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.