Thursday, February 10, 2011

Should we see it coming?

Michael Lewis has a wonderfully engaging, well-written (long) article about the Irish economic catastrophe in Vanity Fair. Worth reading for all sorts of reasons.

Here, I just want to point out the simple arguments and observations used by an economics professor during the boom to argue that there was a housing bubble. It’s puzzling how something that seems obvious in retrospect, based on simple, big-picture statistics that were easily googled at the time, could be so ignored or downplayed or rejected by economists and others alike at the time. The sense that “this time is different,” “past cases don’t apply,” and that all sorts of more or less good “small” arguments are enough to (psychologically?) weaken the impact of the big-picture items. Sometimes, the difficult thing is to just keep pounding on the big, strong, clear argument instead of allowing yourself to get derailed into lots of smaller-scale discussions of all sorts of details that don’t really count for much in the big picture. (It seems to me, for instance on the basis of this graph, that Norwegian house prices are grossly inflated today (the red curve is Norway, the blue US, both in real terms and normalized to 1890 levels)– but when I present this graph to others I constantly get derailed into side-tracks like “building standards are more stringent now than in the past, which might have increased costs”)

Morgan Kelly is a professor of economics at University College Dublin, […] Kelly saw house prices rising madly and heard young men in Irish finance to whom he had recently taught economics try to explain why the boom didn’t trouble them. And they troubled him. “Around the middle of 2006 all these former students of ours working for the banks started to appear on TV!” he says. “They were now all bank economists, and they were nice guys and all that. And they were all saying the same thing: ‘We’re going to have a soft landing.’ ”

The statement struck him as absurd: real-estate bubbles never end with soft landings. A bubble is inflated by nothing firmer than expectations. The moment people cease to believe that house prices will rise forever, they will notice what a terrible long-term investment real estate has become and flee the market, and the market will crash. It was in the nature of real-estate booms to end with crashes—just as it was perhaps in Morgan Kelly’s nature to assume that, if his former students were cast on Irish TV as financial experts, something was amiss. “I just started Googling things,” he says.

Googling things, Kelly learned that more than a fifth of the Irish workforce was employed building houses. The Irish construction industry had swollen to become nearly a quarter of the country’s G.D.P.—compared with less than 10 percent in a normal economy—and Ireland was building half as many new houses a year as the United Kingdom, which had almost 15 times as many people to house. He learned that since 1994 the average price for a Dublin home had risen more than 500 percent. In parts of the city, rents had fallen to less than 1 percent of the purchase price—that is, you could rent a million-dollar home for less than $833 a month. The investment returns on Irish land were ridiculously low: it made no sense for capital to flow into Ireland to develop more of it. Irish home prices implied an economic growth rate that would leave Ireland, in 25 years, three times as rich as the United States. (“A price/earning ratio above Google’s,” as Kelly put it.) Where would this growth come from? Since 2000, Irish exports had stalled, and the economy had been consumed with building houses and offices and hotels. “Competitiveness didn’t matter,” says Kelly. “From now on we were going to get rich building houses for each other.”

The endless flow of cheap foreign money had teased a new trait out of a nation. “We are sort of a hard, pessimistic people,” says Kelly. “We don’t look on the bright side.” Yet, since the year 2000, a lot of people had behaved as if each day would be sunnier than the last. The Irish had discovered optimism.

Their real-estate boom had the flavor of a family lie: it was sustainable so long as it went unquestioned, and it went unquestioned so long as it appeared sustainable. After all, once the value of Irish real estate came untethered from rents there was no value for it that couldn’t be justified. The 35 million euros Irish entrepreneur Denis O’Brien paid for an impressive manor house on Dublin’s Shrewsbury Road sounded like a lot until a trust controlled by the real-estate developer Sean Dunne’s wife reportedly paid 58 million euros for a 4,000-square-foot fixer-upper just down the street. But the minute you compared the rise in prices to real-estate booms elsewhere and at other times, you re-anchored the conversation; you biffed the narrative. The comparisons that sprung to Morgan Kelly’s mind were with the housing bubbles in the Netherlands in the 1970s and Finland in the 1980s, but it almost didn’t matter which examples he picked: the mere idea that Ireland was not sui generis was the panic-making thought. “There is an iron law of house prices,” he wrote. “The more house prices rise relative to income and rents, the more they subsequently fall.”

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