The Irish economy earned the distinction of being called the “Celtic Tiger” due to its phenomenal performance between the years 1994 and 2006. A huge driver of growth for the country was the construction industry, which accounted for nearly 24% of GDP in 2006. The Great recession of 2008 dealt the Irish construction industry a huge blow as demand for housing crashed, this led to the bursting of the real estate bubble in the country, which was fueled by factors other than fundamentals. The bursting of the bubble led to a recession followed by a period of slow growth for the country, with growth picking up again in the year 2014.
To put this bubble into context, if one were to invest $1 in real estate in the year 1993, in the year 2007 it would be valued at $3.12 after adjusting for inflation. In comparison, $1 invested in U.S. real estate, which was in a bubble for the same time period, would have returned $1.57 after adjusting for inflation. This just shows how big the bubble really was.
So what led to this real estate bubble of such proportions?
Sustained Economic Growth
As can be seen from the above chart, the Irish economy saw a sustained upturn in it’s economy from the year 1994. The average GDP growth rate between 1994 and 2000 was 9.2% per year. This slowed to 5.3% per year between the years 2001 and 2007, while slower, still an extremely healthy growth rate for an economy with a per capita income of $26,200 in the year 2000.
A large part of this growth can be attributed to what happened in the late 1980’s. After a period of political instability and irresponsible government policies, the country got a government which was committed to economic reform. Although it was a minority government, the opposition employed a policy known as the “Tallaght Strategy”, where they played the role of a constructive opposition instead of opposing the government just for the sake of it. This gave the then Fianna Fail government the ability to undertake economic reforms which included welfare reform, more competition, reduction in borrowing to fund current spending, and tax cuts. These reforms laid the foundation for the economic expansion seen in the above years.
Another observation from the chart is that the economy had not seen such a sustained upturn since 1971, the year till which data is available. Thus, the initial rise in real estate prices was a rational reaction to a healthy economy.
Move towards smaller households and Population Growth:
As can be seen from the above table, the average size of a household in Ireland fell from 3.68 people per house in 1981 to 2.81 people per household in 2006. While population rose from 3.4 million people in 1981 to 4.2 million people 2006.
The resultant change in population and household sizes between 1981 and 1991 would have required an additional 120,000 houses.
Similarly, the resultant change in population and household sizes between 1991 and 2006 would have required an additional 450,000 houses.
Thus, the changes in the above two parameters alone would have caused the demand for houses to rise by 1.2% per year between 1981 and 1991, and at a pace of 2.4% per year between 1991 and 2006.
The above two points highlight rational reasons for the rise in real estate prices starting in the year 1994. Below are points which exacerbated this rise in real estate prices and turned it into a bubble.
The setting up of the European Central Bank (ECB) in 1998 meant Ireland no longer had the autonomy to set interest rates to tackle inflationary pressures. Interest rates would be set by the ECB, which would then be followed by all the countries that were a part of the European Monetary Union, Ireland being one.
As can be seen from the above chart, inflation was above the benchmark interest rate set by the ECB for 8 of the 10 years in question. This implies that the real interest rates (nominal interest rate – inflation) was negative or in other words people would lose money if they saved it.
Thus, people started looking for avenues to invest their money in to beat inflation. With housing having performed extremely well, buying homes was the natural choice for many people. This in turn increased the demand for real estate, increased prices and fueled the bubble in real estate prices.
Cheap Foreign Funding:
With the emergence of a common monetary union, Irish banks had access to cheap foreign funds from its European neighbours. Thus, non-Irish deposits which were at 25.4% of bank balance sheets in December of 1999 grew to 42.2% of balance sheets in December of 2008. In addition to the availability of foreign funding, economic growth also expanded the amount of money deposited by Irish individuals and institutions. This meant that the size of Irish bank balance sheets increased by 6.5 times in a span of 9 years.
As we all know banks need to earn interest to remain solvent. This meant that the Irish banks had to go out and lend these additional deposits to earn interest to pay its depositors. This led to a decline in the quality of creditors i.e. people who would otherwise have been denied loans started getting loans. These loans received by undeserving creditors was used primarily to buy real estate and fund the construction boom in the country. Banks started indulging in unhealthy competition of who could approve the loans the quickest. This only reduced the quality of loans and made them subprime.
Thus, there was a huge boom in lending which led to the average vale of a new housing loan rising from 62,000 in 1997 to 229,200 in 2006, reflecting the boom in housing prices and ability of banks to lend. Over the same period interest average interest rates on housing loans declined from 7.22% to 4.2%, reflecting the additional liquidity available to commercial banks and low interest rates set by the ECB. While, the number of new housing loans taken rose from 57,901 in 1997 to 111,253 in 2006, reflecting the increase in the number of people getting housing loans.
Thus, what began as a rational response to the increasing demand for housing, ended up in a housing bubble which dwarfed the U.S. housing bubble.
Housing prices fell by more than 30% from their peak in 2007. This fall led to a major crisis for banks as home owners who had based their repayment capacity on capital appreciation failed to repay their loans. In addition, new real estate projects found no new buyers and thus developers found it difficult to repay the loans they had taken to finance projects. This led to a major banking crisis in the country which resulted in the government guaranteeing the liabilities of all commercial banks in the country i.e. promising to pay back the creditors of banks.
Time has passed since the crisis and the economy has recovered and so have real estate prices, but, the primary factors for the bubble i.e. low interest rates and cheap foreign funding have been major contributors to the real estate price recovery. Thus, only time will tell if this recovery is sustainable.