Phantom Income, Phantom Jobs?

The problem with a magic trick, though, is ultimately it’s nothing but a bit of sleight of hand and misdirection. And that is what Budget 2012 is, both in receipts and in expenditure. Let’s look at receipts first. When it comes to government revenues, there are effectively six main headings:

• taxes on consumption (in particular VAT and Excise),
• taxes on income (both personal and corporate),
• other taxes (in particular stamp duties)
• social insurance (in particular PRSI)
• other current receipts (that departments receive doing their day-to-day business)
• and then some various other current and capital receipts (e.g. EU transfers, Central Bank income and even interest on our loan to Greece)

The Government has judiciously assumed that most of these are going nowhere next year: even with the higher rate of VAT, consumption tax revenues are only predicted to grow by 1%, as are revenues from other taxes. Social insurance receipts are projected to fall. And yet – out of nowhere – direct taxes are projected to grow by 7% or over €1.3bn to €18.9bn. This is being driven entirely by projections about income tax, which is expected to grow by almost 10% in 2012.

Bear in mind that tax credits were not changed, nor were the headline rates. So how would this stack up – where will this extra €1,250m in income tax come from? This would only stack up in two scenarios. The first is that everyone’s income grows by 10% next year. “Not bloody likely!”, says you, so I think we can rule it out. The second is that employment grows. How many extra jobs would we need for the Government to meet its targets?

Let’s assume that two types of job are created in equal measure: high-skill jobs, where the salary is €60,000 and more tentative new jobs for those with fewer skills or years of experience, where the pay is €30,000. Let’s also assume that the typical job is created in June (a rough way of saying that not every new job will give 12 months of taxes to the Government in 2012). This means that over the six months, the typical high-skill job will generate €7,200 in income tax and about €1,800 in USC. The other job will generate €3,000 in income tax and a further €700 in USC (all figures thanks to HookHead’s tax calculator).

So without any changes to the tax code, and barring unforeseen growth in incomes, for the Government’s figures to stack up, the economy will need to generate an extra 100,000 high-skill jobs and the same number of lower-paying jobs! Economists are often criticised for making heroic assumptions but surely we’re in the ha’penny place when it comes to this. Really does the Government really believe this is going to happen?!

Clearly, it won’t all come down to jobs growth. As last week’s controversy about older people paying their fair share of tax shows, there is some income that is not being taxed fully at the moment and doing so may generate some extra one-off and recurring revenue. But even as the year only starts, the idea that even a hundred thousand new jobs might be created this year seems far-flung. And without that and without any other measures to boost income in any substantial way, it seems pretty clear that the Government’s revenues are going to fall next year, not rise.

Spending: the usual suspects

There is any number of ways of divvying up how the Government spends money. Two key distinctions to understand are current vs. capital (capital leaves an asset, current does not) and voted versus non-voted (non-voted is effectively done outside the Budget, i.e. no element of choice for the Government of the day). My preferred classification has eight main headings:

• Social welfare
• Health (and children)
• Education (and skills)
• All other current expenditure
• All capital expenditure
• Servicing the national debt
• Bank recapitalisation
• Other “non-voted” expenditure (both current and capital)

As the graph below shows, almost three quarters of all expenditure in 2012 will be current: €52bn out of €71bn. (Quick note for those interested in reading through the budget.gov.ie 2012 reports themselves: always work in gross figures even though the Government insists on working in net figures!) The remainder is made up of €4.4bn in capital spending and €15bn in non-voted expenditure, which in 2012 includes €7.5bn on servicing the national debt and €4.4bn on bank recapitalisation.

Government spending 2012, by major area

The Government of the day has no say in non-voted expenditure (at least not without major fuss such as international defaults), so we can set that aside. And as I’ve pointed out before, there really is no more scope for cutting the capital budget. More importantly than that, provided capital spending is done according to proper cost-benefit analysis, deficits due to capital spending do not matter – the deficit that matters is the one on current spending (including national debt repayments).

So when it comes to closing the deficit, we need to get the €66.8bn in non-capital expenditure back down into line revenues of just €51.2bn. Realistically, if we ignore the bank recapitalisation as finite deposit insurance that is added to the national debt, this is about closing to zero over the next five years the gap between current spending of €62.3bn next year and receipts of €51.2bn.

To give you an idea of the scale of the challenge, it is expected that gross expenditure by the Government will be €1.2bn lower in 2012 than what was budgeted for 2011. To give you an idea of the strategy so far, the pie-chart below shows you which of the four areas of expenditure has contributed to these savings. The share of expenditure is shown in brackets in the chart’s legend.

Proportion of 2011 savings and 2012 cuts by area (area's share of 2012 expenditure in brackets)

All current expenditure outside the areas of health, education and social welfare constitutes about one sixth of all spending but has made up almost two thirds of the cuts. Clearly, this can’t go on. You could scrap every single one of these departments, from Taoiseach’s right down to Arts & Heritage and you still wouldn’t have cut current spending by enough to balance the books.

So if the country is to avoid bankruptcy, it needs to face up to the harsh reality: spending on the poor (social welfare), the young (education) and the old (health) will have to be reformed. One giant step in that direction would be to make all income from any source – including jobseekers allowance, children’s benefit or the statutory pension – should be taxable. Ironically, given the discussion above, doing this would actually significantly boost income tax receipts, perhaps not by the equivalent of 200,000 news jobs – but it would make sure that those who earn enough anyway pay their fair way. And perhaps even more importantly than that, there would be no welfare trap.

Budget 2012: stealing from the future?

Two principal moves in the Budget have the feel of desperation about them: a philosophy of “if we can steal demand from 2014 and cram it in to 2012, we will”. For example, the Government has increased Capital Gains Tax from 25% to 30%, but made an exemption for commercial property purchased in 2012 and 2013 (once it’s held for seven years or more).

Would-be residential property purchasers have even less time to move: tax relief for owner-occupiers has been extended for 2012 but is cut after that. The Mortgage Interest Relief scheme will continue into 2012 and at an increased rate of 25% for first-time buyers and 15% for other (residential) buyers. From 2013, there will be no mortgage interest relief.

The fact that mortgage interest relief for homeowners who bought between 2004 and 2008 (i.e. the bulk of those in negative equity) has been increased to 30% is an almost entirely unrelated measure. The move on bubble-era mortgages is one about alleviating the debt burden (if only slightly), rather than one about stimulating demand (if only temporarily).

