In my book How the Euro Dies, I explain why sharing one monetary policy and one exchange rate between all the vastly different euro using nations is a really bad idea.
After all, we know what the wrong monetary policy does to the UK these days, don’t we…? And we know the benefits of a falling pound too, with investment into Britain hitting records after the Brexit vote – thanks to the pound’s demise.
Well, inside the euro, nations always get the wrong monetary policy. Because it’s set at an awkward in between – too tight for countries struggling and too loose for those in a boom.
In my book, I focus on those struggling with tight monetary policy and high exchange rate. But what about those experiencing an artificial boom thanks to mistakenly low interest rates and an artificially low exchange rate?
In 2015, I failed to make the most of the wild opportunity they presented. You see, it’s an inherent consequence of the euro that the parts of the euro area economy that are doing OK do not face tight enough monetary policy.
Imagine an inflationary and economic boom in the UK which does not get reined in by the Bank of England. What consequences would you expect?
A housing bubble is the correct answer. That is because houses are the most interest rate-sensitive asset. This explains the housing bubble and bust cycle we’ve been going through sine the Bank of England floored rates for the pandemic.
My point is that, at any given point in time, somewhere in the euro area is experiencing the inflation of a housing bubble. The question is where. And the answer is “wherever the economy is doing OK and needs higher interest rates”.
In 2015, it was Germany. GDP growth was doing just fine, but the European Central Bank couldn’t hike rates on without sending Southern Europe back into economic hell. They were barely surviving in purgatory as it was.
And so a German housing boom got going. It was one financed by the European Central Bank, which was trying to send money south… but you can’t control capital flows within the euro area.
I could have and almost did participate in this bubble.
German house prices have approximately doubled since the global financial crisis of 2008, with the real boom starting in 2014.
But for those of you who reckon this is hindsight and armchair analysis, consider that the same hindsight and armchair analysis had been performed before, by Nick Louth in The Fleet Street Letter in August 2007.
This suggests that there’s more than a theory – there’s a pattern which investors can benefit from. But first, over to the other Nick…
Why the Irish economy is riding for a fall
By Nick Louth, August 2007
The Irish economy is heading for a fall. While an overheated global economy, rising interest rates and a sub-prime lending crisis may cause problems in all parts of the world, to see where the biggest damage may be done you have to go to Dublin. The Celtic Tiger economy, galloping away year after year with no monetary brakes, is the one most likely to fall off a cliff. If the worst happens, its membership of the euro will bear part of the blame.
The Irish stock market already recognises the deteriorating economic reality. While London has dropped 8% from its recent highs, Dublin lost a massive 15% from the peak of 10,041 set in February. By 1 August, the Iseq General index was down at 8,407. There’s no market in the developed world with losses that matched this.
So what is the fear that has so spooked investors in the emerald isle? In a word, property. The Irish economy has become over the past eight years a large geared bet on the profits to be made by building of tens of thousands of new homes, financed by low euro area interest rates. Around 90,000 homes were built in Ireland last year, compared with 200,000 in the UK which has 15 times the population. This year, with prices already falling, another 70,000 homes will have to find buyers.
The entire Irish economy is dependent on property. It accounts for 15% of economic output, 17% of tax revenues, and most worryingly of all, 64% of bank lending. On a recent trip there I was amazed to see how much of the countryside had disappeared beneath bricks and mortar. Formerly tiny villages had bulked up to become twice or three times their size, with many homes having been constructed in the last few years. They may have gone too far. Fully 15% of Irish property is empty.
Despite this, the country has the highest rate of house building in the EU, per head of population. By OECD definitions housing starts are 26% above sustainable levels. House prices have risen by 270% since 1996, but are now almost static. Rents, which indicate the underlying level of demand for property, have fallen since 2000, though now prices have moved well beyond the reach of most first-time buyers, they are starting to pick up again.
However, it isn’t just about property alone. Ireland is one the far-flung corners of the euro area, and its runaway economy represents an experiment not dissimilar to that run by the Russian operatives of the Chernobyl nuclear plant who ran it towards meltdown to “see what would happen”.
