Threat of a global debt landslide could still bury us all

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By Cormac Lucey

Irish house prices rose by more than 12% last year. According to the stockbrokers Davy, this rate of increase isn’t sustainable — as sharp property price increases aren’t being matched by comparable jumps in incomes.

In Dublin, prices have regained about two-thirds of the drop they suffered between 2008 and 2013. Rents, meanwhile, have surpassed boom-time levels. The quarterly report for January, February and March showed that the average monthly rent in Dublin was €1,875 — €433 higher than at the peak of the Celtic Tiger bubble.

Are we experiencing a new property bubble? There are two strong reasons to believe we are not. First, a common feature of all asset price bubbles — rampant credit growth — has been totally absent over the past decade.

In fact, the volume of old loans being repaid has consistently exceeded new loans being advanced. The total amount of housing credit has shrunk from €125bn at its early 2008 peak to €75bn last December, and cash buyers remain a big feature of the market. Second, property prices are also well supported by rent levels. Rents exceed 2007 levels while property prices do not, and interest rates have fallen sharply in the meantime.

The equation facing a financially motivated property owner, such as a buy-to-let landlord, has transformed. In 2007, the rental yield that was achievable for landlords — annual rental income divided by property value — was a lot lower than the cost of borrowing. For a highly leveraged property investment, interest outgoings generally exceeded rental income — such landlords had to contribute cash each month to bridge the gap.

The expectation was that capital gains would more than compensate them for their troubles. The property bubble would end if prices stabilised, never mind declined, for it would make no sense to persist with an investment where the periodic expenses regularly exceeded income.

Today the situation is reversed. Rental yields are a lot higher than they were in 2007 while mortgage rates are a lot lower. New buy-to-let-landlords are not dependent on the prospect of future capital gains to justify holding onto their investments. It also means that people renting their homes should see a fall in their monthly outgoings if they move to buy them.

A number of complicating factors muddy such simple analysis. Iniquitous tax changes mean buy-to-let-landlords are not allowed to claim all their expenses against their rental income for tax purposes.

The political system is also stacked against them, and the courts are very slow to assert landlords’ legal rights over their property, even in the face of obvious misbehaviour by tenants. And those sitting around the cabinet table still wonder why there are so many empty properties in our cities.

On top of that, the Central Bank of Ireland has tightened up lending rules. New buy-to-let investors need to have a minimum deposit of 30%. Yet the argument still holds: higher rents and lower interest rates mean that today’s property prices are well supported by fundamentals, unlike in 2007.

This is a key reason why, despite a pick-up in new lending, the Central Bank’s countercyclical capital buffer — the mechanism by which it controls lending here — has been kept at 0%.

It’s also a reason why the Central Bank governor Philip Lane asserted last month that the Irish economy had been reorientated to avoid the mistakes of the past. At a panel discussion entitled Booms and Busts: Are We Better Able to Deal with Them Today? at one of the International Monetary Fund spring meetings in Washington, Lane said the Irish economy was better placed to withstand a recession this time around because of the higher levels of equity being used to finance investment.

I agree with Lane’s logic, but not his conclusion. The risk of a domestically unleashed boom-bust cycle has massively reduced since 2007 as a result of both falling levels of credit and rising levels of equity funding. Yet the risk of an internationally induced boom-bust cycle has significantly increased since 2007.

Global financial authorities, of whom Lane is our primary representative, battled the global crisis by using ever higher levels of debt. As a result, the world economy is now more fragile than in 2007. And any sharp global downturn is likely to have immediate and unpleasant repercussions here because the Irish economy is so exposed to the international economy.

According to the Bank of International Settlements (BIS), global debt equalled about 175% of global economic output back in 2007. That was sufficient to herald a near collapse in the global financial system. At the end of 2016, global debt had risen to more than 215% of global GDP. This should worry us greatly.

William White, a former chief economist at the BIS, was one of the few who warned of impending crisis in advance of 2007. He has said that the risks posed by current global debt levels are greater than in 2007, and that central banking monetary policy has lost its effectiveness.

In 2007 the debt problem was confined essentially to the advanced market economies. Since then, according to White, debt ratios have exploded in emerging market countries, so we now have a global debt problem while previously we had a regional one confined largely to advanced economies.

Gordon Brown, the former British premier, did sterling work as the financial crisis unfolded in co-ordinating a global response to avoid a rerun of the Great Depression that scarred the lives and politics of the 1930s. However, prior to that, as the UK’s chancellor of the exchequer, he confidently asserted an end to “boom and bust”.

Brown and Lane might as well have declared an end to the tide coming in and going out twice every day. Humans may have advanced greatly, yet there are some forces beyond the control of even the greatest and wisest men and women.

Published in The Sunday Times (Ireland edition)

May 13th 2018