To see this, the graph below shows the monthly mortgage payment in 2014 for the same property (the average house) bought in different circumstances. The first two are the 35-year 100% tracker mortgage, enjoying a 2% interest rate in 2014 and with the old 20% mortgage interest relief [MIR] and the new 33% mortgage interest relief. The monthly mortgage repayment for that boom-time buyer will fall from about €970 to just under €850, a welcome relief to boom-time borrowers no doubt (albeit one that has to be funded by other taxpayers or more borrowing).

Mortgage repayment in 2014 for various mortgage set-ups on the same property

The third bar shown is the 2012 buyer, where prices have fallen by 50% and instead of a 100%, 35-year, tracker mortgage, the borrower faces a 90% LTV, 30-year variable interest rate of 5% and mortgage interest relief of 25%. Their repayment is just over €650. The final buyer (say 2014) enjoys prices 60% below peak but no mortgage interest relief. The state has imposed a maximum loan-to-value of 80% but other than that, she enjoys the same borrowing circumstances as someone in 2012: 30-year mortgage and a 5% variable rate. Her repayment is lower again: just below €650.

The preservation of tax-incentive properties (such as Section 23) in Budget 2012 where annual income is less than €100,000 is basically cut from the same cloth: a debt burden measure, not a market stimulant. (The generosity shown to these investors will be funded by a surcharge on those tax-relief investors with an income of more than €100,000, who are now subject to a surcharge of 5%.)

Stamp duty on residential property was reduced to 1% (below €1,000,000 and 2% on the balance) a year ago. That has been preserved this year and effectively extended to commercial property, where a flat rate of 2% now applies.

An addiction by any other name…

An economically literate medical professional will know this type of behaviour immediately: it is addiction. Ireland is addicted to property. And not in the romantic historical we way like to think… “It’s a whole post-Famine thing. Sure didn’t you watch The Field? We could never rent long-term here.”

No, Ireland’s addiction to real estate is quite modern and quite easy to explain. A 2004 paper in the Central Bank’s Financial Stability Report highlighted that actual cost of owning housing was negative for the bulk of the period 1976-2003. The most significant contributory factor was that the capital gain went untaxed: with any other asset, if you bought it at £10,000 and sold it 20 years later at £110,000, there would be tax liable on the £100,000 profit. If capital gains tax of 20% had applied to housing, this would have cooled down house prices as the war-chest you bring to your next deal is £80,000, not £100,000.

But it’s not just untaxed capital gains in isolation. Ireland has the most generous tax treatment of property in the developed world. A 2006 report by the OECD highlighted this: Ireland was the only country that both allowed owner-occupiers tax deductions for mortgage interest payments AND did not tax property values, capital gains or imputed rents.

In fact, the only tax there was on property was stamp duty. And that’s now effectively gone (or at least down to 1%). And the Government has extended tax relief, an integral part of the problem. After an intervention-fuelled bubble, the response has been to intervene more. This is just like the addict who says “Honestly, if I can get just one more hit, then I’ll be fine. Honest.”

Making sure we’re fixing, not getting another fix

The litmus test for any measure is whether it creates a healthier property market in the medium-term, not in the short-term. As is the case with any textbook bubble, there is a real danger that property prices will overshoot on the way down. On its own, that might not sound too bad if you don’t own property right now. However, overshooting means that prices have to recover at some point and the way people form their expectations about house prices, extrapolating from the past, means that overshooting dramatically increases the likelihood of another bubble down the line.

But just because there is the danger of overshooting does not mean any measure will do. The two key ingredients in the property market are confidence and finance. Neither is in abundant supply at the moment, but making borrowing unsustainably cheap – by bullying banks about the variable interest rates and then offering tax deductions on those rates – is not the way to get around this. The solution lies in the rather more boring rebuilding confidence and finance.

Offering borrowers certainty is one solid way of rebuilding confidence. General macroeconomic confidence aside, this should be certainty about how much they can borrow (a legal maximum loan-to-value would do the trick), and what their tax burden will be. On the latter, the worst possible idea is to introduce a €100 flat charge and then “see where it ends up” in five years’ time. A far better idea is to announce early in 2012 what the property tax burden will be from 2017 into the future and how the country is going to get there.

But borrowers are just one half of the equation. Lenders also matter (particularly if the taxpayer owns the bulk of them). Pleading in one ear with the banks to lend more is pointless if you’re shouting at them in the other ear to stop lending (which the Government is doing with the stress tests which require them to deleverage, i.e. lend less). It’s even more pointless if you’re also giving them a clatter across the top of the head for trying to get their mortgage interest rates back to sustainable levels (probably about 6%).

A time of crisis is, as I’ve said before, a time of opportunity. With so many in negative equity (i.e. no capital gains ever likely), never has there been a better time to introduce full capital gains tax for residential property and level the playing field between productive investment and property investment. Similarly, a silly if affordable €100 charge per household is probably the best setting in which to introduce a fair and efficient annual property tax. The huge parliamentary majority enjoyed by the current government means they have the power to wean Ireland off its addiction, generating greater tax revenues in the process, once and for all.

We already know, through the Taoiseach’s State of the Nation address that, on the taxation side, there will be no change to the income taxation system but instead, VAT will increase. In fact, we knew this already as Ireland’s budgetary plans were, per the terms of the EU-IMF loan, sent to those lending to us so they could be kept abreast of their borrower. Unfortunately, Ireland operates under a bizarre system of national budgeting, where the Minister of Finance is supposed to pull rabbits out of hats on Budget Day to the oohs and aahs of the media (and perhaps the public). So the Irish public was none too impressed to learn many of the details of the Budget via the German parliament.

Traffic jams to Newry?

The increase in VAT rates, likely to be two percentage points, led to a rush of people decrying that this would be like 2009 all over again, with traffic jams on the way to Newry, as Irish consumers exploit arbitrage opportunities between Northern Ireland and the Republic. Clearly, if such a stampede were to happen again, more retail jobs would be at risk.

However, what impact will the VAT rate actually have on cross-border differentials? It turns out that this sort of thinking flatters the government, in terms of the power if has over these things.  The graph below takes a hypothetical basket of goods that cost €100 in late 2007 and the same, i.e. £70, in the North. By late 2008, the value of sterling had collapsed, with the euro now worth 97p, rather than the 70p it was a year earlier. That – and the VAT cut from 17.5% to 15% – meant that the Northern Ireland basket now cost just €72, whereas the Irish basket – thanks to inflation – cost €104.

