The property bubble and the irish economy

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Background:

The Irish economy is experiencing its worst economic downturn in its history of state existence. The cause of this economic crisis has been identified as a major property bubble developing, permitting the Irish banking system to become over-exposed to such a property bubble. The building and construction sector grew to a level that was twice the size that would have normally been sustainable and as a result, the subsequent over-heated property bubble "burst" resulting in the economic crisis Ireland faces today (Bergin et al., 2009). Although the global economy is currently going through a crisis of its own, Haughton (2009) suggests that the Irish economy would have suffered regardless of the global credit crunch due to the initial size and extent of the property crash.

To gain a better understanding on how the collapse of Irelands property bubble contributed to the current economic crisis, it has been identified that construction output accounted for around 19.5% of Irelands GDP (Gross Domestic Product) in 2006 (Mc Nulty., 2008 Provisional). Because the construction sector accounted for such a large proportion of economic wealth, its contraction has brought about further economic problems on a much wider scale across the overall economy.

For the overall Irish economy, figures for 2008 and 2009 indicate a weakening in economic growth. In 2008 as a whole, GDP decreased by 3 per cent marking the first annual contraction in economic activity since 1983. A further and much steeper decline occurred in 2009. During the first quarter of the year, GDP contracted 9.3 per cent and GNP (Gross National Product) by 13.1 per cent. This essentially means that for every euro in the economy for the first quarter of 2008, 10 cent had been removed from every euro for the same period of 2009 (Power 2009).

The extent of the current economic crisis in comparison to the previous one during the 1980s has been illustrated by the NESC (2009) in that the years 2007 and 2008 surpasses the previous Irish economic downturn of the 1980s. GDP growth decreased in total by 7.8% in 2007 and 2008. It took six years from 1978 to 1983 for GDP to fall at a similar rate.

The Property Bubble and the Banking Crisis:

'History shows that it is the nature of any bubble, but particularly in real estate, that it creates a "bubble mentality": a belief that prices cannot go down and that borrowing or lending on the security of houses is a safe investment. It was this belief, both driver of and driven by the credit bubble, which inflated house prices to extraordinary highs.'

Calverley (2009, p.ix)

Introduction:

The CIF/IHBA (2009) identify Irelands house building industry as one of the main drivers of the Irish economy over the last ten years. A harsh but yet necessary adjustment is also taking place in the housing sector with adverse developments in the wider national and international economy contributing greatly to the overall downturn in the housing market.

The Rise & Fall of the Housing and Property Bubble:

Honohan (2009a) identifies a stage of the Irish economy in which rapid growth and expansion occurred. This source of growth has been identified as a decade long property price and construction boom which had taken over from exports as the main provider for Irish growth. This was fuelled by a sharp fall in interest rates and an overall increase in household formation.

In relation to the property bubble identified by Honohan (2009a), this marked a prosperous time for the Irish economy with unprecedented levels of output also being achieved by the construction industry. The NESC (2008) state that the level in housing output (private and public) reached its peak with over 93,000 units completed in 2006. Haughton (2009) continues to state that during the year 2007 building and construction accounted for 20 per cent of GDP, twice the proportion of the USA who also experienced a property bubble at the time.

During this time of unprecedented economic growth, Ireland also saw a rapid increase in house prices. According to the NCA (2008) between the eleven year period of 1995 to 2006, the average house price increased by 13.3% per annum with the level of house prices peaking at an average of €311,100 during the January/February period of 2007.

There was of course much speculation amongst economist that such a rise in property prices would lead to a property bubble and a decline in such house prices following a bubble would lead to disastrous consequences for the Irish economy as a whole. A study by McQuinn (2004, p.1) states that 'significant and persistent house price increases of the type witnessed in the domestic property market gives rise to the possibility of a speculative bubble and the consequent possibility of a collapse of such a bubble. A significant decline in house prices levels over a relatively short period of time poses difficulties on an economy-wide basis. Housing output in the Irish economy in 2002 amounted to almost 60,000 units, which is over seven times the per head of output in most EU countries. As a result, the construction industry in 2002 contributed over 15 per cent to national output. A decline in this level of activity in the housing/construction sector would have serious implications for the general economy. The value of housing represents a significant portion of personal wealth levels, a serious erosion of such levels would likely result in a negative wealth effect in the economy.'