No monetary restraint…
Ireland was already a frisky economy when it joined the euro area in 1999. GDP growth averaged 9%, four times the OECD average, in the previous four years, and inflation was well above the euro area average. Until very recently, membership of the currency area has done nothing to slow it. GDP growth was still racing along at 7.5% in the first quarter of 2007 a full eight years after joining, and inflation rose from 2% at the time of accession to 4.5% in the year to July. That is more than twice the 1.9% euro area average.
In a fully monetarily-independent economy, such as Britain, the United States or Japan, the central bank will spot inflationary dangers and head them off with interest rate rises. The familiar cycle of raised rates, more expensive credit, heftier mortgage payments and curbed consumer spending normally does the trick. The idea is to diagnose quickly, and impose the medicine in small doses.
The euro area has 317m consumers in 13 countries and the European Central Bank has to set right across the area one single interest rate which is somehow “correct” for the inflationary conditions prevailing there. Like a pair of standard issue prison trousers, the ECB’s interest rate policies are either going to be too tight or too loose for each of the countries that have to wear them.
Not surprisingly, and recognising the housing splurge, the ECB did start to raise rates. Of course that was nothing to do with noticing what was happening in Ireland. It was because inflationary dangers were now raising their heads in the larger economies. Eight quarter point rises have seen them reach 4%, with economists predicting a 4.5% cyclical peak. Likewise, when Ireland actually needs rates to fall (which it may do now and in six months almost certainly will), you can be sure that the ECB will still be raising them to stem inflationary worries in core euro area members.
How the euro area is meant to work
This illustrates the frictions in the euro area adjustment mechanism. Instead of interest rates, the EU relies on movement of capital and labour between euro area members to even out the imbalances in economic growth. Capital, in a single currency zone, moves easily enough to where potential return is greatest. Labour, though, is notoriously sticky.
When the German economy was growing slowly in 2002, and had high unemployment, euro area theory suggested that jobless Germans would seek out vacancies in Ireland. They didn’t. Indeed, it had to wait for Poland’s accession to the EU in May 2004 for a wave of economic migrants from within the euro area to reach Ireland. These days, if you ask for a pint of Guinness in a bar anywhere in Ireland, you are as likely to be served by a Pole, Lithuanian or Latvian as you are by an Irishman.
So what happens next? There are some apocalyptic voices out there. Professor Morgan Kelly of University College Dublin, who studied adjustments to housing bubbles across a number of different economies, reckons that Irish house prices may lose 70% of their gains, though that would take a number of years to occur.
But it doesn’t need to be this bad to hurt. For banks, estate agents, builders and building materials firms a collapse in house sales volumes would do the job just as well. Asking prices will of course initially be sticky, just as they were in Spain and the United States, before sellers readjust their expectations.
Avoid Irish exposure
Certainly affordability is under extreme pressure. Despite recent moves to help first-time buyers with zero stamp duty, higher mortgage interest relief and extended payment terms, Bank of Ireland reckons that the average new mortgage absorbs 38% of borrowers’ incomes. Given that three quarters of mortgage and consumer debt in Ireland is at floating interest rates, every rise in rates is going to hurt.
The consequences for Ireland could be severe. Though the economy has only once ever experienced an annual house price fall in 30 years, that may turn out to be the norm for the next few years. It can hardly be otherwise. Though we have yet to discover if there is any corollary in Ireland to the dodgy mortgage lending practices in the United States, we can be sure that falling property prices will uncover them. Now is definitely not the time to own shares heavily exposed to the Irish economy.
Investors who understood the inherent flaws of the euro would’ve understood what would happen to the Irish economy once it joined the euro. They would’ve bought Irish property on the creation of the euro… and sold into the subsequent boom.
Imagine a 270% gain on a heavily leveraged investment…
The same investor would’ve punted on German property in 2012, knowing the ECB couldn’t raise rates on the humming German economy because of the Greeks, leading to a housing bubble in Germany (the nation famously devoid of housing bubbles and formerly famous for its tight monetary policy, which is of course just a coincidence…).
My question is, which bubble is the ECB busily inflating next?
Well, Croatia is adopting the euro in a few days’ time…
Bulgaria is stuck in the new version of the ERM, creatively named ERM II, waiting to join the euro soon…
Do you think those economies should have the same interest rate as Greece, Germany, the Netherlands and Spain? Of course not, which is probably why so few Bulgarians support joining the euro.
I’ll bet that all of them have a mortgage…
Editor, Fortune & Freedom