Here is the unedited version of my article in the Sunday Times, November 27, 2011.
Since the collapse of the
bubble, Irish perceptions of the residential and commercial property markets
have swung from an unquestioning adoration to a passionate rejection.
As the result of the bubble,
the overall share of property in average household investment portfolio is
likely to decline over time from its Celtic Tiger highs of over 80% to a more
reasonable 50-60%, consistent with longer term averages in other advanced
economies. But housing will remain a significant part of the household
investment for a number of good reasons.
While providing shelter,
housing wealth also serves as a long-term savings vehicle and an asset for
additional borrowing for shorter-term investments. Security of housing wealth
in normal times acts as an asset cushion for family-owned start up businesses
and a convenient tool for regular savings. Over the lifetime, as demand for
housing grows with family size, we increase our savings, normally just as our
life cycle earnings increase. We subsequently can draw down these savings
throughout the retirement when income from work drops.
In short, in a normal
economy, housing and household investment are naturally linked. In this light,
the grave nature of our economic malaise should be apparent to all. Ireland is
experiencing a continued and extremely deep balance sheet recession, with twin
collapses in property prices and investment that underlie structural demise of
our economy.
The latest Residential
Property Price Index, released this week, shows that things are only getting
worse on the former front. Overall, residential property price index fell to
71.2 in October from 72.8 in September. The latest monthly decline of 2.2% is
the sharpest since March 2009 and the third fastest in the history of the
index. Relative to peak prices are now down 45.4%. Take a look at two
components of household investment portfolios: owner-occupied and buy-to-let
properties. For the majority of the middle class families, the former is
represented by a family home. The latter, on average, is represented by
apartments. Nationwide, per CSO, prices of these assets are respectively down
43.7% and 57.9% relative to the peak.
The impact of these price
movements is significant and, contrary to the assertions of the Government and
official analysts, real and painful. House price declines imply real capital
losses to households and these losses have to be offset, over time, with
decreased consumption and falling investment elsewhere. Absent normal loss
provisioning available to professional financial sector investors and
businesses, households suffer catastrophic collapses on the assets side of
their balance sheet, while liabilities (value of mortgages) remain intact.
Decades-long underinvestment and low consumption spending await Ireland.
Dynamically, things are not looking any
brighter today than a year ago. House prices have fallen 14.9% year on year in
October, the worst annual drop since February 2010. Apartments prices are down
19.8% over the last 12 months – the worst annualized performance since April
2010. Given the price dynamics
over the last three years, as well as the current underlying personal income,
interest rates and rental yields fundamentals, Irish property prices remain at
the levels above the short-term and medium-term equilibrium. This means we can
expect another double-digit correction in 2012 followed by shallower declines
in 2013.
Not surprisingly, the collapse of the property markets in
Ireland is mirrored by an even deeper crash in overall investment activity in
the economy. The latest National Accounts data shows that in 2010, gross fixed
capital formation in Ireland declined to €19 billion in constant prices. This
year, data to-date suggests that capital formation will drop even further, to
ca €17 billion or almost 58% below the peak levels. In historical terms, these
levels of investment activity are comparable only with 1996-1997 average. If we
assume that the excess investments in the property sector were starting to
manifest themselves around 2002, to get Irish economy back to pre-boom
investment path would require gross fixed capital investment of some €26.9
billion per annum or more than 60% above current levels.
Between 2000 and 2009, Irish economy absorbed some €319
billion in new fixed capital investments. Assuming combined rate of
amortization and depreciation of 8% per annum, just to keep that stock of
capital in working shape requires €25.5 billion of new investment. This mans
that in 3 years since 2009, the Irish economy has lost some €15.5 billion worth
of fixed capital to normal wear-and-tear. In short, we are no longer even
replacing the capital stock we have, let alone add new productive capacity to
this economy.
Looking into sectoral distribution of investment, all
sectors of economic activity outside building and construction have seen their
capital investment fall by between 18.4% in the case of Fuel and Power Products
to 70.4% in the case of Agriculture, Forestry and Fishing sector. So the
aforementioned aggregate collapse of investment is replicated across the entire
economy.
The dramatic destruction of capital investment in the
private sector is not being helped by the fact that Government capital
expenditure is also contracting. In 2010, Voted Capital Expenditure by the
Irish Government declined to €5.9 billion. This year, based on 10 months
through October data, it is on track to fall even further to €4 billion – below
the target of €4.35 billion and more than 53% below the peak. In fact, the
entire adjustment in public expenditure to-date can be attributed to the
capital spending cuts, as current expenditure actually rose over the years of
crisis. Since 2008, current expenditure by the state is up 1.9% or €775 million
this year, based on the data through October. Thus in 2008, Irish Government
spent 17.4% of its total voted expenditure on capital investment. This year the
figure is likely to be under 8.8%.
Forthcoming Budget 2012 changes are likely to make matters
worse for capital investment. In addition to taking even more cash out of the
pockets of those still in employment – thereby reducing further the pool of
potential savings – the Government is likely to bring in the first measures of
property taxation. This will reinforce households’ expectations that by
2013-2014 Ireland will have a residential property tax that will place
disproportional burden on urban dwellers – the very segment of population that
tends to invest more intensively over time in property improvements, making the
urban stock of housing more economically productive than rural. A tax measure
that would be least distorting in terms of incentives to increase productivity
of the housing stock – a site-value tax – now appears to be abandoned by the
Government, despite previous commitments to introduce it.
Furthermore, we can expect in the next two years abolition
of capital tax reliefs, increases in capital tax rates and high likelihood of
some sort of wealth taxes – direct levies on capital and/or savings for
ordinary households. In the case of the euro area break up, Ireland will also
see draconian capital controls.
In short, we are now set to experience an 8-10 years period
of direct and accelerating destruction of our capital base. It doesn’t matter
which school of economic thought one belongs to, there can be no recovery
without capital investment returning back to growth.
Box-out:
In the recent paper titled “The Eurozone Crisis: How Banks
and Sovereigns Came to Be Joined at the Hip”, published last month, two IMF
researchers identify Europe’s Lehman’s moment in the global financial crisis as
the day when the Irish Government nationalized the Anglo Irish Bank. In
contrast to the current and previous Governments’ assertions, the IMF study
argues that the Anglo was not a systemically important bank worthy of a rescue.
As the paper puts it: “The problems [of collapsing financial sector valuations]
entered a new phase – becoming a full-blown crisis – with the nationalisation
of Anglo Irish in January 2009. The relevance of Anglo is, at first, not
obvious, since it was a small bank in a relatively small country. However, …it
is possible that the large fiscal costs as a share of Ireland’s GDP associated
with this rescue raised serious concerns about fiscal sustainability. Suddenly,
the ability of the sovereigns to support the financial sector came into
question.” In other words, far from helping to avert or alleviate the crisis,
Anglo nationalization caused the crisis to spread. “In retrospect, the nature
of the crisis prior to Anglo Irish was simple, being mostly driven by problems
in the financial sector… The winding down of Anglo Irish, for example, would
have been preferable to its nationalization…” In effect, the previous
Government made Anglo systemically important by rescuing it. If there ever was
a better example of the medicine that kills the patient.