Basing the current state of the Irish economy on the study by McQuinn (2004) there are two factors deemed to be co-related and should be carefully examined to assess the situation. They are:

1. House Prices.

2. House completions.

House Prices and completions:

The recent adjustment seen in the housing market has brought a contraction in the level of housing construction which has resulted in a decline in house prices.

A study undertaken by Kelly (2007) consists of an analysis of house price cycles across OECD countries since 1970. The study finds a strong relationship between the extent of the initial rise and subsequent fall of house prices and if this relationship between rise and fall were to hold for Ireland, it could result in a fall of 40% to 60% of real house prices over an 8 to 9 year period and that due to the unusually large size of the Irish house building sector, even a slight fall in house prices could impose a heavy adjustment on the economy.

In more recent times following the Kelly study, its findings bare a significant complexion on the Irish housing sector in that a rapid decline in house prices has occurred resulting in an sharp adjustment on the economy.

From their peak in January/February of 2007, national house prices have declined on average 26.6% up to December 2009. For the first ten months of 2009 alone, national house prices declined on average from €261,573 in December 2008 to €228,347 in October 2009. This represents a fall in house prices of 12.7% for the first ten months of 2009, representing nearly half of the overall decline in house prices since their peak. National house prices are now at the same level as they were in October 2003 (Permanent TSB/ERSI, 2009).

The CSO (2008) state that there were over 78,000 houses and apartments completed in 2007. This represented an increase of 35% on the 2002 figure but it also represented a 12% decrease on the 2006 figure. Private houses and apartments contributed to over 91% of total completions in Ireland for 2007. In comparison to the afore mentioned 93,000 units completed in 2006, CIF/IHBA (2009) forecast the total number of housing completions for 2009 to be in around 28,000. It is also expected that contraction will see no meaningful recovery until 2012. At least not until the current supply of vacant housing stock is absorbed and current developments are complete.

The Collapse of the Property Bubble and the Irish Economy: The Causes:

Introduction:

The property boom that took hold on the Irish economy had a major influence on the economy as a whole. The Irish economy was certainly a much healthier one at the peak of the construction boom than it is now, but what fuelled this property boom to make Ireland reach such high levels of economic wealth? Ross (2009) indicates that the Irish economy was driven, and subsequent economic downturn caused by leading Irish banks who recklessly loaned money to property developers and builders to fuel the construction boom.

The Bankers and Property Developers:

'Some commentators, both domestic and international, have attributed the strong performance of the Irish property market to `excessive` lending by Irish credit institutions.'

(Fitzpatrick and McQuinn., 2004)

McQuinn & O`Reilly (2007) find cross-country evidence that there is a direct link between the availability of credit and house prices in that house prices were being driven by the availability of cheaper credit. Other evidence suggests that there are strong links between the prices of commercial property, credit and the macro-economy. Evidence also suggests that increased commercial property prices resulted in increased credit expansion in some countries and that in other countries, lending boosts property prices (Davis and Zhu 2004). It is a well known fact that leading Irish banks came under sustained pressure for giving out loans to fuel the construction boom. To understand why these loan demands became so great, a study undertaken by Fase (1995) found that during times of economic wealth, the demand for loans increases.

In the case of the property-led booming Irish economy from 2000 onwards, the findings made by Fase (1995) similarly apply. Between September 2003 and February 2007, the demand for credit to fund mortgages increased rapidly from €50.5 billion to €120.5 billion. This reflected an average annual increase of 29% of credit demand. Baur and McKeating from Reuters Ecowin (2008). A different perspective on such a demand for credit is given by the Central Bank of Ireland (2008) stating that of €401 billion loaned by Irish banks to the private sector at March 2008, €251 billion (62.6%) consisted of construction and property related lending (including personal mortgages).

