March 2, 2015
Could it happen again? This is the thought that went through my head, as I waited for the first question from the panel at the banking inquiry last Thursday morning. During the previous few weeks, I spent lots of late nights going through articles, books and documentary evidence written since 2000 on how an economic catastrophe builds. It’s funny how things seem so obvious in hindsight, but back then it was not clear to that many people.
In the inquiry, I likened the narrative of economic and financial meltdown in Ireland to a forest fire which starts with a few matches and ends with an inferno engulfing the entire economy. This fire, if it is allowed take hold, will destroy everything around it and therefore has to be put out with force, otherwise it will incinerate the entire economy.
This analogy came to me years ago, sitting in a Croatian café talking to a local fireman as he explained to me what can happen when a fire is allowed catch.
Every summer I visit a particularly parched region of Croatia called Dalmatia, which is subject to quite high and variable winds. All the young lads in the village belong to the most important local institution: the fire brigade. Every few years, vicious forest fires catch that kill tourists and locals. Usually they are started by tourists who are camping in the forests, unaware that they are barbecuing in a potential tinderbox.
Dotted around the higher points of the island are numerous look-out towers where the locals take turns doing eight-hour shifts on the look-out for smoke, day and night. If they see anything suspicious, they radio the base in the village and the trucks – manned by local firemen – head out.
Being a fireman is a rite of passage for these rural Dalmatians, so much so that my own son, who hangs around with the youngsters every summer, is down in the village ledger to be a fireman in 2018.
Now think about the banking/property/credit cycle in this context.
The pyromaniacs who start the fire are the bankers (and all others who cheer-led the credit splurge, you know who you are). Credit is the lighter fuel igniting the economic inferno. Human nature is the wind that whips up the flames because everything I do affects everything you do. You are forced onto the property ladder, not by yourself, but by me. When I buy, prices rise, this forces you to bring forward your house purchase because you don’t want to get left behind. So all our actions affect each other.
In the period 2000-2004 when this was building, the firemen who are supposed to spot trouble – the Irish central bank and regulators – are saying everything is grand.
Yes sure there’s some smoke and maybe a bit of fire, but it’ll be grand!
As they take no action, the fire engulfs the entire economy and culminates in a bank run, which is the financial equivalent of the entire island – forest and village – being incinerated.
At this very late stage – the very last resort – the state wakes up and has to put out the fire with whatever method it can deploy.
To argue about the method used to put out the bank run is like criticising the firemen for the type of water they use to put out a forest fire. It is a legitimate discussion and argument, but it misses the point that the entire episode was predictable and preventable. It needn’t have happened had the warnings been heeded.
There would have been no need for the troika had there not been a credit boom. There would have been no need for any guarantee had the banks been regulated, but once an economy gets into the disaster, the state can’t just say, “Let’s see what happens.”
It is like the Croatian fireman saying, “Let the fire burn itself out, sure you never know, the wind may change at the last minute just when your curtains are catching fire!”
Early warning is the key; prevention is always better than cure.
Now that we are armed with the experience of 2000-2008, could this possibly happen again?
My answer is unfortunately yes, unambiguously yes. The reason is that human nature is a funny old thing. We never learn. Never. Credit cycles are as old as the Bible. Read Leviticus and Deuteronomy and you’ll find the biblical equivalent of Anglo.
We always think this time it’s different; that’s just the way we are.
This consideration of the nature of humanity came to me when I was testifying at the banking inquiry. In the end, the question was whether it could happen again. It could because the way banks, credit and property work in Ireland is that banks will always want to lend, so prices will always have upward pressure and, as prices go up (as is happening now in Dublin) people will always look at the last rise in prices and think, they had better get in before they get left behind.
At the moment, the last monthly increase in house prices amplifies the amount of credit extended for lending next month. If the house price goes up, the banks will feel they can lend more because the house is the collateral and that collateral has gone up in value. Therefore, there is always inbuilt inflation in the system.
Imagine a mechanism where the latest increase in house prices doesn’t increase the amount of money that could be lend out but decreases the credit available. This could be self-regulating and would work as the watchman without having to depend on human frailty.
Think about this.
When a loan is granted, the nominal declared maximum LTV ratio (say 80 per cent) should be multiplied by the average house price index available for the previous 24 months and divided by the latest available price index.
This means that LTV ratios will keep coming down as long as prices go up, and thus the ability to flip over the property to the next guy will diminish.
The system will become self-regulated. The greater the increases in price last month, the less can be lent out next month and therefore increases in prices beget decreases in credit. This implies you don’t need to depend on humans, blighted by human nature, to make judgments, the system can do it itself.
This is a simple way of breaking the link between credit and prices and would go some significant way to reducing the tendency of houses prices to feed on themselves.
As I left the inquiry, I asked myself why hasn’t this type of innovation been introduced.
Could it possibly be because the same vested interests that cheer-led and caused the last boom are still in more or less in power and the system hasn’t really changed?
Surely not – it couldn’t be.