December 16, 2001

Life after the bubble bursts

Posted in Celtic Tiger ·
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In fact, there is a direct link between the discovery of the dead refugees in Wexford, the amount of borrowed cash spent at the tills in the next week and the price of houses in Dublin. All three are products of globalisation and will change utterly how this economy and society works over the coming years.

The borrowing and house price figures speak for themselves. For the past three years, personal borrowing rose on average five times faster than wages. Since 1998 — the year when a legitimate economic miracle turned into a credit bubble — Irish people have been getting into debt six times faster than the average European and three times faster than even the profligate Americans. As for houses, we all know what happened up to this year and what is now happening.

Some argue that borrowing is no big deal and point out that with interest rates as low as they are, more debt can be serviced. But servicing token amounts today on a massive principal is only part of the problem.

The view that debts don’t matter is based on the premise that interest rates will always be lower than after-tax wage increases. So your wages will always cover your interest payments. This view implies that there will always be full employment and every year wages will rise. This is hardly a defensible position as it is founded on the idea that there is no business cycle.

The recent budget, the latest unemployment figures and this year’s fall in house prices indicate that the “no business cycle” school of economics, which held sway in Ireland up until the first half of this year, is not serious.

The huge amount of debt that has emerged over the past few years is not unique to Ireland. The US ran out of its own savings in 1999 and has been depending on foreign capital to finance its current account deficit for some years. All boom periods have been characterised by a huge increase in personal and corporate leverage.

When interest rates are low, this explosion in indebtedness does not become apparent until too late.

The reason interest rates are low and have been reduced again this week to levels not seen since 1948 in the US, is that inflation is almost totally absent from the system. Many theories have been put forward to explain this, but arguably the most compelling can be discovered in the story of the miserable people who stowaway in containers bound for Dover, Bari or Waterford.

The mass movement of cheap, illegal labour into western Europe and the US can be viewed as similar to a huge tax cut offered to western business or a fall in the price of oil. Cheap labour, more than anything else, reduces corporate costs.

In most businesses, wages are over 60 per cent of operating costs, so keeping them down makes business more competitive. Thus, business in Ireland, France and the US benefits greatly from immigration.

In normal circumstances, a business that is saving on costs will increase margin if it can sell at the same price. But this has not happened. Huge increases in competition — associated with the reduction of trade barriers — have kept a lid on price increases in goods that are freely tradable across the globe. Globalisation and multinational investment has added to this downward momentum.

Irish wages, for example, have had an impact on US wages in certain fields. If Intel, Microsoft and Dell can hire good workers cheaply in Ireland, it will, affect wages paid at Dell’s headquarters in Austin, Texas.

Likewise, the wages accepted by Latvian farm workers in Riga has an impact on wages in Wexford, where Latvian immigrants are working today.

Therefore, globalisation has applied downward pressure to both prices and wages, keeping inflation at bay even at the height of the late 1990s boom.

With low inflation, we get low interest rates and the lower the interest rate, the more debt people take on. If all this credit is not pushing up the price of cars, foreign holidays or computer hardware, what is it pushing up?

The answer is straightforward: it is pushing up the price of things that are not tradeable, because if you can’t trade an asset, none of these pressures is going to bear down on its price. More significantly, the difference between prices in the traded sector and the non-traded sector will be huge. An example of a non-traded good is a house.

The price of a house in Prague and a house in Portmarnock have no bearing on each other. Similarly, you cannot readily exchange your flat in Dundrum for an equivalent in Dundee. But you could buy the cheapest car on the market, or a watch, or even an employee.

Thus, the very existence of globalisation exacerbates the difference in prices between those things that are traded and those that are not. In Ireland this means low wages and expensive houses.

Is this a problem? Well, there’s the exclusion of the vast majority of your workers from a reasonable housing market. Or the fact that most young employees are turning into worker/commuters living in dormitory towns miles from the city. Or, according to Central Bank figures, 45 per cent of all lending in the year to spring of 2001 was to the housing sector (when the comparable figure for the manufacturing sector was only 5 per cent of all credit).

If you are not worried about those sorts of numbers, then house price inflation is no problem.

Apart from the social consequences of the low wages/expensive houses combination, another dilemma is that without inflation there are no amber warning lights flashing. In the old days, the economy boomed, hit its capacity, inflation rose, interest rates rose, demand dampened, people lost their jobs and house prices fell gradually.

Now, the economy booms, a lid is kept on immigrant and domestic workers wages (particularly in manufacturing), interest rates remain low, credit continues to gush in. The prices of non-traded goods, such as houses, go through the roof and the process continues. This is how a bubble forms. There are no warning lights in the guise of higher interest rates. The system loses its self-correcting qualities and we get a balloon waiting to burst.

Then we are vulnerable to outside events and the only way of righting the excesses of the boom years is a period of deflation where house prices, once they start falling, continue to fall and companies can only pay off debts by cutting costs elsewhere.

Such an economy is left with high levels of personal debt, negative equity, large numbers of immigrants and deflation.

We’ve seen this cocktail before in many countries and, given that the first signs are now being felt, one has to wonder why it wouldn’t happen here?