The banks of course needed access to such money to fund this massive increase in demand for mortgage credit. Honohan (2009b) identifies that the Irish banks borrowed enormous sums of money from abroad to satisfy the demand for credit. These foreign borrowings obtained by Irish banks were easily available due to the accumulation of global savings and the lack of exchange rate risk for borrowing within the euro area. By the end of 2003, net indebtness of Irish banks compared to the rest of the world was just 10 per cent of GDP. By 2008 however, it had increased to over 60 per cent.

Kenny (1998) suggests that the Irish banking sector is directly vulnerable to any changes that may occur within the housing market because mortgage debt accounts for a significant proportion of the total asset base for most financial institutions and in turn, variations in house prices may alter the value of mortgaged assets. McQuinn (2004) suggests a similar theory in that, a severe decrease in house prices would more than likely result in many households having mortgages that are greater in value than the property itself i.e. negative equity. Should an increase in mortgage repayment defaults occur, problems may arise posing serious questions for the stability of the Irish financial sector.

In an article published in the Irish Examiner by Claire O` Sullivan (15/01/2010) it states that in the year 2009, 26,000 homeowners were reported to have had difficulties in meeting their mortgage repayments.

Give example of people unable to repay mortgages and how it has affected financial sector.

The Mortgage War:

The demand for credit to fund household mortgages also brought a sense of competitiveness between banks to secure mortgage deals. This competitiveness however resulted in banks cutting corners, relaxing lending standards and easing credit conditions. A move that would have significant consequences on the Irish economy. Ross (2009) identifies this phase of competitiveness between Irish banks as "The Mortgage War" in which Bank of Scotland became the first foreign bank to challenge the ever booming Irish mortgage market. It did so by cutting mortgage interest to 3.99% while other leading banks had been charging on average 1.25% higher. Within two weeks both Allied Irish Bank (AIB) and Bank of Ireland also lowered their mortgage interest rates respectively. AIB matched the Bank of Scotlands 3.99% while Bank of Ireland lowered their rate to 3.95%. At the same time, lending standards began to slip as banks got caught up in the competitive side of people obtaining cheaper mortgages. Loans of three - four times a persons income were also adopted as oppose to the previous two and a half times. Mortgage terms were also extended from 20 or 25 years to 35 or even 40 years. Buyers were now able to afford more because of the longer pay back term of the loans. By 2006, 70 % of buyers had taken out mortgages for a term of 30 years or more.

Loan-to-Value Mortgages:

Loan-to-value (LTV) loans became a more common practice amongst Irish banks as the construction sector expanded and as economic wealth increased. A high LTV residential mortgage has been defined as "any loan, line of credit, or combination of credits secured by liens on or interests in owner-occupied 1- to 4- family residential property that equals or exceeds 90 per cent of the real estate's appraised value. (Wang (2007, p.2 from (see bottom of page). In simpler terms, this means that the mortgage loan being offered is for 90 per cent or more of the value of the property. (give risks of ltv mortgages here. )

In an Irish context, Ross (2009) evaluates this risky form of lending adopted by Irish banks. 2005 saw the introduction of 100 per cent mortgages which meant a loan for the entire selling price of the property. First Active were the first to introduce such loans followed by EBS, Permanent TSB, Bank of Ireland and the Irish Civil Service Building Society. In 2006, 36% of first time buyers availed of 100 per cent mortgages.

Poor Regulation by the Financial Regulator:

A significant warning sign often used by regulators to identify an exposed bank is when an annual growth rate of 20 per cent real occurs as illustrated by Anglo Irish Bank when they exceeded the 20 per cent mark in 8 out of 9 years. Its annual average growth rate from 1998 - 2007 was in fact 36 per cent. Irish Nationwide also crossed the 20 per cent mark in 6 out of 9 years (Honohan 2009b). The question must then be asked, why were these financial institutions not regulated to the regulation standards set out?

