The Irish Housing Bubble And Bust

The recent housing bubble in Ireland defied the laws of economics. Supply and demand rose simultaneously, the market rose to absurd heights before crashing to unheard of lows. It went from an extreme of being able to sell a house no matter how high the price, to one where you can’t sell a house no matter how low you drop the price. According to everything I have been taught about economics, this could not happen. Textbooks are useless in understanding the bubble. According to them the price is always right, that left alone the free market will make everyone better off. Bubbles or recessions don’t happen. Any exceptions are temporary; it’s not possible for a decade of boom to be replaced by a decade of bust. But that is what has happened.

Textbook neo-classical economics believes the market is always right so that if prices rise there must be a good reason for this. Initially there was. In the 1990s, the economy began to grow, as did population. There were sensible reasons for construction to expand and prices to rise. However the most common expression in Ireland to describe these years is “We lost the run of ourselves”. Sensible investments were gradually replaced with speculation. Prices began to soar and sales soared with them. Supply and demand went out the window as prices and sales rose higher and higher. It was conventional wisdom that the price of houses always rises. It was one of those “facts” that everyone knew and no one had to prove. It was like saying politicians were dishonest or the Church was a disgrace. It was an obvious point.

We were gripped by irrational exuberance and overconfidence. Newspapers were filled with articles about how great things were. The centuries of poverty in Ireland were over, we were finally rich. Now was a time of prosperity. After decades of despair (that pretty much sums up most of post-independence Ireland) we finally had the right to be confident. Unfortunately this lead to over confidence and hubris. Everyone believed the boom would last forever. House prices would always rise; every investment would always pay off no matter what it was. Everyone got caught up in it. Banks were over-confident and gave out loans carelessly without properly checking if they could be repaid. This money many went to property developers who made investments that were little more than speculation. Build houses and they will sell regardless of location or quality.

Fuel was poured on the fire by government policies that favoured the developers (who were cronies of the ruling Fianna Fail party). There were generous tax breaks to developers, hotels in particular leading to an oversupply which has nearly killed the industry. Low taxes in general boosted the boom and left the state dangerously exposed if house sales and construction declined. Low interest rates and the inflow of capital from Europe after the creation of the Euro helped overheat the economy. Capital flowed into the country and into the construction industry in general. But the main culprit (other than overconfidence) was ideology. It was commonly asserted that the market would solve our problems, that “a rising tide lifts all boats”. There were calls for government to stand aside and allow entrepreneurs the freedom to create prosperity. The financial regulator was someone who believed that regulations only harmed the economy and that the invisible hand of the market would prevent excesses. Governments made people poorer, the market made people richer, or so the thinking went.

Needless to say, it all came crashing down. Left alone the free market drove the economy off a cliff. The housing market eventually collapsed and construction ground to a halt. The economy sharply declined and mass unemployment resulted. Banks came dangerously close to collapse and only government intervention saved capitalism from itself. The collapse in revenue (the disadvantage of having a low tax economy) caused a huge budget deficit, which the government is trying to solve by cutting spending (there’s Irish logic for you). It is quite likely that this period of bust will last as long as the boom did. In year five of the recession and things don’t seem to be getting better anytime soon.

Traditional economics argues that the economy is run by impersonal supply and demand. However Keynes argued that it was “animal spirits”. The housing market went from over confidence to under-confidence. The market has frozen up for the last five years. It is next to impossible to sell a house no matter how much the price is slashed. It is estimated that prices have fallen by between a half and two-thirds and yet the market has not reached equilibrium. The market isn’t clearing. Instead everyone is gripped by fear. Everyone is too afraid to risk investing in a depressed market when no one is buying and assets may not have reached bottom. With deflation there is no point buying a house today when it will be cheaper next month. This means that no one is buying houses. Neo-classical economics was wrong about the boom and it was wrong about the bust.

Looking at the Irish housing market over the last decade and you’d be hard pressed to find any evidence of supply and demand or rational behaviour or anything that neo-classical textbooks describe. Instead we were gripped by animal spirits of euphoria and depression. We’ve swung from extremes of the boom will never end so spend, spend, spend to the bust will never end so save, save, save. The economy is mired in stagnation with no one willing to invest.

This example should provide a lesson on the unregulated free market, speculation, irrational exuberance, confidence, boom, deflation, bust and the failure of neo-classical economics to explain the real world.

9 thoughts on “The Irish Housing Bubble And Bust”

  1. Welcome back.

    I tend to agree with you about the failure of neo-classical economists. Nothing too controversial there.