Price of a basket of goods, North and South, from 2007 to 2012

With about €20 in fuel and tolls for a return trip to Newry from Dublin, you could make your money back on a weekly shop. Since then, though, sterling has strengthened somewhat, with the euro now worth about 85p. Meanwhile, VAT in the UK has risen from 15% to 20%. And whereas prices in Ireland are now only about 1% higher than four years ago, prices in the UK are over 15% higher.

The basket of goods that cost €100 both North and South in 2007 would now, after VAT increases to 23%, cost about €104 in the Republic – and about €98 in the North. Whereas you could make your fuel and tolls back with the weekly shop up North in early 2009, now you’d need to spend €400 just to break even. If inflation continues at 5% in the UK and 3% in Ireland, the gap on this basket will narrow by the next of next year from €6 to €4. To put it another way, to make a saving of €100 from a cross-border shop, you’ll need to spend €2,600, rather than just the €300 needed in 2008.

Competitiveness and cost of living

The risk to the economy from the VAT increase is not about people scooting up North and making a saving. It’s about destroying consumption, not diverting it, in two ways: firstly, it pushes up the cost of living, already a concern in relation to attracting investment into Ireland. More pressingly, it is effectively a tax that falls most heavily on poorer households.

This paper by Eimear Leahy, Sean Lyons and Richard Tol, of the ESRI, outlines the percentage of disposable income paid in VAT by different income groups. Whereas VAT is like a tax of 6% on the disposable income of the richest households (who will be doing tax efficient things like saving in their pension and owning their own home), the poorest households feel VAT as a 16% tax on their disposable income. But with Ireland’s marginal rates of income tax already so high in an international comparison, something has to be done, right?

The government thinks it’s in a bit of a bind. How do you increase taxation revenues, as it must, without affecting either Ireland’s cost of living or its competitiveness, as VAT and income tax inevitably do? Thus it has chosen what it regards as the lesser of two evils: raise VAT, not income tax.

The obvious “third way” in all this is to tax land. It’s immobile, so it’s not going to go anywhere in response to a tax increase, nor will people’s decisions be distorted as a result. I’m hoping the €100 household charge, which is of course incredibly regressive, is only a measure to take the sting of moving from a country with no property tax to one, like every other developed country, that does have one.

The more and more land – residential, commercial or agricultural – is taxed, the less income and consumption have to be taxed. Given that Ireland needs more tax revenues, it’s obvious which choice is best.

Rent Supplement: the story so far

A couple of weeks ago, the latest Daft.ie rental figures came out. The picture was one of stabilising rents, particularly in the urban areas and in the larger homes segments, with rents actually rising in some markets. However, there is something of an asterisk attached to all of this. Whatever about segments where rents are increasing, stabilising rents may reflect as much government intervention in the market as it does stable demand. For those not familiar with rent supplement, a system of state-provided rent supplement is available to the unemployed, with maximum rents which vary by local authority area. Effectively, if you’re on this scheme, you can rent properties with monthly rents up to those indicated.

This is a huge scheme. The Department of Social Protection in Ireland funds about half the private tenants in the residential lettings market in the country: in June 2011, there were 97,000 recipients of rent supplement nationwide. As of the 2006 Census, there were just 150,000 households privately renting in the country. Even if that is an underestimate and the true figure was 200,000 and has since grown to 300,000 (which would require the ‘would-have-been first-time-buyer’ cohort to grow significantly faster than the ‘we came here to build properties and have since headed home’ cohort), the Department controls a third of the market. This is huge market power. And just like in the case of electricity, where the same Department is trying to get a better discount out of the ESB than the current meagre 1%, the Department should use it to the advantage of the taxpayer.

But this is about more than just using market power for the benefit of the taxpayer. This is about a potential price floor, which keeps the cost of accommodation higher for all tenants and thus reduces Ireland’s competitiveness. This is because there is no incentive for a tenant on rent supplement to see their rent reduced, as their likely contribution stays at €24 a month.

Are taxpayers paying for a price floor?

So, as rents generally fell by 25% over the course of 2008 and 2009, they got closer and closer to a point where working tenants could effectively be outbid by welfare tenants. Granted, rent supplement has been cut twice since 2007. The first time, in the Supplementary Budget for April 2009, it was effectively cut across the board by 8%. The second time, in June 2010, maximum supplements were cut in many cohorts but not for single persons (i.e. not for one-bedroom accommodation).

Overall, since 2007, maximum rent supplements have fallen by an average of 14% across the country. However, rents have fallen by closer to 30% for most types of accommodation. The result is that, for one-bedroom properties in particular, taxpayers may now be artificially propping up rents… and footing the bill. To see this, consider the chart below. It shows how the maximum rent supplement compares to the average rent, both at the peak of the market in late 2007 (the blue line) and now (the red line). The closer to 100% it gets, the more the taxpayer has set a floor on rents, as those who are ambivalent to higher rents (those on rent supplement) can outbid the average working tenant.

(Notes for the graph: (1) The figures include the €24 contribution provided by recipients on top of their supplement.  (2) This graph compares the market average with the local authority maximum. The Department of Social Protection tells me they expect those on rent supplement to find accommodation at the 40th percentile, i.e. at a quality a little below the market average. This means that the price floor is even more of an issue as they are competing with bigger budgets for accommodation that costs less than the average. (3) I’ve assumed that both singles and couples with no kids are in one-bedroom accommodation, and that an extra room is added for each child. Where singles are required by their local authority to live in bedsits, or where children are of the same gender meaning two adults and two kids are expected to share two-bedroom accommodation. Again, this would push the bars above higher, as the same household has a bigger budget for cheaper accommodation.)

As you can see, despite the reductions in the supplement, there has been a definite drift towards supplement acting as a price floor. The only segments where this has not occurred (in Connacht and Ulster in 3-4 bedroom homes) were among those segments most distorted to begin with, with rent supplement covering effectively the average mortgage on average.

