A dramatic fall in house prices is possible, but not yet probable, writes Marc Coleman, Economics Editor
Nearer, clearer and deadlier than before, the possibility of a housing market crash approaches. On Thursday the Organisation for Economic Co-operation and Development warned us that our housing market is overvalued. On the same day the European Central Bank raised interest rates for the second time since December.
Last Tuesday new credit figures showed mortgage lending growing at record levels, while the Permanent TSB/ESRI house-price index showed house-price inflation reigniting to double-digit growth. But is a crash - sorry, a correction - really in prospect?
The good news is that, although possible, a crash is not yet probable.
The bad news is that the moderation in prices needed for a soft landing is not happening: quite the reverse. And there is further bad news. In raising rates last Thursday, the European Central Bank has signalled at least one and possibly two such increases are on the cards before Christmas.
This is not enough to cause a crash. But with clear signs that last December's rate rise has dented consumer confidence, the mix of rising debt and tighter money may squeeze consumer spending in years ahead.
Although it doesn't say so directly, yesterday's OECD report on the Irish economy implies that our housing market is overvalued by around 15 per cent. The figure has its origins in a confidential OECD memo The Irish Times published last November.
The memo contains details of conversations held in September between OECD and Central Bank of Ireland officials. It shows that the Central Bank broadly agreed with the OECD's analysis. But it cautioned the OECD against publishing any precise figure on the extent of overvaluation, for fear of frightening the horses.
This approach was reasonable at the time. Then, the extent of overvaluation was modest and easily correctable. A 15 per cent overvaluation can be unwound over four or five years by simply ensuring that house prices grow by a few percentage points less than nominal incomes.
With nominal GDP rising at around 8 per cent, house-price growth of 5 per cent in the coming three years would do the trick nicely. In that scenario, frightening the horses was unnecessary and counterproductive.
Interviewed last November, Central Bank governor John Hurley was able then to express genuine relief that house prices were indeed moderating. But he also said any resumption in double-digit house-price growth would be very worrying. He added that, if this happened, a sharp correction of the market would have serious consequences for the economy.
His first fear has materialised. House price inflation in January rose to just over 10 per cent, compared with just over 9 per cent in December and just over 8 per cent in January 2005, according to the latest Permanent TSB/ESRI house-price index. Mortgage lending is running at a record 29 per cent. With borrowers exploiting the anticipated leverage from SSIA money later this year, the surge will go on until at least 2007.
Given how often the Central Bank has been crying wolf on this issue, its singular cry could be easily ignored this time. But that cry is now a chorus coming from the OECD, the European Central Bank, the International Monetary Fund and the Economist magazine. In the fable of the boy who cried wolf, the wolf did eventually come.
There is much evidence to suggest that economic conditions are changing in a way that makes further house price growth less sustainable than before.
Incomes and employment - the linchpins of the housing market thus far - are increasingly reliant on sectors that are themselves exposed to the housing market. Economic inbreeding - an over-reliance on one sector - has resulted in the construction sector contributing one-third of the new jobs created last year. And many of the jobs created in the financial services sector were property-related.
Ireland's savings ratio is healthy enough to bulwark the housing market against any moderate declines in house prices. But what if the decline is not moderate?
Correcting a property market overvaluation is a bit like jumping off a wall. If the wall is six feet high, little damage will be done. If it's 12 feet high, you might sprain an ankle or break a leg. If its 24 feet high, make sure you've got medical cover. In short, we need to know exactly how far above the ground our property market really is. Far from discouraging the publication of estimated levels of overvaluation, the Central Bank should be monitoring them closely.
A further justification for high housing prices is that levels of mortgage lending are moderate compared with the assets with which they are backed. But we come back to the issue of economic inbreeding. Are those assets well diversified holdings of stocks and bonds and property? Or are they increasingly dominated by property? If so, that asset base is itself vulnerable to a correction in the housing market.
And to what extent have bank deposits been inflated by temporary factors such as equity withdrawal and SSIAs? At the very least the Central Bank must gather more information on this and, perhaps, on the extent of interest-only loans, a factor associated with overvaluation on the US housing market.
Even if a correction in the property market doesn't happen, expect to see an economic impact from rising rates. On its own, one rate increase is like a speed bump in the path of a speeding juggernaut. But a prolonged tightening phase will squeeze consumption among younger mortgage borrowers.
A recent survey of consumer sentiment indicates that confidence dipped sharply in February. This was because consumers are increasingly worried about their financial situation as the ECB raises rates. On Thursday the Department of Finance published Exchequer returns that showed revenues relating to the property market - such as stamp duty - roaring ahead, but returns related to consumption, such as VAT and excise duties, performing less well than expected.
There is one further concern. With a quarter of a million construction workers in the economy, the Government will now have to start thinking about the consequences on unemployment of any slowdown in housing construction.