a year in Ireland, as they did in the euro zone, even though Ireland’s economy grew at an average annual rate of almost 6 per cent (compared with less than 2 per cent for the euro zone) and Irish inflation averaged 3.5 per cent a year (compared with 2.25 per cent a year for the euro zone).

Because Irish interest rates were substantially lower than they should have been for an economy growing as fast as Ireland’s was, Irish households and businesses borrowed (and Irish banks lent) far more than they would otherwise have done, resulting in (among other things) an unsustainable property boom in which Irish house prices more than doubled in less than seven years (they have since fallen by almost a third).

In order to explain the second cause – investor speculation – I have borrowed heavily from the Ireland Central Bank’s (ICB) 2007 Financial Stability Report.

Like in Australia, lending restrictions on investor mortgages were relaxed in the mid-1990s, which enabled property investors to borrow at the same interest rate and on similar terms to owner-occupiers. This led to a surge of property investment, as shown by the below ICB chart.

In fact, as at June 2007, investors accounted for around 27% of total mortgage lending – slightly below Australian investor’s share of 30% of total mortgage lending.

And like in Australia, the sharp rise in property prices prior to the global financial crisis (GFC) forced rental yields down:

As such, recent investors were cash flow negative in 2007, since rental income nowhere near covered holding costs:

So just as property investors in Australia rely predominantly on capital appreciation to make ends meet, investors in Ireland were doing the same.

However, once property prices began to fall, Ireland’s over-geared investors rushed for the exits, thus helping to force house prices down. The risk of investors fleeing the property market en masse was acknowledged by the ICB in 2007 just prior to the crash:

…buy-to-let landlords, acting as dispassionate investors rather than emotionally involved owner occupiers, might decide more quickly than owner occupiers to dispose of properties in the event of a house-price fall, and this could potentially destabilise the wider housing market. The concern is a mass exodus of investors at the same time would put additional pressure on an already fragile market, causing a quicker downward spiral than would have otherwise been the case.

Still, in true central bank fashion, the ICB rejected the notion that Ireland would experience a sharp housing correction, instead predicting a soft landing due to strong underlying fundamentals:

Regarding future house price developments, factors that will have an influence on the future direction of house prices are investors’ participation in the property market, the sustainability of current rates of immigration and the future direction of monetary policy. The underlying fundamentals of the residential market continue to appear strong, as evidenced by rent increases. The central scenario is, therefore, for a soft, rather than a hard, landing.

Lessons for Australia:

The Australian and Irish economies have some major differences. Most importantly, Australia controls its own monetary policy and has its own currency. As such, it has the ability to set interest rates to stimulate/slow growth and its flexible exchange rate acts to smooth positive (negative) shocks via appreciation (depreciation) of the Australian Dollar.

By contrast, Ireland does not control its monetary policy or currency. The former is determined by the European Central Bank, effectively set by the larger European economies, Germany and France. Likewise, since their currency is the Euro, they are unable to devalue in order to regain competitiveness. In this regard, as long as Ireland remains in the euro, its economic anguish will not end.

Despite the important differences between the two economies, the implosion of the Ireland property market offers some important warning signs for Australia.

First, like Ireland, Australia’s governments have grown overly addicted to property taxes, which have been largely squandered on tax cuts and wasteful recurrent spending. To highlight this point, consider the below chart showing the growth of state property taxes as a proportion of the tax base.  

 
 
 
 
 
 
 
 
 
 
 

The story is similar at the federal level where tax collections have surged on the back of growing property values and rising debt levels, which has boosted consumer spending, employment and the economy more generally.

Now you don’t have to be a rocket scientist to predict what will happen if Australia’s housing market corrects – government finances will take a hammering as consumer spending dries-up, unemployment rises, tax collections fall, and welfare payments rise. And the impact will be a whole lot worse should Australia’s other economic pillar – mining – experience a sharp contraction of demand and falling commodity prices.

