Housing Sector
In the case of the Irish economy, as discussed earlier in this Review, there is a considerable exposure to any disturbance affecting the building sector. In the US Adjustment or Low Growth scenario described in Section 6.2 there would in any event be a rise in unemployment consequent on the economic slowdown in 2007. While in the case of a smooth adjustment the unemployment rate would peak at under 8 per cent of the labour force, such a rise could unsettle the confidence of the household sector. The demand for housing is particularly sensitive to changes in personal disposable income and the rise in unemployment could give rise to significant fears among many of those still employed about their job security. Given the high level of indebtedness of the household sector many households are not in a good position to sustain a prolonged loss of employment. Such a loss of confidence could precipitate a much more dramatic internal adjustment process affecting the building and construction sector. Some of those who lost their jobs could be forced to sell on a market where many potential buyers were holding off buying until their own personal position was clarified. Even if the number of forced sales were limited, the consequence could be a major fall in house prices over a short period of time.
Table 6.7: International Experience of Real House Price Falls
Maximum Fall in Price
Denmark -37 Finland -50 France -18 Germany -15 Ireland 48 -27 Netherlands -50 Sweden -38 United Kingdom -34 United States -14
Source: OECD, 2005 Economic Outlook, No. 78, November.
It is not possible to model the possible magnitude of the fall in house prices that might occur in the face of a sudden deterioration in the expectations of the household sector. To gauge what might occur under very unfavourable circumstances it is useful to look at the magnitude of the falls in house prices that have occurred in other countries in the face of shocks affecting expectations. Table 6.7 shows the maximum fall in house prices that has occurred in any cyclical downturn in the relevant economies. Larger economies tend to experience smaller falls because of the regional diversity in their housing markets. Also, home ownership is lower in countries such as Germany and France, which reduces their exposure to changes in sentiment by the
48 In Ireland the fall in real house prices was experienced between the third quarter of 1981 and the second quarter of 1987.
household sector. For the smaller countries shown in the table and for the United Kingdom the biggest falls in house prices experienced in the past range from -27 for Ireland up to -50 for the Netherlands and Finland.
Here we examine what would happen if just such a sudden loss of confidence did occur in Ireland. We have calibrated a housing price shock with an illustrative fall in house prices of approximately a third in 2007 – within the range shown above. Obviously, this does not represent a forecast as to whether a fall in house prices will actually occur or if it should occur as to what its magnitude and timing would be. However, it allows us to examine what would be the consequences of what would in any terms be a fairly severe recession. This illustrative fall in house prices would contrast with the steady small rise in prices of 2 per cent a year envisaged in the Low Growth scenario. In this case we assume that house prices do not begin to recover till after 2010 and we analyse the potential impact of these major changes on the economy as a whole over the period 2007 to 2010.
Figure 6.3: Housing Shock – Housing Completions
2006 2007 2008 2009 2010 0 20 40 60 80 100 T hous ands
Low Growth Housing Shock
Figure 6.4: Housing Shock – GNP, % Change
2006 2007 2008 2009 2010 1 2 3 4 5 6
Low Growth Housing Shock
Figure 6.5: Housing Shock – Unemployment Rate
2006 2007 2008 2009 2010 0 2 4 6 8 10 12 %
92 MEDIUM-TERM REVIEW 2005-2012
Such a sudden large decline in house prices would precipitate a rapid adjustment in the output of the building industry. Builders would see their profits turning to losses and they would rapidly adjust their activity rate. Instead of housing completions falling from their peak of between 70,000 and 80,000 next year to around 62,000 in 2010 as in the US Adjustment Low Growth scenario, they would fall to under 40,000 in 2009 in the housing shock scenario (Figure 6.3). This would represent a near halving of output over a three year period. Such a fall in output would, in turn, trigger a very large cumulative fall in employment in the building and construction sector of 15 per cent spread over 2007-09.
As discussed in Chapter 2, the building sector represents a very large share of the economy today so such a large shock to that sector would have major consequences for the economy as a whole. As shown in Figure 6.4 GNP would grow by only just over 1 per cent in 2007 as a result of the collapse of the housing market and it would still grow at less than 3 per cent in the second year of the shock, 2008. It is only from 2009 onwards that the economy would begin to recover with the growth in GNP per head rising more rapidly than in the Low Growth case. The consequence of this would be that unemployment would rise very rapidly to 10 per cent or more from 2008 to 2010 (Figure 6.5). Such a large rise in the unemployment rate would further aggravate uncertainty about the future.
Many of those who would lose their jobs as a result of such a downturn would seek employment elsewhere provided that the rest of Europe did not suffer as serious a decline in output. The consequence would be that by 2010 net immigration would almost cease, further reducing the potential demand for dwellings. This reduction in immigration would see a reduction in the population below the Low Growth case.
Figure 6.6: Housing Shock – Wage Rates
-1 0 1 2 3 4 5 6 %
Low Growth Housing Shock
These simulations suggest that the worst effects of the downturn in the housing market would be felt in 2007 and 2008. By 2010 the economy would be beginning to recover. An important part of the recovery would be a very much lower growth in wage rates than is assumed in the Low Growth scenario (see Figure 6.6). The reduction in the rate of increase in nominal wage rates, with a small fall in nominal wages in 2010, would be a consequence of the very high rate of unemployment. By contrast with the 1970s and the 1980s, today we see a significant Philips curve effect, with wage rates responding to unemployment and growing at a slower rate. This would help improve the competitiveness of the economy in the period after 2010. However, even with an improvement in competitiveness it would be some considerable time before employment growth in other sectors of the economy would come to replace the jobs lost in the building sector. It would probably take about five to seven years for the economy to recover fully from this very substantial shock, returning employment to near the level it would have attained without the collapse in housing prices.
In this scenario we have assumed that the government would react to the severe loss of revenue and the growth in expenditure on transfers to the unemployed by raising taxes or cutting other forms of expenditure. The result would be that the government’s borrowing would not rise, in spite of the fall in revenue from taxes such as stamp duty. If all the adjustment were concentrated on income tax the share of such tax in personal income might have to rise dramatically out to 2009, falling back thereafter as the economy recovered. This would be a very procyclical response to the shock.
If, instead, the government allowed the deficit to rise without responding, the impact on the public finances would be quite large. By 2009 the deficit would be almost 3.5 percentage points of GNP higher than in the Low Growth scenario. Such a neutral fiscal policy would provide some insulation to the economy from the shock, and GNP might recover to the level it would otherwise have been at by 2010 rather than 2011. Given the low levels of debt, such a neutral fiscal policy stance might well be appropriate. However, the feasibility of adopting such a course of action would depend on the public finances being in a strong position prior to the shock occurring. This highlights the importance of governments maintaining a significant surplus while the economy is growing rapidly and while there remains this major exposure to a shock to the building industry.
This scenario, where the economy would recover from the housing price shock by 2010 or 2011 (though it would take longer for full employment to be achieved), would represent a satisfactory outcome to a very serious shock. If the labour market were to prove less flexible than we expect, the consequence could be a much more prolonged period of adjustment, with higher costs for all those who would be unemployed. In addition, this scenario assumes that the financial sector would prove to be robust in the face of the major shock to the housing sector and the very rapid doubling in the unemployment rate. Should significant problems arise due to the high level of household indebtedness this could greatly complicate the recovery process.