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History suggests landing will not be soft

THE housing market busts in the early Nineties in Scandinavia and Japan were very different in terms of intensity and duration. In a way, it's like the difference between a deep-tissue Swedish massage and a traditional Japanese massage.

The Scandinavian countries suffered several years of collapsing house prices as well as deep economic and financial crises. These economies and property markets subsequently made quick recoveries.

In contrast, the Japanese housing bust was less intense but it lasted a long time. Nearly 15 years, to be more precise. Between 1991 and 2004, real estate prices in Japan dropped 60 per cent. House prices in Tokyo plummeted 90 per cent.

To put things in perspective, if house prices here were to follow a similar pattern, the average price for a house in Dublin in 2022 would be about €42,000! Doesn't bear thinking about.

So what kind of housing adjustment are we likely to experience? Unfortunately, the prospects for a soft landing are growing dimmer by the day. Anecdotes suggest that the much anticipated autumn selling season opened with more of a whimper than a bang. Recent readings show a sharp drop in confidence among households and builders. These are hardly ingredients for a soft landing.

Mortgage holders got a welcome respite when the ECB decided to postpone a hike in interest rates. And the ECB might even cut rates in the coming months if all hell breaks loose in global financial markets and the credit crunch threatens to drag the euro area into recession.

But banks may not pass on these rate cuts to customers if spreads in the credit market don't narrow. Moreover, it is hard to see how an economic downturn and associated increases in unemployment could be positive for the housing market. Nothing discourages potential homebuyers more than concerns about losing their jobs.

Nor are there convincing reasons to believe that the housing bust here will be short-lived. For starters, consider the foreign experience. In a US Federal Reserve study of 44 house price booms and busts in industrial countries since 1970, the average bust lasted nearly five years. More precisely, real (that is, inflation-adjusted) house prices typically declined for almost five years after the peak.

In countries with high inflation, actual house prices did not need to fall by much, as the real drop in prices was usually brought about by inflation. But it was a different ball game in countries with low inflation.

That matters for us because inflation in Ireland is expected to moderate to relatively low levels in the next year or two. The ongoing steep rise in the euro against the US dollar will push down the prices of goods imported from the US.

The construction-related slowdown in economic growth over the next couple of years will generate some slack in our economy, which will help to contain increases in consumer prices. With low inflation, adjustments in real house prices will have to be mostly delivered through declines in actual house prices.

In addition, standard measures of housing valuation -- such as comparing house prices to rents -- suggest housing here remains overvalued by as much as 20 per cent in inflation-adjusted terms. It's probably reasonable to expect that much of this overvaluation will be squeezed out.

It is worth keeping in mind that Ireland's housing boom dwarfed each of the 44 booms mentioned earlier. Why should we expect such a boom to be followed by the mildest and shortest correction ever recorded?

Which brings us back to the Scandinavian and Japanese experiences.

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Arguably, what turned the housing booms and busts in Scandinavia into outright crises was these countries' fixed, but adjustable, exchange rate regimes.

For example, when Finland's housing market started to wobble and foreign investors began to withdraw their money, the Finnish central bank was forced to hike interest rates to defend against capital outflows and speculative attacks.

After much financial stress, the central bank in Helsinki eventually had to abandon the fixed exchange rate and the Finnish currency dropped like a stone. Finnish companies that had borrowed in foreign currencies got hammered -- and many defaulted on their debts. These defaults bankrupted the banks.

Fortunately, our membership of European Monetary Union means that we have no currency of our own to defend. This greatly reduces the likelihood of a full-blown crisis here.

Japan's biggest problem was that they attempted to sweep the consequences of the housing bust under the carpet. You see, when housing markets go bad, lots of money is lost. Be it homeowners, property investors, developers, banks, and taxpayers, someone has to take the hit.

The Japanese wasted a decade-and-a-half arguing over how to allocate the losses, and their economy stagnated in the meantime. Let's hope we don't do that.

Alan Ahearne is a former senior economist at the Federal Reserve Board in Washington DC. He lectures in economics at the Cairnes School of Business and Public Policy at NUI Galway


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