To gain a better understanding on why Irish banks were not regulated correctly, a study examining the increases and decreases in real house prices since 1970 across eighteen major industrial countries with particular attention being paid to monetary policy practices shows that house price booms are generally accompanied by a loosening of monetary policy. (Ahearne et al., 2005).

The findings made by Ahearne et al., (2005) mirror strongly, the monetary policy adopted by the Financial Regulator of Ireland during the construction boom years. The CCP (2009) conclude that the Financial Regulator did not adhere to its primary duty in ensuring a healthy financial sector was maintained. Furthermore, consumers with mortgages will suffer due to the unsatisfactory supervision by the Financial Regulator on Irish banks reckless practices.

Employment and Construction Output:

Co-relation Between construction activity & employment trends.

A recent study by the RICS (2008) suggests that there is a strong relationship between the decline in construction activity and employment trends across the Irish construction sector. The RICS (2008) continues to state the fundamental reasons for the loss of jobs in that the recent tightening of credit conditions means that first-time house buyers cannot get mortgage approval, resulting in housebuilders and developers ceasing work due to lack of revenue resulting in a reduction of construction output. This results in developers and housebuilders failing to complete developments due to lack of demand. To curtail the effect of this to a certain extent, builders and developers seek to reduce their cost base to remain solvent. The first costs to be cut are variable costs which generally mean a large-scale reduction in the workforce.

Unemployment amongst Irish Construction Workers.

The relationship is clearly evident in an Irish context in that the decline in construction output has had a significant effect on employment trends across the construction sector. Due to the strong correlation between the construction industry and the wider economy, the construction sector has been the most affected area above all other sectors. DKM (2007) state that during the peak point of the construction output, there were 280,300 persons employed in the construction sector. This figure represented 13.4% of Irelands total employment. The NESC (2008) give a different perspective on the employment levels achieved in the construction industry, stating that the sector was responsible for 29.3% of the countries total employment growth between 2000 and 2006. Within this six year period, employment increased by an annual average of 8 per cent within the construction industry.

The NESC (2008) continues to detail the marked slowdown in employment figures within the construction industry, indicating a severe downturn in the economy and a sharp correction of the housing market. Construction industry employment continued to grow during 2007 with a further increase of 3.6%. Following this increase however, a marked slowdown in the growth of construction employment occurred and during the same year, this figure turned negative in the final quarter of 2007. It was clear at this point that the economic crisis was beginning to take its toll on the construction sector. Employment in the construction sector fell by 2% (5,600 people) in the year to the final quarter of 2007, in comparison to an increase in employment of 12% in the same period of 2006.

More recent figures released by the CSO (2009) indicate that the construction sector suffered more among any other sector in that employment in the construction sector fell by 80,800 (-34.8%) between the beginning of January to the end of September of 2009. Also from its peak of 273,000 employed in the construction sector in the second quarter of 2009, a decline of 115,000 persons has occurred (Beggs et al., 2009) Check!!

Unemployment amongst non-Irish nationals.

Since the establishment of the European Union, it allows for citizens of EU countries the right to be employed in any EU member state. Irelands construction sector accounted for the largest share of employment in all EU countries. In 2005, it accounted for 12.6% of total employment in the sector. (Bobek et al., from CSO 2006 (2008). As the construction sector accounts foe such a large proportion of foreign employment, it was deemed necessary to be analysis.

According to the CSO (2009) non-Irish nationals accounted for 13.7% of all persons aged 15 and over in employment during the third quarter of 2009 in comparison to 15.4% in the third quarter of 2008, showing a decrease of 1.7% in the Irish labor force. The construction sector accounted for the largest decrease in employment across all sectors amongst non-Irish nationals where 19,100 lost their jobs.