The most noticeable increases, i.e. where the potential is greatest for a distorted market where there was none previously, have been in Leinster and Munster. Where rent supplement had traditionally been 80% of the average rent, it is now 100% or greater. This is particularly acute in the two-bedroom segment, where every single local authority has maximum supplements for a couple above the average rent paid. If I’d compared single person supplement with bedsit rents (not one-bed accommodation), the problem in that segment would look equally serious. The short version is: welfare tenants – with no incentive to haggle down their rents – are easily able to outbid working tenants.

And yet lower rents may be wishful thinking (for some)…

I would be careful about believing that reform of rent supplement will push rents significantly further down in all segments. Within Dublin, for example, there is a noticeable difference between Dublin’s southside, where maximum supplements are still just 50%-75% of average rents, and the North city and West Dublin regions, where particularly for two, three and four-bedroom homes, the figure is over 100%. Where rents are well above supplement rates and not only stable but rising at the moment, there’s little to think that reduction in supplement rates will have an impact.

Added to this, it may also be the case that working tenants and welfare tenants form separate markets, at least in some parts of the country. On daft.ie, those listing their ads can state whether they will accept rent supplement. Only one in six do, meaning that there are large cohorts of landlords who are not interested given the perceived extra costs associated with Rent Supplement tenants. (There are also, presumably, many roll-over Rent Supplement landlords, who don’t need to advertise on daft.ie.)

What to do next?

Ultimately, the problem here is that Rent Supplement tenants are currently being sent into transactions with their landlord, without any incentive to haggle the rent down. The cost, as ever, falls on the taxpayer. Reforming Rent Supplement without addressing this is just a stop-gap.

It’s my own belief that rent supplement should be incorporated into general welfare payments, or ‘social income’ and that this income should be treated as taxable. This would level the playing field between workers and welfare recipients and make it far easier for someone coming back into employment to take a job offer. It would also encourage Rent Supplement recipients to haggle on their rent, as they would see some of the savings.

Clearly, there are issues about those on Rent Supplement regarded as vulnerable, including those with addictions. However, that is not an excuse not to reform a broken system. Where there are vulnerable people in society, provisions should be made for making sure they are not damaged by lack of care for their welfare.

That property two doors up from me I mentioned at the start, the one with 17 bedsits, went on fire a few weeks ago. The woman who discovered the fire said to me out on the street “How can they allow people to live in accommodation like this?” And she lives there. One can hardly argue that the current system, which sustains properties such as that one, is working for our most vulnerable.

In the forthcoming budget, the Government has the opportunity to achieve a triple-win by reducing rent supplement. The first win is for the taxpayer: the taxpayer is currently spending about €500m a year on rent supplement for almost 100,000 tenants. Significant savings can be made as the Department uses its market power to lower rents. The second win is for the welfare tenant: by making better quality accommodation more affordable, society can at last move beyond the modern urban tenement.

The final win is for the working tenant and for Ireland’s competitiveness: while some tenants will see no reduction, particularly in family homes in the cities, many will enjoy collateral benefit from the Department using its market power. The glut of property in the country generally should mean Irish rents are cheap compared to other countries and thus the post-rent disposable income here compares favourably. This December, with the Budget, a major step in that direction can be taken.

In truth, while there are those who couldn’t and still can’t believe that rents are stabilising after a fall of between 25% and 30% from the peak, this is not a surprise to anyone who’s been paying attention to the number of properties available to rent. Indeed, as far back as January 2010, the signs pointed to stabilising rents. Whereas the total stock sitting on the sales market has been doggedly at close to 60,000 for three years now, the total number of properties available to rent at any one time has fallen from a peak 24,000 in mid-2009 to less than 16,000 on November 1 last.

A Tale of Two Irelands

The national average hides variations across different segments, however. The stability in rents is being driven by trends in urban areas. Rents in Cork city, home to Ireland’s pharma hub, are up over 6% in year on year terms. Rents in Dublin are up less dramatically, by 0.8% year-on-year, but the size of Dublin’s lettings market means that probably had an equal impact on dragging up the national average. Rents in Wexford are still falling, down 8% annually, with rents in Leitrim, Longford and Kerry also down by more than 5%. As Philip O’Sullivan says in his commentary to the report, it’s a tale of two Irelands.

And unsurprisingly, stock available to rent in the cities is what has driven the fall-off in stock nationwide. Of the fall nationally of 8,000 units, 60% has been due to a fall in the stock available in Dublin, which is down by a half in the last 18 months alone. A further 16% of the fall is due to what’s happened in the four other cities. In contrast, the stock available to rent in Connacht and Ulster on November 1 was 3,200, compared to 3,700 in mid-2009.

But geography is just one way of breaking down the market. Another is by bedroom number. Given how different areas seem to have balanced each other out, the same might be true of different bedroom numbers. Whereas oversupply and the legacy of boom-time construction has flooded many provincial markets, both sales and lettings, Department of Environment figures indicate that this is not an issue for family homes in Ireland’s major cities, in particular.

The correction in rents in 2008 and 2009 seems to have been one of incomes and emigration. The whole market needed to adjust and that has by and large happened. Since early 2010, trends are more likely to have been driven by supply and demand: where is the legacy of over-construction affecting the supply of rentals? And where is there at least some prospect of employment?

A Tale of Four-Bedroom Ireland

Thus it would be nice to see how rents have changed by bedroom-and-region segment, not just since the peak but comparing the fall from the peak to early-2010 with the fall from the peak to now. Showing everything in one graph turned out to be more of a challenge than I’d anticipated. I’ve done what I can in the chart below, which will hopefully be more readable following a couple of introductory notes.

• From left to right, the chart is broken down into three ways. The first is broad region, Dublin, other cities, and rest-of-country, as indicated. Within each region, the colours then show the different bedroom numbers, from blue (1-bed) to orange (4-bed).
• The reason that there are each colour appears a number of times in each broad regions is because they are broken down into sub-markets: six in Dublin (city centre, north city, south city, north county, south county and west), each of the four other cities (Cork, Galway, Limerick and Waterford), and six main regions in the rest of the country (commuter counties, Midlands, the south-east, Munster, Connacht, and the three Ulster counties).
• There are two figures given for each bedroom-market combination. The lighter diamond is the fall from the peak to early 2010. The darker square is the fall from the peak to now (the third quarter of 2011). What I’m particularly interested in is segments where the square is above the diamond, i.e. where rents have risen over the past 18 months.

