There are two phases in an asset price bubble that repeat themselves with clockwork regularity. The first is the phase of the bogus economic theory. I am sure you heard the one about the paradigm shift due to the more widespread sharing of credit risk; or the one about the profits/wages ratio rising indefinitely.
The second phase is a prolonged state of denial.
In the US subprime mortgage bubble, we are now in phase two. It is difficult to explain rationally why anyone would want to give out large mortgages to people with no credit rating, or why a bank would want to give out interest-only mortgages at more than 100 per cent of a property’s value to anybody. Most of those products are based on irrational expectations by lenders and borrowers.
The European Union is a little behind the US when it comes to such crazy financial innovation, but only a little. There is a subprime mortgage industry in some markets, such as the UK and Spain. You can also find interest-only mortgages.
Unsurprisingly, these are also the markets that have seen the strongest increases in property prices over the past 10 years. The Europeans are still in phase one of the bubble. The bogus economic theory from Spain is that large immigration can maintain a construction boom indefinitely.
Let us just look at some statistics. In Spain, the construction and housing sector accounts for 18.5 per cent of gross domestic product, about twice as high as the eurozone average, according to the latest data from the EU’s Ameco database. The comparable figure for Germany is 8.7 per cent. The justification given for this increase are: a net inflow of immigrants, many from Latin America, who find it easier to purchase, rather than rent Spanish property; changes in the Spanish way of life, as young people leave homes earlier than they used to; and Spain’s continued popularity amongst sun-loving northern Europeans. In other words, the Spain-is-special-crowd argues this is a structural boom, not a bubble. They claim that Spain’s property market can grow at faster rates for longer than most other European markets.
I do not want to dismiss all of these points. The trouble is that these merely tell us why the bubble happened in the first place, not why the path should be sustainable. In Spain, the average price of a square meter of residential property went up from about under €700 in 1997 to just under €2,000 at the end of last year – up threefold. House price growth has moderated more recently – from year-on-year growth of more than 15 per cent two years ago to more than 10 per cent now. It is true that Spain still has an extremely low level of mortgage defaults compared with the US. It is also true that Spanish mortgage banks are relatively flexible in terms of their willingness to refinance loans. Then again, Spain is in a different phase in the housing boom-bust cycle. Spain is today where the US was approximately a year ago.
In Spain, most mortgages are variable-rate, so the rise in short-term market interest rates to more than 4 per cent is beginning to have an effect on the Spanish housing sector. Monetary statistics tell us that the boom in European mortgage lending is slowly receding but this process still has some way to go. If, as a likely consequence of the subprime mortgage crises in the US, there is a global reappraisal of the price of risk, Spain would be hit by a double whammy – higher rates and higher spreads.
Now since 18.5 per cent of the Spanish economy is housing-related, a gradual convergence towards the eurozone average would seriously weigh on economic performance for a long period. Post-unification Germany experienced flat house prices for 15 years and a depression in the construction industry.
Spain has one of the lowest rates of productivity growth in the EU. The rest of the economy may not be strong enough to fill the gap left open by construction. It does not take much imagination to see that a perfect storm is building up. The idea that Latin American immigrants will continue to jump on the property ladder under these circumstances and rescue the housing market is a little optimistic. While it is true that there has been a structural shift from a conservative to a more liberal society, such shifts end at some point. And Germany and British homebuyers may eventually find alternative and better priced homes in other parts of the Mediterranean. The explanations of the past cannot be extrapolated.
Another example is Ireland. In Ireland, the GDP share of construction and housing is even higher, at 20.7 per cent. While the performance of the Irish economy during the past few decades was remarkable, there are some deep underlying structural problems that are now surfacing. In particular, Ireland has been fast losing competitiveness within the eurozone – not a subject that has been talked about much outside Ireland recently. With interest rates rising and a slow return to sanity in the financial sector Ireland is going down the same route as Spain, perhaps only faster.
The US housing recession is not over yet. In the past the correlation between US and European property price movements has been extremely high. If the transatlantic tsunami comes, it is perhaps best to avoid some of Europe’s western coastline states for a while.
Written by Wolfgang Munchau for the Financial Times, published on Monday March 19, 2007.
Property in Observatory, Cape Town, South Africa on http://www.hotpropertyincapetown.com
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