Thursday 20 June 2019

Brendan Keenan: 'Foreign money more at risk from any new Irish bubble'

The need to prepare for another financial rainy day could be brought home by a downturn in the US financial cycle. Stock Image
The need to prepare for another financial rainy day could be brought home by a downturn in the US financial cycle. Stock Image
Brendan Keenan

Brendan Keenan

A number of commentators, this one included, have begun to fret about the apparent repetition of the behaviour which led to the Great Recession; in particular the cycle of public spending, but also the rapid rise in property prices.

All very unscientific of course, but the pattern of boom and bust is well-established and, on the face of it, the worries are justified. So it seems worthwhile revisiting the much more scientific paper produced last month by National Treasury Management Agency chief economist Rossa White and Lisa Sheenan of Queen's University Belfast.

This examines Ireland's financial cycle, going back to the 1970s. The financial cycle is embedded in all economies, despite the regular attempts to claim it has been abolished, but with different specific characteristics. Hence the worry about Ireland's particular characteristics.

Surprisingly perhaps, for something so important and well established, the paper points out that the financial cycle has not been central to macroeconomic analysis. The authors say this may be because it sits better in economic history rather than mathematical equations.

Not so surprising is the fact that it has received more attention since the crash, including the application of the new insights from behavioural economics. The paper examines the proposition that "good times sow the seeds of their own destruction," with evidence that recessions since the mid-1980s have been triggered by financial excesses more than spending or consumption.

Before that, too. Even the famous shoeshine boy associated the great crash of 1929 with the stock market frenzy which preceded it; but the economists generally did not, clinging to the idea that it was all part of some underlying equilibrium.

They clung to it until the present day and the argument is not entirely over. While economists differed, governments took full advantage of the absence of warnings about a financial cycle while.

The NTMA analysts, like many others, see the inflation-busting policies of US Treasury Secretary Paul Volcker in the early 1980s as crucial. Volcker's interest rate rises led to two recessions but they did kill off inflation, with the much plauded 'Goldilocks' era of non-inflationary growth (not too hot and not too cold) lasting until 2007. We all know what happened after that. Both the upturn in the financial cycle and the subsequent crash were on a scale not seen in modern times. Policy, particularly under the Federal Reserve chairmanship of Alan Greenspan, may have had a lot to do with it.

Financial cycles are long relative to business cycles, but they seem to have got longer, and more extreme, since the 1980s.

This coincides with the US Federal Reserve reacting to trouble in stock and credit markets by aggressively cutting interest rates.

The "unfinished recession" explanation holds that a sharp downturn after the dot.com bubble burst in 2001 was prevented by Fed action. The cycle was extended to 15 years as markets began to believe in the 'Greenspan put'," whereby asset price falls would be countered by easier monetary policy. What should have been a couple of downturns was compressed into one monumental fall. Although the NTMA paper does not specifically say so, it is not clear that the Greenspan put has followed Mr Greenspan himself out the door. Fear of recession still seems to outweigh fear of bubbles at the US central bank.

On the other hand, the ECB was excoriated for not taking more account of the state of the economy in the early stages of the crash. This changed in 2012, with its promise to do what was necessary to prevent the collapse of the eurozone. Since then, it has kept interest rates at or close to zero.

Quantitative easing in the United States, in which central banks bought bonds in financial markets, began in December 2008 and the Federal Reserve did not start raising interest rates from close to zero until 2015. It has now indicated that any further rate increases are on hold after an interest rate rise in December 2018 that took the Federal Funds rate to 2.25-2.50pc.

The ECB began its version of QE, the Public Sector Purchase Programme, in 2015. Short-term rates were cut to the unprecedented levels of zero for loans and negative for deposits. The euro economy responded, but has shown signs of weakening again despite the historically low rates.

As for Ireland, the economy was too closed until the 1960s to have much of a financial cycle in credit and asset prices at all. Since then, as a very small, very open economy, it has been buffeted by all these international events.

The research finds evidence of an Irish financial cycle in the 1970s when land and house prices soared. The government introduced incentives for home-buyers, while the Central Bank cut interest rates from 15pc to 5pc. Mortgage volumes rose by a half from 1970-1974.

At least that government was dealing with something new but its successors, led by Garret FitzGerald and, with delicious irony Charles Haughey, were obliged to reverse much of what had been done in the 1970s.

This instability itself sowed the first seeds of the 2000s disaster. The unfairly mocked Celtic Tiger of the 1990s saw the economy making up the losses forced on it in the 1980s. But this rapid growth coincided with the sharp fall in interest rates in the run-up to the launch of the euro in 1999, when Irish rates were replaced by German ones.

Credit growth took off from 2003. Lending to property developers rose tenfold in five years, financed by Irish banks borrowing at fixed rates from overseas investors, and lent on in residential mortgages averaging 90pc of value and commercial loans to developments with absurdly low returns.

This was the epic end of what the paper finds was a very long pattern of behaviour. From 1971 to the beginning of the bubble, there is a strong relationship between the cycles for overall credit to business and those for construction and property development.

Irish banks have invariably favoured lending against property, it seems, thereby reinforcing the cycle up and down. This may reflect the shortage of large indigenous companies outside construction to which the banks could lend.

That was then and this is now, but what exactly is now? The scale of commercial construction and the rise in house prices could be taken as signs that another classic Irish cycle is underway. But they must be set against the slow growth in credit from Irish banks.

Capital has flowed freely into the property market in a search for yield since 2011, but it is foreign capital. The likes of hedge funds, private equity funds, even sovereign wealth funds - often characterised as 'vultures' - have taken the place of domestic banks in providing finance.

This is something new, because nothing like the policies pursued by the major central banks has been seen before. Just as Ireland benefited disproportionately from low interest rates in the bubble, it now gets a double boost from loose Fed and ECB monetary policy because of its strong ties to the USA and membership of the euro.

The size of foreign inflows is difficult to quantify because the statistics include the finances of the huge multinational sector. But everyone knows it is happening and it cannot be ignored in any assessment of the new financial cycle which began in 2011-2012. That creates its own worries, but they are a different set of worries. The paper uses non-mortgage purchases of residential property and land, along with commercial investment in existing properties, to try to get a handle on the scale and nature of the influx of foreign credit.

There is also a well-known sign of bubbly conditions when investors stop requiring compensation for the inevitable risk in assets like property. Things are complicated by the ultra-low interest rates, but there is evidence that yields on Irish commercial property factor in very little risk of price falls.

The cycle may be turning though. Foreign inflows are seen to have risen from €1bn to €6bn but may have fallen by a quarter since that peak. Allowing for all these caveats, the paper estimates that the cycle is at a midway point, despite the modest lending by domestic banks suggesting it has barely begun.

The US financial cycle is further along still. Ireland's will be brought to a rapid halt if and when it turns down. Foreign credit would evaporate, investment would slow, property prices would decline.

But the absence of Irish banks in the present property cycle would make this more of a typical recession than a financial crisis like 2007. The bulk of the losses would fall on the foreign lenders and purchasers, or those domestic players who joined the fray.

That is all fairly encouraging, unless one takes the view that the world in general is heading for another credit crisis. Many do. As always, the motto for a very small, very open, economy is that for the cops in the old TV series 'Hill Street Blues' - be careful out there. Pity we have not followed it more often.

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