Fall in rents (to 2010-q1 and 2011-q3) across different segments of the market

It’s clear that in many segments of the market, rents have continued to fall since early 2010 (the squares are below the diamonds). For example, outside the cities, one-bed rents have fallen by an average of 6% in that period, while two-bed rents have fallen by 5%. And in Dublin, rents for one-beds have continued to fall. However, there are also clear differences. Whereas two-bed rents are clearly falling outside the cities, they look to be very much stable in Dublin.

If you look at the orange squares (4-beds), they have certainly stopped falling in the urban markets and in almost cases risen by non-negligible amounts over the past 18 months. (Only the final two “Other Cities” 4-bed segments, Limerick and Waterford, as well as West Dublin have had stable 4-bed rents since early 2010.) And there is evidence of greater demand than supply of family homes to rent, with people making do with either less space (see the three-bed segments in Dublin, green squares) or greater commutes (Dublin commuter county four-bed rents have risen).

Anything to be said for building new homes?

While it might be too early to talk about shortages in the property market, there does not appear to be any over-supply of family homes in Ireland’s main cities. Thus, it’s frustrating to read about attitudes like Wicklow County Council’s to plots of residential land near urban centres: the ‘all hope is lost, we’ll never need new homes again’ attitude. The sooner we stop thinking of one national property market and instead of different markets around the country, the sooner it will be possible for local authorities and others to ensure an adequate supply of competitively priced housing across the country.

A higher interest rate does not a greedy banker make

Once you’re aware of this trade-off, it appears everywhere in current economic discussion. This morning, word has come out that National Irish Bank is ignoring the Financial Regulator’s call for the ECB’s rate cut to be passed on variable rate customers and will instead proceed with its planned increase in variable rates of almost 1%. Given that An Taoiseach Enda Kenny said last week that he would bring in laws to force lenders to lower rates in response to ECB cuts, surely this must be a case of greedy bankers taunting the public, right?

There are a couple of facts worth pointing out at this point. Firstly, according to CSO data, the average variable rate in Ireland is currently 4.3% so by raising its rate to about 4.5%, what NIB is proposing is effectively bringing itself into line with other banks – as shown in the graph below. Secondly, and related to this, NIB has also not increased its variable rates since June 2008. Thirdly, National Irish Bank is not funded by the ECB – it’s a subsidiary of Danske Bank – so changes in the ECB rate are largely irrelevant to the bank.

Variable interest rates for 80% LTV, various institutions

Most importantly, however, An Taoiseach Enda Kenny and perhaps more worryingly the Financial Regulator Matthew Elderfield are falling in to the trap of thinking that interest rates cause mortgage arrears. To put NIB’s move into perspective, its variable rate customers will face an interest rate of about 4.5%, which is in line with the average variable rate charged by Irish banks over the period 1999-2011. If its customers are struggling, they are struggling to pay back at a rate similar to when interest rates in Ireland were at historic lows. If that’s the case, something is wrong and it’s not the interest rate.

What causes mortgage arrears?

Last month, the Central Bank organised a conference, The Irish Mortgage Market in Context, which I attended as a discussant. The second and third sessions featured presentations on understanding what drives mortgage arrears and repossessions. The key debate at the conference was among those who believe that negative equity drives arrears (BlackRock Solutions, responsible for the stress tests) and those who believe that unemployment drives arrears (the academic experts). This is the so-called ‘double trigger’: negative equity and unemployment are both needed for arrears – the argument is about the weight attached to each part.

Ireland’s policy in relation to the mortgage market here urgently needs to reflect this discussion: interest rates don’t cause mortgage arrears, some mix of unemployment and negative equity does. The government getting into the business of setting prices charged by banks shows a complete misunderstanding of the nature of the problem. Given that the negative equity part of the equation will not be going away any time soon, to halt the slide into mortgage arrears, the government needs to tackle unemployment.

Today’s borrowers versus tomorrow’s borrowers

Policy here also needs to reflect the trade-off between current borrowers and future borrowers. According to work by economists at the Central Bank, just 30% of outstanding mortgage balances is on a variable rate mortgage. Of the 145,000 mortgages in negative equity out of the 475,000 mortgages covered in that study, 40,000 were on variable rates.

It’s my own belief that the next generation of Ireland’s mortgage market won’t just happen, it will need to be created by policy and that a central feature of the new market should be a requirement to issue covered bonds: i.e. banks borrow long (30 years) to lend long (30 years). Where this is the requirement, there is no such thing as a variable rate mortgage, a product viewed in the same terms as subprime mortgages in the US. Instead, the monthly mortgage repayment is fixed, providing consumers in Ireland with insulation from interest rates set with the rest of the Eurozone in mind.

However, I appreciate that until such a change is made, almost all new borrowers are going to be on variable rate mortgages.  This is a stream of probably 40,000 new borrowers a year into the future. So we face a situation where out of myopia and incorrect diagnosis of the problem, the needs of the 40,000 are being placed above the needs of the 400,000, the generation born in the 1990s. No-one is arguing that the pain faced by those on the cusp of mortgage arrears isn’t real – but in this debate we need to also remember that the welfare of others, less obvious or less vocal, also matters.

As outlined by Bob Quinn over on Money Adviser, the Financial Regulator believes that banks setting their own interest rates is self-defeating, “adding to the mortgage arrears problem and ultimately costing more in terms of capital”. Surely that is for NIB/Danske Bank – and possibly the Danish taxpayer as shareholder of last resort – to worry about.

What is certainly self-defeating is preventing banks in Ireland – particularly the few we have that are not taxpayer-owned zombies – from covering their costs. This is a Pyrrhic victory for current homeowners: its biggest impact is not reducing the price of mortgages, it reduces the number of new mortgages given out. This contraction in the supply of credit pushes down house prices, leading to greater negative equity. And unlike interest rates, negative equity does actually have an impact on arrears.

If the Government wants to change Ireland’s mortgage market, it should set policy not prices.

Getting back on track

It is no surprise that both these trends have proven unsustainable and in the last three years, Ireland has been trying both to regain international cost competitiveness and to put its Exchequer on a sounder footing. On incomes, since 2006, wages have been static: OECD figures suggest that a household with one earner on the average wage and another earning two-thirds of a full wage earned €65,900 in 2010, barely up from the €65,600 they earned in 2006. In contrast, wages have grown by almost 10% in France and Germany, while they have been static in Ireland.