It has been identified by Krings et al (2009) that although both Irish and foreign national workers are affected by the economic crisis, the latter seem to be more affected when it comes to unemployment. Figures indicate that the unemployment rate among Irish nationals increased from 4.3 per cent to 7.3 per cent. In the case of foreign nationals however the unemployment rate saw a sharper increase. It rose from 5.6 per cent to 9.5 per cent (QNHS 2009). Another indicator of the fall of employment of foreign nationals as oppose to Irish nationals is presented by the Central Statistics Office (2009). Between December 2007 and 2008, the number of foreign nationals seeking social welfare benefits climbed to over 130 per cent from 23,234 to 54,455. as oppose to a much lesser figure of 60 per cent. It should also be remembered however that there are far more Irish nationals working in the con ind tha non i

What does this mean for foreign nationals who have lost employment during the economic downturn? On one hand, the theory is that although unemployed, evidence suggests that migrant workers are remaining in Ireland and not returning to their home countries. Krings et al (2009) concludes by stating that "a significant majority of NMS migrants remain in employment, in spite of the downturn, and the situation in the home countries may be even worse. Furthermore, even if migrants should lose their job in Ireland, welfare arrangements offer some protection against unemployment. Moreover, the longer migrants stay in the host country, the more non-economic factors such as social networks and quality of life take on a greater importance. NMS migrants may be more mobile than previous generations of European immigrants, but for the moment at least, there is little evidence to suggest that the current crisis will trigger large-scale return migration from Ireland."

A more recent study shows however that this is not the case, ( see number of foreigners who have gone back to their country cso q3 2009)

Effect on Construction Output.

The decline in construction output strongly mirrors the decline in employment stated above. According to the CSO (2007) "The volume of production in building and construction decreased by 8.1% in the first quarter 2007 compared to the first quarter 2006. The volume of production in residential building decreased by 19.0% in the first quarter of 2007 when compared with the corresponding period of 2006. The volume of residential output has been decreasing on an annual basis since the second quarter of 2006." The most recent figures released by the CSO (2009) state that "the volume of output in building and construction decreased by 36.9% in the third quarter of 2009 compared with the third quarter of 2008. The fall in the volume of output largely reflects declines of over 55% and over 31% respectively in residential building work and non-residential building work."

When comparing this to the output experienced in construction during the boom years, the effects become evidently clear. (state output here)

Future employment.

According to Morgenroth (2009) public capital projects is the long term future for the construction industry. It is unlikely that employment levels will reach the same levels as they did during their peak and therefore the construction industry will have to grow again along with construction workers skills. However given the amount of construction workers in Europe, it may not take as long as expected to re-build the industry again. It is also noted that if policies supporting the construction sector keep the size of the sector above its long-run level, it will only postpone further contraction.

Morgenroth (2009, p.9) continues to state that "it is important to avoid a situation where employment in the construction sector is maintained at artificially high levels through public projects as seems to have been the case with Japan. Japan has been spending consistently more on public capital than other OECD countries. An often cited example is that of dam building. While Japan has only around 100 major rivers and none longer than 367km, 100s of expensive dams were built. Now construction companies find a lucrative market in dismantling old dams." The effects of this are unnecessary costs to public finances which accommodate the payment of workers and running of the projects.

Conclusion:

The Irish economy has been brought to its knees by what has been described as a twin crisis in that the main driver of economic growth over the past decade, the property bubble has collapsed, coupled with poor bank related mortgage lending practices and failure by the financial regulator to lull such reckless practices being carried out by banks. The lengthy period of property related economic success gave a false sense of security to policy makers who failed to ensure the basics; Prudent and strict regulation of the main Irish banks.

Because the construction sector was such a prominent driver of economic growth, it has resulted in it being the most affected area across the labor force. Tens of thousands of construction workers continue to lose their jobs and join the long list of many who currently claim social welfare benefits or have been forced to emigrate to seek work in other countries with more favorable economic conditions than Ireland.