Then there is the issue of Australia’s large pool of loss-making property investors – 1.2 million of them as at 2007/08. Just like in Ireland, there is the risk that they will sell en masse once they realise that the days of easy capital appreciation are over and house prices might actually fall. This rush for the exits is likely to gather pace as the Baby Boomer’s retire.

Let’s hope that the bulls are correct and the China growth story continues well into the future. Otherwise, the Australian economy is cruising for a bruising.

Cheers Leith

Comments

  1. This is one of the best articles I have seen yet. When the mining boom crashes and it will Australia is screwed plain and simple. So many people or going to lose alot of money. Australias day of reckoning is on the way.

    LBS

  2. As a UK citizen freshly off the boat, I have been reading this blog with great interest, esp. with a couple of properties in my partner's portfolio !

    I guess my next thoughts are how to invest in a potential bubble economy ? I would reluctant to take on more debt, so does this mean Term deposits to maximize interest on my savings ? Or aggressively pay off home loan debt before rates rise ?

    In any case, will keep reading to get a handle on the climate here. Thanks Leith.

  3. While there are always differences, it is the similarities that you point out that really make you pause and take a deep breath.

    Property booms can go on for a while. Property is not actually all that freely traded (unlike Hong Kong, for example) so "the market" is not as efficient as other markets when it comes to telegraphing potential bad news. Also, your Reserve Bank has held interest rates up enough to entice foreign capital looking for a carry trade (so liquidity is not an issue for the time being).

    Usually these things need a trigger. Besides a mining bust prompted by a change in China's appetite for raw materials what other potential triggers do you see?

    The reason I ask is because it may be something other than China. Most senior officials in the US thought that subprime was a small, containable issue because objectively it was a small, containable issue. Unfortunately, it also happened to be the first domino. Once it hit the overleveraged system, that's when the fun began.

  4. Perhaps if not for the mining / resources boom the Keating suggestions of "banana republic" may end up being on the button.

  5. John C, most senior officials in the US had no clue – the complexity of securitisation, deriviatives, cdo's and so on, was completely beyond them. Those that were aware of the time-bomb were ignored, ridiculed, labelled "doomsayers". Massive financial interests certainly didn't want the property ponzi to end. And that is true here too. Generally our media are not up to the task – thank goodness for blogs like this.

  6. Leith – excellent article and thank you.

    You may like to check out the Annual Demographia international Housing Affordability Surveys (house prices to household incomes measure), to compare the scale of the Australian bubble, with that of Ireland.

    Clearly – Australia has a bigger top to fall off as its bubble bursts. Just "bubble exhaustion" will likely suffice. It will not require a downturn in the mining sector to trigger it.

    There is an excellent article on the Irish situation by Brian Gaynor in the NZ Herald today.

    Hugh Pavletich
    Co author – Annual Demographia International Housing Affordability Survey
    http://www.PerformanceUrbanPlanning.org
    Christchurch
    New Zealand

  7. What might trigger the collapse of our housing bubble? Many of our policy planners are talking about addressing the extreme shortage of land for housing estates. Many are already laying the ground-work for massive estates with blocks considerably cheaper than the average. These cheaper blocks will force down the average price for existing housing. This will leave many mortgages "under water" and will result in a small wave of foreclosures.. That could spook the market and pop the bubble – resulting in a massive wave of foreclosures..
    See www vs2020.com + policies/shortage-of-land-for-housing.html

  8. Leith great article. The one thing that really stands out to me is who will be affected by this bubble or a double bounce bubble (mining and housing) if it bursts.

    People here seem to wonder how it will affect them individually, for those with a reasonable morgage's and who don't have lots of depreciating toys/personal loans and are owner occupiers, you will feel it but it probably won't financially kill you.

    If you are an owner occupier with a highly leveraged debt on an over priced home, you will suffer.

    Those who have speculated with investment properties which aren't even making 3% rental returns, well below bank interest (which 10 years ago was scoffed at by people investing money). Who are negative gearing with losses that exceed the tax which they wish to offset against. Their highly leveraged loans will still exist when the properties they hold onto depreciate, futilely hoping the bust will reverse. Bankrupt? Sell for losses seem like the options for these people, god help you if your a baby boomer retiring.