If wages continue to be largely static in Ireland between now and 2014, rising by just 1% a year on average, this would mean that wages would have risen by 43% between 2000 and 2014. If current trends continue elsewhere, this would compare with a 52% rise in the Netherlands, 42% in France, 38% in Austria and 31% in Germany. Likewise, the tax burden is reverting to normal. In 2006 it was just 11% compared to an OECD average of 20%. In 2010, it had risen to 13% and – with reduced tax credits in particular but also perhaps taxable child benefit – it is likely to reach 18% by 2014.

So far, this just sounds like yet another economist drooling over austerity. But this matters for our future prosperity because Ireland needs to restore its competitiveness. The good news is that Ireland has been making significant inroads to restoring its competitiveness over the four years. Key to this has been the collapsing property market.

There is lots of worry at the moment about what kind of Ireland this generation is leaving to its children. I’ve outlined before how the banking debt is almost certainly going to be not a worry for our children and grandchildren. On the other hand, while falling property prices are bad for the generation who bought in the 2000s (born in the 1970s), they are really good news for those who will be looking for work in the 2010s (born in the 1990s).

Housing & competitiveness

To see how this connects back up to competitiveness, remember that just as income levels determine property prices, so do property prices determine wage demands. In an economy ticking along without bubble or crash, people will set aside about one quarter of their wages to cover accommodation, either rent or mortgage repayments. So if house prices fall by a half, that frees up disposable income, even if taxes increase.

The graph below explores the impact both of falling prices and the reordering of Ireland’s financial system on mortgage repayments. Ireland’s property prices look set to fall by between 55% and 60% from the peak. A South Dublin family home that cost €750,000 at the peak had a typical mortgage repayment of about €3,150 – this is based off a 35-year mortgage, 4% average interest rate and a 95% loan-to-value.

How a mortgage repayment on a South Dublin family home may change, 2005-2015

Assuming banks require a greater deposit of say 15%, to protect both lender and borrower from negative equity, this actually pushes down the mortgage repayment to €2,800. However, banks will also be reluctant to issue 35-year mortgages and so a 30-year ceiling would push up the repayment by €200 a month. More significantly, Irish households can no longer plan on interest rates of 4% and will instead be budgeting for interest rates of 6% on average of the lifetime of the mortgage. This pushes the repayment up a further €800. However, by far the largest impact is the fall in house price. A fall of 45% in the price of the house to about €340,000 would cut the mortgage repayment by over €2,000 to just over €1,700.

Competitiveness regained?

So we know that incomes in Ireland have been stagnant the past few years, while taxes have risen but property prices – and thus accommodation costs – have been falling. What has been the net effect on Ireland’s ability to attract workers? How does after-tax, after-rent income in Ireland compare to elsewhere?

The graph below uses OECD figures on incomes and taxes paid by the average family, as well as information from daft.ie and Global Property Guide on prevailing rents, to see how disposable income (i.e. after tax and after rent) has changed in six European cities of similar scale over the past decade. Information on rents has been used because this is easier to compare across countries (mortgage market considerations are left aside) and also because this is probably the more appropriate for executives considering relocating as part of an FDI operation. Growth in rents over the period 2000-2010 uses the housing component of each country’s consumer price index.

Annual income by category, for standardised family, selected cities, 2000-2014

A scenario for 2014 has been included – feel free to skip this paragraph if the details don’t interest you particularly. For cities other than Dublin, this scenario involves extending out 2009/10 growth rates in incomes, maintaining current tax burdens in percentage terms, and assuming growth in rents of 2%, in line with inflation. This latter assumption is used for Dublin also, but instead of extending the 2009/10 trend, which would mean falling nominal incomes, instead growth of 1% a year has been assumed instead, and the tax burden on the average family is assumed to be 18% in 2014, rather than 13%. The level of rents in each city in 2010 is assumed to be three quarters of the rent of that city’s prime areas (taken to be Dublin 4, 6 and 14 in Dublin’s case).

I think there are three things of note from the graph:

• The tax burden (the red bar) faced by the nuclear family in Dublin has been and will continue to be small when compared with other cities. This initially sounds promising – but it is worth remembering that very high tax-free allowances in Ireland mean that there is a large gap between the average rate (on all income) and the marginal rate (on the next euro of income). This is an economist’s nightmare, as it muddles with people’s will to work and means people feel heavily taxed even when they are not.
• The property bubble is clear when looking at the 2006 figures: the green bar gobbles up almost 30% of total income in Dublin in that year, compared to about 20% in the other cities. This appears to have fallen back somewhat – to about one quarter of total income – but is still high in international comparison. Figures using mortgage repayments (as per the graph above), rather than rents, may reveal a more dramatic change.
• Perhaps most importantly, though, disposable income enjoyed by a Dublin-based family compares favourably with income enjoyed by families in other cities. This will still be true in 2014, even if the tax base is increased between now and then (hopefully by reducing tax credits, not by increasing rates) and if incomes are static while rents rise slightly.

The analysis above does not correct for difference in the cost of living, which would certainly have punished Dublin in 2006, as prices rose far in above of elsewhere in the Eurozone. Since then, though, as with wages, prices have been remarkably static, which if it persists augurs well for future competitiveness and creating jobs for the next generation.

Increasing taxes while improving competitiveness is a tricky tightrope to walk, as disposable incomes take a hit. The last four years in Ireland have shown that it is possible – provided you have a property crash to unwind. Those that genuinely care about the prospects the next generation enjoy should see pretty readily that the more accommodation costs for families and businesses fall, the better off the next generation will be.

The Dublin Flood

It was also unsurprising, given the freakish volumes of rain, that the city was ill-equipped to deal with this, particularly as it happened at a time of year when drains are most likely to be blocked by leaves. A major emergency plan was announced, after a number of rivers, including the Dodder, the Poddle and the Camac, all burst their banks. The scene from one of Europe’s largest malls, Dundrum Shopping Centre, the video below, was like something out of a horror movie.

Flooding in Dundrum Shopping Centre

Extreme weather events and major natural disasters are, clearly, hugely important events for those involved. Thus, they must be important for economists to understand in and of themselves. However, they are also important because help reveal to economists how humans actually interact with each other and with the world around them. For example, economists typically rush to assume – as a simplification to make life easier – that humans have a reasonable understanding of risk (i.e. attaching the correct probability to an event) and uncertainty (i.e. assigning the correct range of probabilities to an event). This may sound very arcane but it has implications both for economics as a subject and for everyday life.