    You repeatedly blame “the free market” for what happened. But presumably you wouldn’t argue that we had a completely pure form of capitalism during the boom; you would agree that we had some significant elements of government intervention at all times. I might suggest you try a little harder to imagine what a purer form of capitalism would look like.

    Do you understand where money comes from? It wasn’t a creation of the state. Indeed, money is older than the state. It arose spontaneously as people sought ways to expand the sphere of trade. It was discovered that accepting a highly marketable commodity as payment enabled you to trade that commodity in exchange for the good or service which you had originally wanted in the first place. Thus did human society evolve away from the barter system and solve the terrible problems with that system – the non-coincidence of wants (the fact that the good or service which you desire may not be offered by someone who also desires the particular goods and services which you produce) and the problem of divisibility (for example, if you are a housebuilder, it may be impossible for the person who buys the house from you to repay you with the many different goods and services which you would have hoped to receive in compensation for your work).

    Why do I bother pointing this out to you? To help make it clear that money itself is something which existed and would exist without the state. There is no technical reason why there must be a central government monopoly over it. Once we know this, it is clear that any era of government-controlled money, and particularly a government-controlled fiat paper money, is quite far from that which should rightfully be referred to as “the free market”. The free market would very quickly see people insisting that their money was backed by gold. Banks would compete with each other to issue banknotes which people trusted, and interest rates would finally be aligned to the actual time preferences and investment and consumption opportunities available to the people. Importantly, banks which continued to operate with unacceptably low and unstable fractional reserves would see their supplies of base money flow to their rivals. The economy would get onto a sound footing with investment which was based on real savings and not just on the expansion of fake credit or the rapid injection of worthless new quantities of digital base money.

    It should only take a further moment’s thought to realise that, purely on the grounds of its fiat money system, Ireland has not had something which could properly be called a true “free market”. It has had elements of the free market, and elements of socialism.

    I was not active in the Irish economy in the early 90s (I am only a few years older than you), but it only takes the reading of short publications such as “The Irish Pound: From Origins to EMU” which is available on the Central Bank’s website, to see that the Central Bank, in concert with their European counterparts though the exchange rate mechanism, was heavily involved in manipulating the value of the Irish pound throughout the late 20th century. Interest rates were depressed and money markets interfered with, time and time again. This process of manipulation only accelerated with the creation of the euro.

    I have already explained that to manipulate interest rates is to fundamentally alter the structure of an economy, ruining the process of the inter-temporal allocation of resources. But there is something else I would like to mention which I have discussed before on CLR and which you mention in the above post – financial regulation.

    You have claimed that a lack of regulation was to blame for the crisis. However, you are rather light on the details of how exactly more regulation would have been of any help.

    It’s true that fraud was committed during the boom, but fraud was not responsible for the boom. Rather, the boom was caused, as I have argued, by a fiat money system which continuously suppressed interest rates and expanded the money supply until it finally exploded in 2007-2008. But even if you disagree with that diagnosis, I think we both agree that assets were mispriced and that this is at the heart of the crisis. Therefore, the problem was not strictly speaking one of fraud, but that people did not know that their assets were mispriced.

    Given this, how can financial regulation be of an help? Such a theory implies that financial regulators have greater knowledge of what asset prices should be than the people who are actually investing in these assets with their own money. Of course, the irony here is that the academics and bureaucrats who inhabit these institutions are in many cases responsible for causing the crisis in the first place, by the inflation, the moral hazard, and the lack of competition in the banking sector which they have incited and encouraged over many years thanks to their faulty understanding of economics. But even putting that aside for one moment, it is a ludicrous suggestion on its face that any small number of individuals should be given dictatorial control over asset prices in the economy. We already have that in the form of central bankers, and we can see that they are unable to predict anything in the economy. Look at the record of the Bank of England’s inflation forecasts over a two-year time horizon, the ECB’s predictions regarding stability in the eurozone, and Ben Bernanke’s assessments of the US economy if you don’t believe me. To hand absolute control over asset prices to people like this would be an even faster form of economic suicide than that which we are already committig.

    And there is one other point here with respect to democracy: if you think that people in general aren’t intelligent enough to figure out that assets are mispriced, it seems unlikely that they will vote for the appropriate economic policies which will then correct these mispricings. It’s more likely that the government and therefore the regulators will be packed with people who generally reflect the misconceptions of the public at large. This is borne out in the observation that the democratically-elected governments of Ireland and the regulators at the time were very happy with the booming economy of the late 20th and early 21st centuries.

    1. Thanks the detailed comment as always. Your first premise is wrong, money cannot exist without the state. Without the state to place value on money and to standardise it, money is useless. It is only as good as its intrinsic value, in other words it is no better than barter. In Europe all money was originally minted by the state and had the rulers face on it. So there is nothing natural about money.