    I also fear for the genration working in the mines (where we live they are many) on unskilled wages several times their actual potential work value in a normal economy (the cashed up bogan syndrome) a lot of these people(not all!) have had excellent wages/wage expectation and squandered it in over simplified terms on flash utes, 4wd's, speedboats, big TV's and overseas travel and saved little. Where will they be when mining jobs dwindle and the overall unemployment goes up? I do worry about those who refuse to see what is coming. This really is a story much like the bedtime story the 3 little pig's!!!

    Damian

  9. I got a taste of the Madness around 2002-03 when working in Ireland even then there had been serious clouds over the way some of the banks operated. I never thought John Stewart at NAB did anything of value but I take that back when I consider at least he offloaded Nab owned Irish at made a profit 2005
    http://www.smh.com.au/news/business/nab-makes-1bn-profit-on-irish-banks-sale/2005/10/24/1130006039135.html
    had they kept them the $2 billion homeside in the U.S would have looked like a mere blip
    james

  10. "The Australian and Irish economies have some major differences. Most importantly, Australia controls its own monetary policy and has its own currency. As such, it has the ability to set interest rates to stimulate/slow growth and its flexible exchange rate acts to smooth positive (negative) shocks via appreciation (depreciation) of the Australian Dollar."

    Good article but I think that you over emphasis how important it is to be able to set your own interest rates & print money. It makes little difference what the government does because ultimately it’s the market that rules.
    What makes you think low interest rates stimulate growth? History suggests low interest rates occur in times of little growth such as the USA now. Japan has been stimulating its economy for nearly 20 years now much of that time with very low rates without success.
    Sure Aus could slash rates in a crisis and maybe everyone will do an Ireland and rush out and borrow and send property soaring but what is important is how the market views things. For low rates to create a boom the market would need to see low rates AND a strong economy but what if the market interprets low interest as a sign of weakness? The dollar would fall, import costs would rise, overseas funding may dry up/higher rates etc. again similar to the UK now.
    Just because you can lower rates and print means very little. This creates no wealth but simply moves it around and remember much of the wealth that people think exists, especially in property, is just an illusion.

  11. On a slightly general note;but interesting for those concerned with housing/booms/busts in both Ireland and Australia there is an article in today's Sunday Times supplement on the housing boom/bust in Ireland.A deeply salutory reading.As I read it I kept mentally deleting the word Ireland and inserting the word Australia–read it and see what I mean

  12. Speculation is ubiquitous. The problem becomes when downside risk is discounted. Why does downside risk in housing markets get discounted? Typically, because of supply constraints.

    Ireland essentially had a land cartel. An article by Fintan O'Toole, based on his book, describes the Irish land cartel. As I said in a speech, O'Toole refers to:
    " '… certain landowners [who] had accumulated large landbanks at the outskirts of urban areas which they then released in dribs and drabs in order to manipulate the market and artificially to maintain high land prices.'
    In Australia we have a name for such people. We call them ‘State Governments’. If Australians were as free to buy and sell land as Texans—a State that has a bigger population than Australia, faster population growth, higher average income and a bigger proportion of its population in its five largest cities—our houses would cost half to a third (or even less) their current prices. Instead, a country with one of the world’s lowest population densities has the most expensive metropolitan housing in the Anglosphere. A true regulatory achievement."

    But higher revenue from property taxes is one of the benefits State Governments get from restricting the supply of housing land. The problem with housing in Australia is the same as the problem with the cost of taxi licenses: most of what people are buying is bureaucratic approval.

  13. Australia maybe has advantage of controlling its own monetary policy but at the same time has few disadvantages. Ireland has much larger share of productive industry (46% of total GDP – huge IT sector) compared to 26% in Australia (including mining). Even if Australia devaluate currency there is almost nothing to export because there is almost no industry left in this country. Second disadvantage is much bigger risk because Australia is riding two bubbles at the same time (housing and commodity). If they burst at the same or close times (year or two apart) fall will be horrific. Third problem that may hit Australia is high population volatility. Immigration helped inflation of housing bubble but it may reverse it overnight. Many immigrants especialy from Asia may decide to go back to their growing home countries (reasons maybe different: unemployment, debt avoidance …). This already happened in Ireland (many immigrants from the rest of Europe left) but on much smaller scale.