For economics as a subject, if how humans react to extreme events suggests major deviations from the rational homo economicus, then much of the larger scaffold of economics – including macroeconomics – will certainly have to be rebuilt, if not torn down. For the real world, there are significant policy issues in relation to, for example, insurance against flooding or wildfire risk. Insurance markets may be incomplete or governments – in acting with good intentions – may actually subsidise bad choices by households.

What economic research says

There is evidence – from an article in the 2009 Journal of Real Estate Finance and Economics called ‘Do repeated wildfires change homebuyers demand for homes in high-risk areas?’-  that risk is mis-perceived by households. The authors use repeated occurrence of forest fires in a small geographical area to analyze the impact of natural disasters on house prices and to better understand perceptions of the risk. In their model, which includes about 2,500 homes from the Los Angeles area over the period 1989-2002, they find that houses that have been the victim of one fire are, everything else equal, 10% cheaper than other homes. As this discount only happens after the fact, wildfire risk does not seem to be priced in until it happens: households do not properly understand risk. Worse than that, houses affected by a second fire had their prices further revised down, by 23%. So when households did price in the risk of fires, they did it incompletely. After all, the underlying risk to the house hadn’t changed, just the market’s understanding of it.

Of course, one paper cannot be definitive. In relation to flooding, it seems that households do factor in the risks… but incompletely. A paper from 1989 does not find buyer myopia in relation to flood risk. Looking at a town in the US that suffered from flooding more than a decade previous to the study, the author finds a floodplain adjustment of just over 12 percent on average. A more thorough study from 2004 by Bin & Polasky in the Land Economics journal, on 8,000 homes in North Carolina, found that houses located within a floodplain have lower prices than houses located outside a floodplain, a negative differential that increased after a major hurricane caused severe flooding. This suggests household are aware of the risk but mis-perceive it.

Evidence from Ireland

In relation to flooding, and to what happened in Ireland on Monday, it’s worth noting is that it is rivers, rather than lakes or the sea, that pose the greatest risk. While major arteries such as the M50 ring-road were affected, many of the worst flooded streets were close to Dublin’s smaller rivers (its largest river, the Liffey, having relatively solid defences).

Part of my doctoral research at Oxford focuses on what determines the cost of accommodation. The factors range from access to good labour markets, schools and retail facilities to other amenities that may be typically regarded as too touchy-feely for economics: the value of living near the coast or of the social capital that a Gaeltacht area brings. In an analysis of about half a million ads from the daft.ie website over the period 2006-2011, a number of environmental amenities were included, such as proximity to the coastline, to lakes and to rivers.

The graph below highlights the effect of those three amenities on advertised house prices and rents. The model is set up to strip out other measurable factors, such as house size and type, local unemployment, the maturity of an area, etc. So, to the best extent possible, these are the estimated effects of living near the coast, a lake or a river. The most obvious finding is the difference between the positive effect of coastline and lakes and the negative effect of rivers. As these effects seem to taper off (i.e. they are strongest for properties closest and weakest for properties further away), it does seem as though this model is capturing the effect of natural amenities.

The effect of coastline, lakes and rivers on house prices in Ireland, 2006-2010

What the Irish housing market is telling us, then, is that while people will pay to live on the coast (especially in the cities) or on a lake, to live near a river, the price needs to be discounted by about 5%. Thus, this 5% is a crude estimate of the costs of flooding factored in to people’s decisions on where to live. What is particularly interesting for future research is the difference between the effect on house prices and the effect on rents: owner-occupiers appear to face more costs than those of the landlord and tenant combined.

The next step for this research is use the database that exists of flooding events in Ireland and see what kind of memory Irish households have in relation to floods. This might help disentangle the effect of remembering past floods and fearing future ones. Indeed, if the risk of floods is correctly included, the presence of a river close to a property should be a positive amenity like the coast or like a lake. Ultimately, though, to understand properly flood-risk and the effect it has on people’s homes, and whether Irish people themselves are factoring the risk in correctly, maps of the Irish flood-plains need to be made available. I understand this is due to happen but, for obvious reasons, the timing is a commercially sensitive decision.

Shocks and Great Expectations

The IMF produces twice-yearly estimates of their World Economic Outlook, complete with a dataset tailored for number-crunchers like myself. The dataset covers dozens of economic indicators for almost 200 economies, stretching back to 1980 where it can and also – crucially – giving forecasts for the coming five years. These forecasts are an excellent benchmark of expectations about future economic performance. Revisions to the forecast for, say, growth in 2012 across WEO reports tells us a lot about how economic conditions have changed.

We can see this by, for example, comparing the October 2008 and October 2010 WEO reports. The former would have been written largely before the tumultuous events of September 2008 and forecast growth in developed economies of 2.1% in 2009. For 2012, it predicted growth of 4.8%. The latter report showed growth in 2009 to be negative, at -2.4%, and its forecast for growth in 2012 was 4.1%. The first difference shows the impact of shocks – the second difference shows how expectations can change.

What has all this got to do with the Eurozone and sovereign debt crises? Well, according to the September 2011 WEO, the IMF estimates that this year the world’s developed economies will have a combined GDP of $40 trillion (that’s $40,000 billion). About $11 trillion of that is the Eurozone economy, a further $15 trillion is the US economy, with Japan, Korea, the UK and various other developed economies comprising the remaining $14 trillion.

This $40 trillion figure is about 6% below what the IMF expected it to be as of late 2008. Most would argue that the IMF’s expectations in 2008 – which reflect expectations of the broader economic community, including governments and the markets – were overly optimistic. The correction in expectations about what developed economies would look like in 2011 had already occurred by this time last year. Estimates from both last year and this year for 2011 GDP are close enough as to make no difference.

The cost of the debt crisis

However, looking to the future, one can see the cost of inaction around Europe’s sovereign debt crisis. The 2010 WEO estimated OECD growth over the period 2012-2015 to average 4.1%. The current estimate is for average growth of just 3.3%. In the Eurozone, the downward revision to growth has been even more dramatic. The average growth rate of 3.4% has been revised down to just 2.4%, a far cry from 2008 when the expectations were for growth of 4.4%.

