(This is an unedited version of my Sunday Business Post on the 8th of February)
Credit. Economies can’t live with it, and can’t live without it. Credit greases the wheels of the economy, gets investment going, changes household and firm’s expectations about the future. Credit also blows up economies on a semi-regular basis. As a nation of 4.58 million reformed credit junkies, we should know our limits when it comes to using this potent stuff, but, in the end, nothing stays learned for long, and we’re back asking for more before we’re really ready for it.
A property market bubble shouldn’t be able to start without access to lots of credit. But that might be happening in parts of Ireland right now.
A bubble takes place in a market when the price you pay for something is way above a reasonable long run trend. Think about those Elsa dolls we scrambled around for last Christmas. The long run trend of those dolls was, I’m fairly confident in saying, well below the price stressed out parents were paying in the weeks coming up to Christmas. Now they aren’t.
Credit binges aren’t just an Irish thing, even though Ireland’s dependence on bank loans is high by international standards. In 2012 the IMF’s Giovanni Dell’Ariccia and his co-authors found when they studied 170 countries from 1960 to 2010 over 14% of the time there was a credit bubble. Each credit bubble burst, of course, and as each bubble burst, the depth of the economy’s suffering was proportional to the heights reached during the bubble’s expansion phase. It typically takes about 5 years for an economy to emerge from the wreckage caused by a credit bubble.
Ireland, of course, experienced a particularly crazy bubble based entirely on the avaibility of cheap credit, as the first chart shows. We’re starting to see an uptick in credit, and, as the price of Irish housing and commercial property begins to rise rapidly, while S&P expects house prices to rise by 9% in 2015. Ireland will grow faster than any other Eurozone economy in 2015. So are we back? Is it time to get back on the credit cycle? Is that really a good thing?
One way to measure whether increasing credit flows to households and businesses are a good idea is to see how the ratio of credit to gdp changed over time. But we have to be careful here. Gross Domestic Product (GDP) is the standard way we measure the value of the output of an economy. GDP is a flow variable, and credit is a stock. So we have to look at the credit ‘impulse’, which compares the change in GDP to the change of the change (stay with me folks) of the stock of credit. Then we can see how much more credit, as it is injected into the system, effects the change in GDP. We always see a strong positive correlation between the credit impulse and economic growth. In the Irish state, that’s what we see too. The change in GDP is strongly positive in recent quarters, but it isn’t being matched by strong changes in credit. When we look the relationship between credit flows and the difference between actual and potential output, we don’t see any indication of a bubble either.
There is another piece of information we need to think about: a lot of the changes in the property market we are seeing are happening because of cash sales. Long term this isn’t sustainable, but it is a good way to make sure there won’t be a large asset bubble of the kind we saw during the construction boom from 2002 to 2007. Cash reserves are finite, domestically, and while Ireland is small enough so that foreign cash can dominate for a while, global imbalances just don’t last that long. Today’s hot market is tomorrow’s has-been.
Another way to see this weird change in the composition of the property market is to look at the value of loans approved, and the volume of those approvals, and index them to 2011. You see that they are about 3.2 times higher in December 2014 than they were in January 2011. The overall picture is a credit market returning to health after a protracted period of retrenchment following the bursting of a massive bubble, but still, the surge in property prices isn’t coming from an excess of credit.
That said, since June 2010, household’s mortgage repayments with Irish credit institutions have exceeded new borrowings, so the total stock of credit is going down. Household loan repayments were 43 million larger than drawdowns by during December 2014.
If the rise in house prices, especially in Dublin, isn’t coming from credit, where is it coming from? The ‘bubble’ is coming from a release of cash from domestic and foreign buyers seeking either a home or an investment vehicle in a low inflation market characterised by low yields everywhere else. The ‘boom’ in commerical property is coming from a portfolio choice investors are making, in other words, and from the lack of supply of residential property on the market in desirable areas.
Claudio Borio and his coauthors studied the evolution of the financial cycle in the recent past. Borio feels the financial cycle can be understood by looking at the evolution of credit and property cycles, which seem to be diverging in Ireland in 2015. Crucially, a financial cycle typically has a lower frequency than regular business cycles so they are harder to spot, but they can be identified in real time by comparing the change in credit to the change in potential output, and when you do that for Ireland, you don’t find evidence of a big credit splurge happening. We know financial cycles depend on light-touch regulation, of the kind we are not seeing thanks to the Central Bank’s action on loan limits.
To flourish the financial cycle depends on inappropriate policy, and hopefully we will see serious efforts to tackle the shortage of social housing in the coming years by the political system that will damp the cycle down further. Remember folks: excess credit is a truly destructive force that should be avoided and actively resisted by any financial regulator worthy of the name.
Long term, as the balance sheets of the nation’s households, firms, and the government heal, credit supply will start making inroads into pushing housing prices up again, especially following a few years of quantitative easing by the European Central Bank.
The bubble in prices is not coming from credit. It’s coming from cash and portfolio changes, which are temporary, from a shortage of supply the government need to address, and from expectations which the Central Bank has set about dampening down with the enthusiasm only economists have for ruining everyone’s day.