House prices: bubbles versus booms
The end of one quarter and the start of another sees the usual slew of economic reports and the start of Q4 is no exception. Today sees the launch of the Q3 Daft.ie Report. In line with other reports in the last week or so, and indeed with the last few Daft.ie Reports, there is evidence of strong price rises in certain Dublin segments. What is new this quarter is the clarity of the divide between Dublin and elsewhere: all six Dublin regions analysed show year-on-year gains in asking prices (from 1.4% in North County Dublin to 12.7% in South County Dublin), while every other region analysed (29 in total) continues to show year-on-year falls (from 3.1% in Galway city to 19.5% in Laois).
The substantial increases in South Dublin over the last 12 months have led to talk of “yet another bubble” emerging, with internet forums awash with sentiment such as “Not again!” and “Will we never learn?”. To me, this is largely misplaced, mistaking a house price boom for a house price bubble. Let me explain.
Firstly, I should state that, unlike “recession” which is taken to mean two consecutive quarters of negative growth, there is no agreement among economists on what exactly constitutes a bubble, in house prices or in other assets, but the general rule is that prices have to detach from “fundamentals”. For example, the Congressional Budget Office defines an asset bubble as an economic development where the price of an asset class “rises to a level that appears to be unsustainable and well above the assets’ value as determined by economic fundamentals”. Charles Kindleberger wrote the book on bubbles and his take on it is that almost always credit is at the heart of bubbles: it’s hard for prices to detach from fundamentals if people only have their current income to squander. If you give them access to their future income also, through credit, that’s when prices can really detach.
In that vein, I think it would be useful for commentators to distinguish between price bubbles and price booms, even if that distinction may be less clear in real life than in theory. Stop any friendly economist and they will tell you that the price is just the outcome of the interaction between supply and demand. If supply falls, or if demand rises, this will push prices up. We are familiar with house price booms in Ireland: between 1995 and 2001, significant growth in house prices – even adjusting for inflation – was the result of a number of factors (fundamentals). These include demographics (how many people per household on average), household income and the supply of housing.
House price growth between 2001 and 2007 was, in contrast, a bubble, driven by banks over-extending themselves (lending relative to deposits) and over-extending borrowers (higher loan-to-value). Every increase in incomes that happened in that period was offset by an increase in the supply of housing. House prices rose because banks went from lending out 80% of their deposits to lending 180% (by borrowing themselves from abroad).
Somewhere in the middle of this split between boom and bubble is what’s known as “user cost”, basically how interest rates compare to people’s expectations about house prices. Expectations are clearly central to bubbles as no-one will pay €400,000 for a 1-bed apartment unless they expect it will be worth at least as much in the future – so we can say that expectations are a necessary precondition. However, while I may expect that this apartment will be worth at least €400,000 in ten years, unless I can turn my desires into effective demand, that’s not enough. And that’s where credit comes in. So, when we are talking about prices being a multiple of average incomes, expectations are necessary but not sufficient to bring about a bubble.
What do we see in the Irish market at the moment? We certainly do not see easy credit: fewer than 2,000 mortgages are given out to first-time buyers each quarter at the moment, one fifth of the number given out in 2005 and 2006. But whereas now is too few, then was almost certainly too many. What is the right level? Well, there are about 7,500 births to first-time mothers per quarter, which gives us an idea of how many households are being formed. Allowing for households that never buy (and for the moment excluding households that never have kids), this means a healthy market would see perhaps 6,000 mortgages being issued each quarter to first-time buyers. What we have is – still – a housing market starved of fresh credit, not stuffed with it.
This suggests that what we are witnessing is being driven more by fundamentals than by credit. For simplicity, if we think of house prices as demand divided by supply, it is clear that rising prices may be nothing to do with too much demand and may instead be driven by too little supply. This helps explain why it is Dublin, and not the rest of the country, that is seeing rising prices at the moment: Dublin has no oversupply from the bubble. This is being compounded by negative equity preventing trader-upper type moves, creating a crunch in a market where there is at best moderate demand.
The limitation to a neat split between house price booms driven by fundamentals and house price bubbles driven by credit is market momentum. Rising prices now may generate rising prices in the future because rising prices now affect people’s expectations. But the point made above still remains: unless those expectations can tap in to credit, they will not translate into a rise in demand.
Does this mean there is nothing to worry about? Absolutely not! The graph above shows the ratio of prices for a four-bed semi-d in South County Dublin to one in Mayo, and the same ratio for a one-bed apartment. The “Dublin differential”, which was steady from 2006 to 2009 and falling until early 2012 has increased dramatically since then. For a one-bedroom apartment, it has doubled (from 120% to 240%).
Rising prices may be good for those who already own their homes but for those looking to buy, affordability of property in the capital is paramount. When prices rise because of a bubble, you can prick the bubble by restricting the supply of credit, but this is invariably messy (UK: take note!). When prices rise because of a boom, what is needed to moderate prices to simply an increase in supply. What we need to understand now is why there is so little construction happening in Dublin, when the city clearly needs it.
Thoughts on the above welcome in the comments below.