The total cost to developed economies of the crises of the last twelve months amounts to lost growth of $1.3 trillion, or more accurately $1,342,000,000,000. Let’s face it – that looks like little more than an international phone number, making it very easy to forget that there are real jobs and incomes on the line – both ones that exist now and ones that do not exist yet but would have been created in the near future under different economic conditions.

The graph below tries to correct for that. It takes the average lost GDP over the period 2011-2015 and expresses it as a multiple of GDP per capita for the Eurozone, the USA and the rest of the developed world. In other words, the graph shows the IMF’s implicit estimate of the number of livelihoods destroyed by politicians’ inaction regarding the sovereign debt crisis… over the past year alone.

Estimated number of annual livelihoods, 2012-2015, lost since October 2010

There will be those who would argue that some of the livelihoods that will be lost were jobs that shouldn’t have existed in the first place – that what’s happening now is not so much the cost of inaction by political leaders by the inevitable consequence of the bursting of a global asset bubble. Even if they are right, it doesn’t really matter because it doesn’t mean that the losers are any less real. Anyone in Ireland will tell you, seeing large chunks of the population suffering from some combination of unemployment, negative equity and mortgage arrears, that it matters not one iota for public policy if one person’s lost job in construction was unsustainable while another’s wasn’t.

Talking to Peter Mathews, a banking expert and now TD (representative of the Irish Parliament) and government backbencher, he estimated that what is required is about a €75bn write-down of Irish banking debt, a similar amount for Portugal and slightly more for Greece. In other words, for the sake of about $300 billion in debt, which the markets believe are largely unsustainable anyway (hence the crisis), Eurozone leaders are willing to forsake $300 billion over the coming five years in output, jobs and livelihoods.

The latest news

The quarter-on-quarter fall in house prices in the third quarter of the year was 3.5%. This is once again in the 3-5% range, i.e. house price falls were of a similar scale to the previous 12 quarters. For the third quarter in a row, the fall in Dublin was greater than the fall outside Ireland’s five main cities. Indeed, there are only two quarters (the final two of 2010) where the average asking price in Dublin fell by less. As a result, asking prices are now 51% below the peak on average in Dublin, compared to 45% elsewhere in the country.

Asking prices actually rose in Galway (city and county) and in a more substantial way in Monaghan and Carlow in the third quarter of the year. It’s unclear what’s driving this. One could argue it could be just an artefact of the quieter summer months. However, this didn’t happen in 2008, 2009 or 2010, so I think what’ s more likely to have happened is that sellers (and/or their estate agents) are trying to factor in bidders’ discounts below the advertised price. Given the subsequent experience of other counties where asking prices have been stable for three or even six months, I would expect prices to fall in those areas in the next quarter.

The key supply-side metric, stock sitting on the market, remains stubbornly high. This is particularly the case in Munster and Connacht-Ulster, where time to sell is typically 9-15 months. In per capita terms, stock sitting on the market is relatively low in Dublin, where the typical time to sell is just four months, and is still high but steadily falling (slowly) in Leinster.

Calling the bottom

Three month ago, when the last Daft.ie House Price Report was released, I put its figures into a longer-term context. In particular, I compared current asking prices with long-term series for two standard metrics for calculating the value of housing – income multiples and rent ratios. Both of those metrics suggested that the average house price in Ireland “should” be about €150,000. As of three months ago, it was €201,000 and it is now €194,000.

How does that compare with the fire-sale prices we are seeing? Last week, I took a look at the latest fire-sale prices in Ireland. The finding was that the typical fall in price from the peak is of the order of 70%. A 70% fall in the typical value of a home would equate with an average house price of €115,000.

I think the fire-sale prices differ from equilibrium prices in two key respects: firstly, they are almost exclusively cash-only prices (i.e. no mortgage credit). And secondly, they are overwhelmingly investors, not owner-occupiers. As longer-standing readers of the blog may remember, part of my academic research is investigating just how investors and owner-occupiers differ in their real estate decisions. But theory would suggest that owner occupiers will pay more, like for like, than an investor will. So 70% marks the watermark for the Irish economy as it currently stands, an economy without credit.

But what if Ireland does actually return to being an economy with credit? When might the market bottom out in such a circumstance? It’s worth noting just how steady the average quarter-on-quarter fall in asking prices has been since 2008, at basically 4% with only minor variations either side. What would happen if this trend continued? If asking prices continue to fall 4% every quarter, by the first quarter of 2013, the average asking price nationwide will be €150,000, or 60% below the peak, in line with the expectations from using income or yield metrics of what house prices should be.

Average house price (and how long to reach it), by different measures

The graph above shows the average level of house prices at various different points in time/scenarios and also (on the right-hand axis) how long it would take in quarters of 4% falls to get from current asking prices to that level.

Worrying about the next bubble

If, however, credit hasn’t returned by the start of 2013, if the Government hasn’t changed tack and the banks are still trying to “deleverage” (i.e. ignore new lending and run down old lending), then prices will continue to fall. They may continue to fall for probably another two years. On-going 4% falls each quarter would mean prices were 70% below the peak, or €115,000 on average, by end-2014.

The risk, of course, is that credit doesn’t return until that point is reached. Were that to happen, instead of the bottom of the market looking like it should, i.e. prices stabilise and then increase in line with inflation, prices instead would be 33% undervalued (according to the two metrics I’ve used above). This overshooting on the way down is a real danger because it risks creating a bubble on the way back up. After all, we all know what happened the last time house prices increased at double-digit rates!

Another bubble is probably farthest from the minds of most, including the Government, at the moment. However, it’s precisely when that’s the case that we must put in place the protections we need, such as site value taxation, maximum loan-to-value and even a ban on variable rate mortgages. I’ve heard that a number of US retail banks have had their interest in setting up in Ireland stymied by the Financial Regulator, probably out of fear of deposit flight.

But if the Government is effectively shutting Ireland off to new banks, then it is even more imperative that our existing banks serve the function for which they were saved using our money. The next round of stress tests for Irish banks, in early 2012, offer the perfect opportunity to set aside capital specifically for new lending. Banks are petrified that new lending equals new write-offs down the line – as long as they base it on conservatives multiples of rental income, there is little risk that will be the case.

House prices bottoming out sooner and without the melodrama of overshooting and another bubble, or prolonging the bust for another two years and risking a new bubble? The choice is with the Government.