Economics Jim O'Leary Single-digit house inflation may be at hand

The critical issue for the housing market will be its sensitivity to changing conditions in financial markets

Economists have a poor record in forecasting Irish house prices. At least one high-profile member of the tribe has been predicting a collapse in the market since the mid-1990s. Others, myself included, have been expecting a return to low single-digit inflation for at least the past two years.

Meanwhile, in the real world, house prices have continued to surge ahead. In the 11 months to last November, according to the Permanent-TSB index, average prices nationally rose at an annualised rate of 13.5 per cent.

On average, the price of new houses countrywide is now three times the level of a decade ago. The average price of existing houses is now four times higher than 10 years back, having increased at an annual average rate of 15 per cent in the meantime.

Why has this happened? Are current house price levels sustainable or are they in imminent danger of collapse? Two recently published papers shed some fresh light on the matter, one by Maurice Roche of the Economics Department in Maynooth (Will there be a Crash in Irish House Prices?, ESRI Quarterly Economic Commentary, Winter 2003) the other by Davy Stockbrokers (Where have all the houses gone?, Research Report, November 2003).

Maurice Roche's paper is principally concerned with establishing whether there is a price bubble in the housing market. His conclusion is that there is not, in the sense that the current price level is more or less fully explained by fundamental factors.

It is important to understand what Mr Roche means when he speaks of fundamental factors. He includes in this category not only those variables that are commonly understood to be the main influences on demand, such as interest rates, disposable incomes and demographic trends, but also supply-side variables like the price of land and building costs. What he is saying therefore, is that when allowance is made for what has happened to land prices and building costs, as well as the demand-side variables, the huge rise in house prices can be almost fully explained.

Some readers will argue that there is a circular logic at work here. Undoubtedly, land prices strongly influence the price of houses, but is it not also the case that the price of land is in turn strongly influenced by house prices? If this is the case, the reassurance that might otherwise be provided by Mr Roche's findings crumbles: house price inflation is no longer explicable in terms of variables that can meaningfully be regarded as "fundamentals". It may instead form part of a mutually reinforcing speculative spiral with land price inflation and, if so, there may be one hell of a bubble ready to burst.

Mr Roche devotes part of his paper to addressing this issue and uses a battery of sophisticated statistical tests to explore the question of whether changes in house prices cause changes in land prices. Perhaps surprisingly, his conclusion is that they do not: the statistical evidence, based on a rigorous analysis of the data for the past quarter century, indicates that causation runs exclusively in the opposite direction, that is from land prices to house prices.

Does all of this mean then that there is no danger of a sharp fall in house prices? Well no, it doesn't. In the first instance, even if one accepts Mr Roche's conclusion that there is no bubble in the housing market, it cannot be ruled out that there is a bubble in the market for building land. Indeed, Mr Roche's work begs some important and as yet unanswered questions about what has been driving up the price of land.

It is clear that a collapse in the market for land, given the big role that land prices play in determining house prices, would trigger a substantial fall in house prices. Incidentally, I'm not predicting that this is going to happen, I'm drawing attention to a possibility.

Secondly, even if there is no bubble in either market, house prices would fall sharply if there was a corresponding deterioration in "the fundamentals" in either market, in the shape of rising interest rates, declining household incomes or softening demographic trends, or in the shape of radical action by the Government to significantly free up the supply of land. Again, I'm not predicting such radical action. I think that the last thing the Government wants, a prospect indeed to which it is much more averse than the prospect of increasing problems of affordability for first-time buyers, is a sharp fall in house prices.

Probably the most critical question for the housing market going forward will be its sensitivity to changing conditions in financial markets. In this connection, a feature of the market in recent years that is of enormous significance is the extent to which the number of new houses built has exceeded the number of houses needed to accommodate new households. This is the subject of the Davy report referred to earlier.

The authors calculate that in the 1996-2002 period, new household formation accounted for only 60 per cent of new house completions and that, by 2003, the equivalent proportion had fallen to 50 per cent.

Most of the balance is accounted for by the demand for second homes. Davy calculates that almost one-third of the output of new houses since 1996 has been going to satisfy demand for second homes. In 2003, it seems, some 24,000 of the 67,000 new houses completed were second homes. These are striking numbers. Regrettably, they relate to a sector of the market that is poorly understood and sparsely documented.

Accordingly, it is appropriate to exercise more than usual circumspection in framing hypotheses about the behaviour of this market segment. However, it seems reasonable to propose that conditions of rapidly rising wealth, extremely low interest rates and poorly performing equity markets provide the setting in which demand for second homes is especially buoyant.

It follows that the combination of more moderate wealth accumulation, rising interest rates and strengthening equity markets - which seems in prospect for the next few years - is likely to dampen this segment. The rest of the market is unlikely to remain immune from these trends.

Perhaps the era of sustained low single-digit house price inflation is at hand at last.

Jim O'Leary lectures in economics in NUI-Maynooth. He can be contacted at

jim.oleary@may.ie