      Your proposal for each bank having their own money supply seems a recipe for chaos and hyperinflation. How will people choose the best money? I don’t think you can argue banks are a business like any other, for example there is a wide scope for theft and fraud, and banks can derail an entire economy. I fail to see how banks will be prevented from taking large risks or reckless gambles.

      If a fiat currency means a country cannot claim to have a free market, surely that excludes every country currently in existence today and for the past couple of centuries? In fact would that mean there has not been a free market since the Bronze Age?

      The essential cause of the crash was that banks (Anglo Irish Bank in particular) took huge reckless risks and invested carelessly. The financial regulator should have prevented it from taking these risks (for example it has a very low reserve ratio and was highly leveraged). That’s the argument in a nutshell, the definitive account is “Anglo Republic” by Simon Carswell.

      True asset prices were the main element of the boom, but banks were heavily reliant on these assets by heavily lending to property developers. So when the construction industry collapsed it brought the banks down with them.

      The government cannot set the price of assets (I’m not advocating Communism) but it can dampen the rise in prices through taxes, interest rates, lending rules etc.

      Ironically competition made the situation worse not better. The old establishment banks (AIB and Bank of Ireland) stuck to safe conservative loans. It was the new banks (Anglo and Irish Nationwide) that made the reckless loans. As it was a bubble these reckless gambles paid off and they made huge profits. So pursuit of profit lead to the crash. The establishment banks had to follow Anglo’s lead or lose their share of the market. The only way a bank can have an edge over its rivals is if it has either lower interest rate on its loans or has laxer rules, both of which added fuel to the bubble. (I am speaking of banks which focus on development loans as most Irish banks did in the boom)

      1. Hi there,

        Before we go any further, I have to point out the money has existed in many forms without the imprimatur of the state.

        Besides privately minted coins which have existed from time to time (when the relevant government was unable or chose not to monopolise the Mint), there is also a long free banking tradition which has existed in many countries, of which Scotland and the United States are in my opinion the most noteworthy:

        And for the reasons I outlined above, there are overwhelming economic reasons for people to use a medium of exchange. A widely reported phenomenon in World War 2 was the use of of cigarettes as money among captured prisoners. Rather sophisticated pricing systems developed spontaneously, facilitating trade among POWs. It doesn’t take a great deal of analysis to see that the economic forces underpinning a medium of exchange irresistibly attract people to use money regardless of whether the government chooses to monopolise its production. The notion that money is worthless without the approval of government is something which ascribes economically supernatural powers to the State.

        One other thing: with respect to standardisation, I need only point out that the free market produces standardisation whenever it makes sense to do so. Consider the shape of credit cards, DVDs, USB ports etc. These formats are settled voluntarily by market participants. We can have standardisation without any government monopoly.

        Again, the mere fact that most governments have monopolised the production of money does not prove the money cannot exist without the government. We know that governments tends to monopolise the most critical and often the most valuable sectors of their economy. It makes sense that rulers would have a strong interest in controlling their money supply. The history of currency debasements, devaluations and hyperinflations in Europe is testimony to the great thefts which have been committed by governments against their people.

      2. Each paragraph of yours contains such a knot of errors (from my humble perspective) that I can’t respond with just a single paragraph to each one.

        “Your proposal for each bank having their own money supply seems a recipe for chaos and hyperinflation. How will people choose the best money? I don’t think you can argue banks are a business like any other, for example there is a wide scope for theft and fraud, and banks can derail an entire economy. I fail to see how banks will be prevented from taking large risks or reckless gambles.”

        What you’ve got to remember is that the reason people accept banknotes as payment is a combination of (1) belief that the banknote has some value, and (2) the fact that the banknote has the privileged status of legal tender – valid for the settlement of all debts.

        Some people falsely believe that free banking leads to hyperinflation because they think that rival banks will issue banknotes until they are worth less than the paper they are printed on. The banks would do this, but only if they each had the power to issue legal tender. On the other hand, if we aren’t obliged to accept a bank’s notes as payment, then it is up to each bank to gain a reputation for issuing notes worthy of being used. The over-issuance of notes will lead to a collapse in their value (made all the more obvious if the notes are supposed to be backed by a hard commodity, which is likely). Therefore, in order to maintain their business for the long-term, banks will have to issue notes which people trust.

        If this seems impossible or unimaginable, then simply reflect on the struggle for general acceptance between Visa and Mastercard and their competitors. Think of bank cheques, whose acceptance is at the discretion of the payee. Think of Andorra, which historically allowed people to use either Spanish pesetas or French francs as they preferred.