Building and construction output is also at a serious low mainly because of over-developing during the boom years. Also, house buyers who once bought property at the peak of the construction boom now find that their property is worth less than what they paid for it. Investors also suffered as prices of the property they invested in declined.

While there is a possibility of economic recovery beginning by 2011, it is expected that the economy will not reach a meaningful stage of recovery until 2015 (Bergin et al., 2009).

REFERENCES:

Ahearne, A. Ammer, J. Doyle, B. Kole, L. Martin, R. (2005) House Prices and Monetary Policy: A Cross Country Study, International Finance Discussion Papers No. 841, Board of Governors of the Federal Reserve System, September.

Bergin, A. Conefrey, T. Fitz Gerald, J. Kearney, I. (2009) Recovery Scenarios for Ireland, Dublin, Economic and Social Research Institute.

Calverley, J. (2009) When Bubbles Burst: Surviving the Financial Fallout, London-Boston, Nicholas Brealey Publishing.

Central Bank of Ireland (2008) Sectoral Developments in Private Sector Credit, March.

Consultative Consumer Panel (2009) Submission on the Performance Review of the Financial Regulator 2008/2009, December.

Davis, E. Zhu, H. (2004) Bank Lending and Commercial Property Cycles: Some Cross-Country Evidence, Technical Report No. 150, BIS.

DKM Economic Consultants, (2007) Review of the Construction Industry 2006 and Outlook 2007-2009, Dublin.

Economic and Social Research Institute (2007)

Fase, M. (1995) The Demand for Commercial Bank Loans and the Lending Rate, European Economic Review 39, 99-115.

Fitzpatrick, T. McQuinn, K. (2004) House Prices and Mortgage Credit: Empirical Evidence for Ireland, Research Technical Paper, Economic Analysis and Research Department, Central Bank and Financial Services Authority of Ireland, October.

Haughton, J. (2009)

Honohan, P. (2009a) What Went Wrong in Ireland? Trinity College Dublin, Prepared for the World Bank, May.

Honohan, P. (2009b) Resolving Irelands Banking Crisis, Department of Economics and IIIS, Trinity College Dublin and CEPR, Dublin, January.

Kelly, M. (2007) On the Likely Extent of Falls in Irish House Prices, UCD Centre for Economic Research, Working Paper Series, February.

Kenny, G. (1998) The Housing Market and the Macroeconomy: Evidence from Ireland, Technical Paper, Economic Analysis, Research and Publications Department, Central Bank of Ireland, March.

McQuinn, K. O`Reilly, G. (2007) A Model of Cross-Country House Prices, Research Technical Paper, Central Bank and Financial Services Authority of Ireland, July.

Naoum, Dr. S. G. (1998) Dissertation Research and Writing for Construction Students, Oxford, Buttersworth-Heinemann.

National Economic and Social Council (2008) The Irish Economy in the 21st Century, No. 117, June 2008.

National Economic and Social Council (2009) Irelands Five Part Crises: An Integrated National Response, No. 188, March 2009.

OECD (2008a),

Permanent TSB/ERSI (2009)

Power, J. (2009) Picking Up the Pieces: Economic Crisis and Hope in Ireland, Dublin, Blackhall Publishing.

Royal Institution of Chartered Surveyors (2008) Construction and Building Research Confrence: Cobra 2008, September.

Ross, S. (2009) The Bankers: How the Banks Brought Ireland to its Knees, Dublin, Penguin Ireland.

Notes.

Downgrading of Irelands international credit rating (p.13)

Foreign investing (p.13-14)

Global downturn (p.15

Now everything's a little upside down, as a matter of fact the wheels have stopped, what's good is bad, what's bad is good, you will find out when you reach the top, you're on the bottom

Bob Dylan, 'Idiot Wind', 1974

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