  14. I have a question. Obviously when a property bubble (or any other sort of bubble) bursts, those left holding the assets get seriously hurt. But along the way, quite a few people must have made serious money selling to the bigger fools. What happens to that money? In the case of Ireland, for example.

  15. Leith, thanks for an excellent article.

    I don't believe it would get as dire as Ireland because our banks are less exposed to the property market due to mortgage insurance.

    I'd like to point out that Australia has a mandatory lender's insurance for mortgages with less than 20% downpayment. The insurance companies here (most notably QBE LMI) would be the first to fall if there is a large systemic drop in property values.

  16. Leith great work as always. You answered my rhetorical question regarding the addiction of Australian govts to property taxes from an earlier post.

  17. Being in the Euro doesn't mean Ireland's 'economic anguish' has to continue. It just means that they have to default rather than devalue.

  18. Leith Thank you,

    I am an Irish Citizen leaving in Perth. I fell in love with Australia in 2005 because it wasn't as superficial and pretentious as Ireland was back then. But now after seeing the boom/bust in Ireland….I can tell you that it will happen here. The similarities are unreal. Perth is Dublin 2002. It will not happen for a while yet but it will burst and the people who can afford to invest here in Perth at the minute will move and head back to Ireland and England or onto the next “up and coming” country.
    I meet and speak to these people every day and I know that most of them had worked and invested in Ireland in the last 8 years. Most of them are the investors that you speak off that pulled out of Ireland in 2007. Everyone pays on Credit, most live past their “means”, and they think that what happened in Ireland won’t happen here. I just hope that when it does happen that the bitterness towards immigrants leaving (like what happened in Ireland) won’t happen here. I hope that the Australian Government will open their eyes, take the blinkers off and begin to think long term. Money that comes fast leaves fast

  19. Nicholas, there are 2 LMI companies in Australia.

    Sure they would be the first to fall, but there will be pain for the banks after that.

    Plus the deleterious effects on government revenue would still be there…

  20. Anonymous Irish citizen, then jig is already up in Perth (and Brisbane too). Prices are only down a few percentage points but that's enough for a few investors to look for the exit. Of course, that puts downward pressure on prices and the snowball gathers. If you're planning on heading back to Ireland you might want to think about taking any property gains soon. Also keep in mind that the AUD is likely to tank once the RBA cuts rates to attempt to prevent a disaster as more and more investors head for the door!

  21. Leith another excellent piece. Thank you.

    Re: LMIs

    This is the problem with such a massively inter-connected global financial and monetary system. How many claims are stacked upon other claims on assets that would have to be liquidated in markets that are soft?

    I doubt that anyone can answer this question in a meaningful way. It appears that uncertainty has been priced as if it was risk.

    I have never been able to understand how a mortgage could be 'insured' in the first place. Consider the variables and the uncertainties. Can you insure against divorce? Job loss?

    FWIW I cannot see any way out of this mess that does not involve defaults. The 'losses' will be as spectacular as the illusory 'gains'.

  22. Couple of points on LMI
    – it is not "mandatory". The capital required on a bank's balance sheet for a residential mortgage with an LVR greater than 80% is significantly higher than the capital required on an LMI insurer's balance sheet for supporting the same risk. LMI is purely a capital arbitrage and if the capital requirements for LMIs were aligned with the banks, or vice versa, LMI insurers would likely cease to exist.
    – According to the latest available data from APRA (June 2010), the LMI underwriters (there are 7 included in the APRA list), the total asset base for the LMIs in Australia is $6.3bn. They would have reinsurance on top of hard cash, but I doubt it would bring the total resources of the LMI industry in Australia above $10bn. This would be a handy buffer if (when?) the crunch comes, but I am not sure it would be anywhere near enough – the banks would still feel considerable pain.