        If the legal tender consideration is removed, then the only reason for somebody to accept is a banknote is if they consider it worthy of being accepted. The monopoly power of the central bank and the cartel of commercial banks which it operates is broken. The Bank of England (for example) now has to overcome the threat of rival banks to demonstrate that Bank of England notes are the best available form of money. This means, among other things, convincing people that their money is a reliable store of value. This means not pursuing inflationary policies which devalue people’s savings in BoE banknotes over time. This means commercial banks with BoE deposits offering attractive interest rates. Above all, this means regaining the trust of society at large.

        Your paragraph is delicious in its irony.

        “I don’t think you can argue banks are a business like any other, for example there is a wide scope for theft and fraud”

        We have just witnessed a meltdown in recent years of the central bank-controlled banking cartels in most of the Western world, with considerable theft and fraud having taken place inside the system. Arguably the greatest theft of all has been that committed by the counterfeiting central banks themselves, whose inflationary policies (quantitative easing and ZIRP) have impoverished savers and transferred vast quantities of wealth away from ordinary people and to the government itself (buying government debt) and to the banking system (bank bailouts and guarantees).

        “banks can derail an entire economy. I fail to see how banks will be prevented from taking large risks or reckless gambles.”

        Banks just did derail our entire economies. They took large risks and reckless gambles as part of a massive credit bubble in our fractional reserve banking systems – caused by the policies and the powers of the central banks themselves. Deposit insurance and the regulators gave people a false sense of safety, as did the assumption that implicit government guarantees and the “lender of last resort” central banks would come to the rescue in the event of a crisis. Our systems are rife with moral hazard and dulled incentives, precisely because we don’t have a free market in banking.

        1. I think you are over simplifying a complex issue. Listen competition is good in most areas but not every single one. If there are multiple currencies, say 10 or 20, then we would not have simple free market, but confusing chaos. How are ordinary people supposed to understand and base decisions upon the intricities of monetary theory? What average non-economist could tell you which currency is more stable or reliable? I’m not sure if I could and I study this stuff! If businesses accept some currencies but not others then the economy would become infinitely more complex and messy. They might need one currency to pay for their dinner another to their rent and a third to pay electricity. One of the advantages of having one currency is that you are guaranteed it will be accepted and it is a common measurement. In your world every consumer would have to become a financial expert to follow the constant changing value of all the currencies. If they didn’t then there wouldn’t be free competition and chaos would result.

          Hyperinflation is usually caused by a massive increase in the money supply. If there are multiple competiting currencies then each one will aim to print enough money for the entire economy because people will naturally choose the currency that is accepted everywhere rather than one which is limited. (A bit like facebook and social network sites, you want to be on the one everyone is on) This massive printing of money will lead to hyperinflation.

          Visa and Mastercard are not a good example as they are not seperate currencies but rather seperate ways of paying. They are still based on solid foundations. Likewise Andorra allows other currencies (backed by states much larger than itself) because it is too small to support its own currency.

          I think you missed my point on fraud. I’m am talking about literal fraud which occurred in private banks and was not prevented because the regulator did not want to interfere in the free market. What you are refering to is less theft and more a redistribution of wealth. It also hasn’t happened recently as inflation is very low.

          There is nothing stopping banks from taking reckless gambles in a free market. In fact doing so gives them a competitive edge (this was the case with Anglo). In a free market, the market would be free to drive itself over a cliff.

          1. You are right that money enjoys network effects – its usefulness is a function of how many other people are using it. This is why it is a good example of what many people call a natural monopoly. Therefore it’s highly unlikely that there would be anything like 10 or 20 different currencies in common usage in any area at any particular time. People will all tend to use the same currency, and this is true regardless of what the government does.

            The question then is whether something which is a natural monopoly should be turned into a coercive monopoly; i.e. whether competition should be not merely difficult for structural reasons but also a criminal offense.

            I’m glad you mentioned Facebook. “Social networks” also clearly have this same property which money has; it’s usefulness depends on how many of your friends are also using it. Does this mean that Facebook should have a government-backed coercive monopoly, without nobody else allowed to compete with it? Of course not. The structure of the market for social networks is such that anybody else has a very difficult time competing with them, but to make it illegal to use any other social network would not only be completely unnecessary but it would permanently remove Facebook’s fear of being usurped by another company. The outcome would be worse services for Facebook users.

            You ask whether ordinary people would be able to understand which currency to use, if they were offered multiple alternatives. They might not know for sure, and they might make mistakes, but at least the outcome would involve issuers of banknotes attempting to prove their trustworthiness, rather than needing to provide no evidence of trustworthiness whatsoever. As for the commodities which might be redeemable with those banknotes, it is likely that a free society would do what free societies have done for thousands of years, and select a precious metal as their money of choice.

