June 18, 2000

Housing proposals should focus on credit availability

Posted in Sunday Business Post · 2 comments ·
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Credit cutting would reduce house price rises

In the 10th century, Ethelred the Unready, King of England faced a crisis. Danish long ships threatened rape and pillage all along the east coast of England. Sensing that his armies would be routed, Ethelred conjured up a scheme: instead of facing the enemy head on, he would persuade the tide not to come in, thereby stopping the invaders before they even set foot on land.

He raised a tax, melted down the proceeds into gold coins called Danegeld (Danish money) and flung the coins into the sea in an effort to buy off the waves. Needless to say, this rather unique and innovative solution didn’t do the trick.

The big question facing this government is whether the latest Bacon proposals will do the trick for the housing market. The Bacon Report centres exclusively and, many would argue, sensibly on supply and demand.

However, what if focusing solely on supply and demand is insufficient? What if there is a greater force driving Irish house prices? You might now rub your eyes because here is an economist questioning the divine right of supply and demand to explain everything. Surely this is economic heresy? Well maybe it is, but my hunch is that something else is driving prices, something much more powerful than immediate demand and sluggish supply.

Let’s consider an opposite extreme for a minute. Ireland is not the first country to experience a demand and supply mismatch in bricks and mortar. The entire continent of Europe and particularly Germany after WW2 was in a similar but much more acute situation.

It took the housing stock almost 20 years to recover from aerial bombardment at a time when the baby boom was in full swing, yet house prices did not explode during the continent’s “wirtschaftwunder” years.

More extreme still, the Soviet Union had a housing problem from almost day one of the Revolution, yet house prices did not explode (the Soviet example is for illustrative purposes only. However, it is interesting to note that Muscovites to this day prefer to live on the top floors of apartment blocks, not for the views, but because the supply response was so slow that building materials and engineering techniques improved the higher up you were).

The point is that both the post-war continental boom and the Soviet case had similar supply and demand problems but they differed from Ireland in one crucial respect. That key ingredient was personal credit. Without abundant credit, prices cannot rise dramatically.

So yes, a sudden unexpected demand for housing should push the price up, but the absolute amplification in prices is determined not by sluggish supply alone but by the amount of credit available. This is the nub of Ireland’s housing problem. It is not that house prices have risen but that they have risen so much as to make accommodation unaffordable.

In my opinion, credit is the culprit. When there is no constraint on credit, normal supply and demand imbalances lead very quickly to asset price bubbles and once this process takes hold, credit expansions and asset price bubbles tend to be self-reinforcing.

Rising house prices not only encourage further demand, but rising house prices enable people to get even more credit and these two dynamos explain almost everything. Rising prices of owned houses give those owners collateral for the extension of further credit. We all know the story.

Many of us have remortgaged houses, borrowed against the huge rise in wealth experienced from the boom. Parents have provided crucial equity to children from the proceeds of remortgaging and so on.

Lenders are at the same game. Shareholders of banks and building societies would not allow them to miss out on the credit boom so, in many cases, they securitise their existing mortgage books, giving them extra resources which they subsequently lend back to the original mortgage holders (securitising is a jazzy word for bank’s borrowing against the stream of income they get from their mortgage books).

It is easy to see that when asset prices are rising, credit expansions become self-reinforcing. The same carry on pertains when a company’s share price is rising. The company can borrow against its inflated share price to buy more assets thereby inflating its own share price further.

The upshot of this credit amplification is that when demand is higher than supply, prices can shoot dramatically upwards. It is also easy to see why the converse occurs. In a downturn, asset prices can fall by much more than is warranted by supply and demand because credit is withdrawn as quickly as it was injected and financial systems are typically exposed to be far less robust than many suspected in the first place.

Therefore, some mechanism is needed to smooth this volatile credit cycle. Unfortunately, most people here, including the government, have taken a “rabbit in the headlights” position, blaming EMU and saying there’s nothing we can do but tinker at the margin and pray. But we do have an ace up our sleeve, even at this late stage, which might help us to avoid calamity.

It is standard practice for a bank to value a house at today’s price, to assume the asset will rise in value and on this basis lend some fraction of the value for ten or 20 years. This approach clearly fuels further price rises. Instead, the government might force banks to construct a backward looking moving average, taking the average price of the house for, say, the past five years and lending against this. We would still have the same process enabling people to use their assets as collateral, but the values would be much less.

This approach, if applied evenly, would cause house prices to stabilise almost overnight because the in-built mechanism that reinforces asset booms with too much credit, would no longer work. It would also leave the financial system in much better shape because in upswings less credit would be injected into the economy, while in downturns less credit would be withdrawn.

Taken together with the supply and demand measures recommended by Bacon, this credit restraining policy involving the government, the central bank and the banking system might just do the trick. Otherwise, supply and demand measures which don’t take into account the huge waves of credit cascading into Irish house values might be about as useful as Ethelred’s Danegeld.


  1. [...] initial paragraph, however, appeared before, in 2000. β€œIn the 10th century, Ethelred the Unready, King of England faced a crisis. Danish long ships [...]

  2. [...] initial paragraph, however, appeared before, in 2000. β€œIn the 10th century, Ethelred the Unready, King of England faced a crisis. Danish long ships [...]

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