The heading on the article said :'In the Central Bank's Autumn Bulletin two of the bank's economists, Tom O'Connell and Terry Quinn, concluded. 'The vulnerability of the Irish economy to events that might cause a large asset price reversal would seem to be relatively small.' This view has also been taken by Jim O'Leary, the chief economist with Davy Stockbrokers, and quoted approvingly by Dr. Garrett Fitzgerald, if my reading of press comments is correct (wrote WILLIAM SLATTERY). He continued:
'I believe this conclusion to be wrong. At some time in the next few years we are likely to see the beginning of what will be a significant decline in property prices, including in particular, residential property. The main reason for such a decline will relate to the size of the current rate of growth in borrowing which is, of course, supporting the existing level of asset prices.
Exceptional credit growth
Year on year aggregate credit growth (the total level of credit in the economy now compared with this time last year) is currently running at 30% (end October figure) and it is likely that end-year growth will be running around this level. The 1999 figure follows four years of exceptionally strong growth, e.g. growth in 1998 and 1997 exceeded 20%. The Central Bank forecast of GNP at the end of 1999 is €74 billion.
On the basis of a maintained year-on-year growth rate to the end of the year aggregate private sector credit will be €90 billion or about 120% of GNP (I should point out that Irish credit data are somewhat distorted by the inclusion of lending to IFSC companies. However taking account of this and other distortions in the statistics, I believe the underlying picture is not materially different to that presented here.)
What is remarkable is that growth in credit in 1999 at about €20 billion will be around 30% of end 1998 GNP, and about 20% of GNP or €13billion in excess of the nominal growth in GNP. GNP figures are more meaningful in Ireland's case than the usual GDP figures quoted because of the distortionary effects of profit repatriation by foreign companies on Ireland's GDP.
This level of credit growth cannot be sustained but there is currently no sign of a slow-down. Indeed, the construction industry is currently running to full capacity and there appears to be a general expectation that this level of activity will continue through 2000 and beyond. The size of the tax concessions in the recent budget seems likely to fuel significant activity in 2000. A continuation of 1999 years growth into this year would bring aggregate credit to about 140% of GNP. It is beyond the scope of this article to undertake a full international analysis of the levels of aggregate credit but the systemic crises which occurred in Asia last year took place when aggregate credit in those countries appears to have been of the order of 150% of GNP. Further, peak credit growth in the Scandinavian economies when their banking systems went through systemic crises about ten years ago, was around 35%, not much more than our current levels. So, previous experiences point to the severe dangers that we face. An article in the December 22 edition of Standard and Poor's Credit Week mentioned Ireland as one of seven countries with a financial system vulnerable to a credit bust.
Over the next few years, nominal GNP growth will probably not be more than 10%, taking account real economic growth and inflation taken together. At some stage credit growth will have to revert to that level as that would bring about a stabilisation of the level of credit relative to the size of the economy. When that happens, annual expenditure of around 20% of GNP i.e. the difference between the current rate of credit growth and the stable rate, will be removed from the economy. This will have to happen either at once or gradually over the next very few years because if credit growth stayed at the current level the total stock of credit at the end of 2002 would be around 200% of GNP, an exceptionally high figure by international standards.
Major slowdown scenario
What happens then if there is a major slowdown in credit expansion over the next few years as I expect must occur? It is clear from the figures I quote above that a decline to a more sustainable level of credit growth will result in the removal of the source of a large volume of expenditure in the economy. When this happens I believe it is likely that the supply of property will substantially exceed demand. I say this because the current level of new annual credit is required to absorb the current property supply and any substantial decline in credit will result in the then existing supply being unable to be absorbed.
In that event, a substantial decline in property prices is inevitable. The cost of building houses is substantially less than the current sales prices, reflective of very high profit margins for builders and inflated site costs. A return to more normal levels for each of these elements would mean a substantial drop in house prices, perhaps as much as 30 to 50 per cent.
This analysis takes no account of what might happen to house prices this year. There is a serious possibility of the current bubble being further substantially inflated by the increase in disposable incomes which will arise from relatively high nominal increases in salaries and the budget tax cuts.
The government must do everything in its power to prevent house prices increasing this year. In my view this can only happen if house buyers can be reassured that the likelihood of continued increases in house prices is small. The key to this is a liberalisation of the planning process to release much more land for housing development, accompanied by a determined following through at the local level in respect of the Government's policy of increasing housing densities in urban areas. The already announced fast-tracking of housing infrastructure development water, sewerage etc., is also important. A dramatically increased supply of land is necessary throughout the country in order to create competition in the supply of housing sites. This will have a dual effect. In the first instance it will help alleviate the panic buying by potential house-buyers which arises when house prices are increasing rapidly. In addition, it will help stabilise, or even better, result in a decline, in the cost of housing sites, thus removing some of the cost push impetus to increasing prices.
The current policy on zoning of land arises from an unholy and totally unwitting alliance between those who call themselves conservationists and large house developers who appear to exercise a sort of oligopolistic hold on development land, at least in the major conurbations. The impact of the current restrictive policy on the cost of housing is swinging and results in Irish people paying much more for housing or selling for smaller or lesser quality housing than is necessary.
There is also the knock-on effects of high and steeply rising house prices on wage claims and on our long term competitiveness in the fixed exchange rate low-inflation regime which is EMU, which are potentially even more serious but are beyond the scope of this article.
Banks' lending policies must, in these circumstances be conservative and take account of the overall macro-economic environment, as well as the position of individual books. My own personal view is, however, a minority one in that, from a macro-economic perspective, too much is expected of individual banks in an environment when monetary conditions are out of control.
In summary, a combination of house prices which have increased rapidly over a prolonged period of time, very rapid credit growth and a high volume of credit outstanding relative to the size of the economy, is a cocktail which will give rise to significant problems in future. A further increase in house prices this year will seriously exacerbate what I believe is likely to be ultimately a quite traumatic situation for many current house buyers.'
Note: Slattery revisited his original 2000 article, in a retrospective article which he wrote in 2008 here