            I can’t definitively guarantee that precious metals would be chosen as money by any society which was allowed to make the choice, but I can say it with as much certainty as I can about any forward-looking claim which concerns economic behaviour. For all practical purposes, it is a certainty.

            The claim “competition would be chaotic, therefore we must have a government monopoly” has been made about virtually every major service since the dawn of socialism – utilities, schools, healthcare, postal services. In extreme Communist regimes, similar claims would have been made for food, clothes, housing, etc.

            But the government is not composed of altruistic, omniscient, omnipotent people. The government, in other words, is not God. Giving the government a monopoly over a service just means that some people get jobs safe in the knowledge that anybody who tries to provide a better service will get locked up in prison.

            I might sound revolutionary with these arguments, but I don’t actually expect that if the Bank of England lost its monopoly powers tomorrow that people would suddenly stop using British pounds. All that I expect would happen is that some other companies would form offering rival currencies and seeking to gain reputations for their money not depreciating as quickly as British pounds and being a safer store of value. The Bank of England would then be faced with a choice: continue to dilute the value of their currency and risk losing their natural monopoly, or else change to more responsible monetary policies which satisfied the desires of their customers. I expect that they would choose the later.

            There is a common fallacy when you say that rival currencies would attempt to “print enough money for the entire economy”. So long as the money units are sufficiently divisible, any nominal quantity of a currency is sufficient for any economy. It’s not a terribly difficult technological problem. What really matters is what (if anything) is backing the currency.

            Visa and Mastercard are examples of payment-related services which are close to being natural monopolies. It’s true that they aren’t currencies themselves, but they are examples of private companies facilitating transactions with global recognition and without holding government monopolies. From that starting point, it’s easier to imagine a private company offering a currency which had global recognition and was accepted around the world, but had no government monopoly.

            You are correct, by the way, that Andorra is too small to support its own currency – or, more precisely, too small for the government of Andorra to successfully impose a coercive money monopoly on their people. All I wanted to note was that their economy functioned absolutely fine when the people were allowed to use more than one currency. I have visited the Far East and witnessed the use of multiple currencies. It’s a reasonable state of affairs which does not cause chaos. Indeed, the true cause of chaos is the imposition of separate government monopolies in each country in the first place. The fact that thousands of people are able to make a living out of nothing more productive than trading forex is evidence of the vast inefficiency which is created by the imposition of these monopolies.

            Literal fraud in private banks – can you point to some specific examples? Most of the alleged “fraud” cases I have seen were just bets which went wrong for one of the parties, who then alleges that they were misled about the beliefs or intentions of one of the parties before they signed the contract. Outright fraud can be policed and prosecuted without the need for excessive regulation. I think I would like to see specifically what you are talking about before commenting further on that issue.

            Finally, what you say about banks taking reckless gambles in a free market is true not just about banks but about any business. Let me put to one side for a moment Anglo’s status as an issuer of credit and loans within a government-controlled inflationary money monopoly bubble, and specifically talk about this question of debt. Any business can take on great debts and thereby provide the potential for outsized returns to the equity holders. But equity investors tend to worry about things like the capital structure of the business which they are investing in, and to assign risk premia according to the possibility of financial distress. Banks such as Anglo were leveraged to an unfathomable degree and the investors were happy enough with it at the time. Their investments turned to nothing. They took that hit. The same should have been true for the debt investors, who unfortunately have been bailed out.

            Debt investors, the source of Anglo’s leverage, have been proven to have made successful investments, thanks to the willingness of Irish governments to bail them out. If you want to lower the risk of banks taking on too much debt, then absolutely the first priority must be to abolish a system which bails out debt investors. Without the promise of governments providing a backstop to the financial system, they simply wouldn’t have access to that debt in the first place.

            Or if your great concern is about the vast quantity of fractional reserve credit loans made out of thin air, then again you need to look to get rid of this system we have which allows for digital money to be created with very little or nothing to back it up. It’s not merely about raising reserve requirements – governments have no idea what the reserve requirements ought to be. In a free market which, for example, had chosen gold as its medium of exchange, banks wouldn’t want to extend too much credit because it would mean that gold would start to flow to their rivals, and it would be difficult to hide this fact. Without an automatic bailout for creditors and depositors like they have today, banks which acted irresponsibly would see their sources of funding dry up as people sought out safer banks. Taking reckless risks would be terrible business for banks as it is for any business. Instead of the crumbling illusion of safety we enjoy today, we would have a system based on reality and on accountability.

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