Business Irish

Wednesday 1 March 2017

Signals were flashing red on the property bubble but were ignored

Why did no one shout 'Stop'? Former chief economist of the Central Bank Tom O'Connell outlines the many reasons

Abandoned building
materials lie on the ground
at the Belmayne site,
Malahide Road, Dublin. Photo: Martin Nolan
Abandoned building materials lie on the ground at the Belmayne site, Malahide Road, Dublin. Photo: Martin Nolan

WHAT was it that led to such a phenomenal increase in property prices during the halcyon years of the Celtic Tiger? My contention is that it was largely due to factors within our own control.

With sensible policies, the bubble and subsequent crash could have been avoided along with the major disruption to society and the country that followed.

It is a truism that supply and demand factors determine the evolution of property and indeed all prices.

In the case of Ireland, a major dysfunctional factor in the property area was the very restrictive zoning policies of the authorities that have been relaxed only in recent times. Such policies were bound to result in large price increases if housing demand increased substantially.

Much of the land that had been zoned was tightly held by major players who had accumulated this land over time. For example, the construction sector analyst, Jerome Casey, has documented how eight major developers had effectively cornered the market in zoned land in North Dublin.

In addition, some of these developers were related to one another, thereby ensuring even tighter control over the release of this land for development than might appear at first glance. With the Irish population's attachment to land and property for all sorts of historical and perhaps psychological reasons, a surge in demand for housing, if it were to occur, was always likely to lead to substantial increases in prices.

Who can forget the crowds that queued overnight to buy housing off the plans? In the event, we know that some of those queueing were paid by estate agents to do so, and the media was contacted to hype things further. This mania extended to the acquisition of investment properties overseas.

As well as creating the conditions for a surge in prices if housing demand increased substantially, a very restrictive zoning policy was also conducive to corruption. It mattered greatly where councillors and planners arbitrarily drew the line on the map for zoning.

Through my contacts with various colleagues in other European central banks, I endeavoured to clarify how Irish house prices compared with those in their countries.

The data that I received showed that Irish house prices were higher, sometimes substantially so, than prices in all other locations except for central London.

What could have been done to limit the bubble? If the authorities had the will, the price of development sites could have been substantially reduced -- literally at the stroke of a pen. A liberal zoning policy would have had the effect of reducing the price of sites like the proverbial stone. Clearly, the surge in the demand for housing could not have occurred without the financing provided by the banks.

From the start of the last decade, aggregate bank credit here increased massively -- averaging 21pc a year up to 2007, when things began to ease.

As Central Bank governor Professor Patrick Honohan stated, such phenomenal increases in lending should have set off alarm bells. Why did no one shout "Stop?"

In this respect, there has been an unfair criticism of civil servants, in my view.

It can be safely assumed that civil servants did not recommend the most egregious policy errors such as adopting a pro-cyclical fiscal policy stance, granting extensive property tax breaks, decentralisation or pushing benchmarking.

It is also clear from papers submitted to the Oireachtas Public Accounts Committee that civil servants actually advised against the blanket bank guarantee of September 2008.

In the light of this, it is worth recalling that the former Minister for Finance, Mr McCreevy, stated on one occasion that, while he listened to the advice of his civil servants, he decided on policy and, if necessary, he could have thrown the advice received 'in the bin'.

In response to rising house prices in the latter part of the 1990s, the economic consultant Peter Bacon was requested by the relevant government department to assess developments in house prices and related issues. In the period 1998 to 2000, Dr Bacon submitted three reports. What is very surprising is that, as property price inflation began to accelerate some time after that, there seemed to be little concern expressed by Government, and as far as is known, no further reports were commissioned.

What is equally, if not more, astounding is that the then Taoiseach has stated in strong language in recent times that he was not informed about the huge increases in bank lending related to the property sector, even though the Bacon reports had been completed and the proverbial 'dogs in the street' were aware of the accelerating house price inflation and the associated huge bank lending increases.

There was a range of levels at which the huge and glaring excesses of the banks could and should have been challenged.

First, the board and top management of each bank have a responsibility to ensure that their institution is run in a prudent and effective way with due acknowledgement of the risks being undertaken.

Secondly, the shareholders and bondholders of the institutions would be expected to be vigilant as to how the businesses in which they have a stake are run.

Thirdly, the financial sector authorities -- the Financial Services Regulatory Authority and the Central Bank -- have responsibility for the oversight of the banks. Given what has transpired, clearly these three layers of control and oversight failed to deliver.

Turning to the Central Bank and the Financial Services Regulatory Authority, it should be noted that, during the Celtic Tiger/bubble period, the composition of the boards of these authorities was dominated by political appointments. Some of them were very prominent figures linked to the major government party.

With one political party in power semi-permanently in Ireland -- not unlike the PRI in Mexico -- there was unlikely, therefore, to be the necessary diversity of views on the board to ask the hard questions and challenge the conventional wisdom regarding the sustainability of what was happening.

In addition, until Professor Honohan's appointment, the Governor of the Central Bank had always served previously as a top official in the Department of Finance working closely with the Minister who appointed him, and the Secretary General of the Department of Finance is an ex-officio member of the Central Bank board. The ubiquitous social partners were also represented on the board.

In their report, Regling and Watson refer somewhat coyly to 'the socio-political context' in which key decisions were or were not taken, indicating that it would have required some courage for the authorities to take a contrarian stance during the mania period.

The point of recording this is that, with the euphoria and hubris of the Celtic Tiger period, the disposition of the financial sector authorities was one of not 'rocking the boat' -- even, one might argue, and as was fairly obvious -- if the boat was heading for the rocks.

Having said that, the Central Bank is a legally independent entity with the capacity, if it so chose, to change the course of developments of the financial sector.

To do so would not necessarily have been popular during the mania period.

However, the financial/regulatory authorities are not participating in a popularity contest, and the reason for conferring independence on the institution is presumably to permit this to be exercised in practice, particularly when most required.

In my view, the major vulnerabilities of the Irish banking sector were well flagged in the various Financial Stability Reports produced by the Central Bank and Financial Regulatory Authority over the years, and this is broadly acknowledged in Professor's Honohan's report (par.6.8).

The three main risks facing the banks, as flagged in these reports, were the very large increase in credit across the system, the massive concentration of lending in the property sector and the huge recourse to potentially volatile wholesale funding.

Although it seems that the Irish banks conformed to the EU Directives on regulation and supervision, based as they were on the Basel standards, this did not curb the three main emerging risks.

Professor Honohan's report considers four possible instruments that could have been used to calm things down (Chapter 7).

In the event, he states that only moral suasion and increased capital requirements were employed -- and the latter only in a very modest way and very late in the day.

In all, far too deferential an approach was considered to have been adopted towards the banks, and supervisory implementation was insufficiently forceful and pre-emptive (Regling and Watson, page 37).

Government policy is now focussed on putting the banks that remain on a sound footing and stabilising the public finances with the aid of the EU/IMF programme.

Of course, it would be desirable that holders of senior bank debt rather than taxpayers should bear a large part of the losses incurred by banks and that the interest rate on the EU/IMF support should be reduced.

However, it is clear that these can only happen in the context of a general agreement among EU countries.

In the meantime, there would seem to be little scope for an improvement in living standards for some years, while we deal with our present problems.

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