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Australia’s property bubble: heed the lesson of Ireland Former Wall Street bond trader Michael Lewis is the author of incisive books that reveal the inner workings, and crimes, of the global financial system, including Liar’s Poker, on bond trading in the 1980s; The Big Short, on the hedge fund managers who correctly bet the US property bubble would crash (now a major motion picture); and Flash Boys, on the rise of insidious high-frequency computerised trading. In his 2011 follow-up to The Big Short, titled Boomerang: The Meltdown Tour, Lewis profiles countries which were bankrupted in the 2008 global financial crisis, including Iceland, Greece, and Ireland. His chapter entitled Ireland’s Original Sin details the Irish property bubble; Australian readers might recognise, in the following excerpt from that chapter, eerie parallels to the dominance of the property market in the Australian economy today, and to the official denials that this dominance will have serious consequences. MORGAN KELLY IS a professor of economics at University College Dublin, but he did not, until recently, view it as his business to think much about the economy under his nose. He had written a handful of highly regarded academic papers on topics regarded as abstruse even by academic economists (“ The Economic Impact of the Little Ice Age”). “I only stumbled on this catastrophe by accident”, he says. “I had never been interested in the Irish economy. The Irish economy is tiny and boring.” Kelly saw house prices rising madly, and heard young men in Irish finance to whom he had recently taught economics try to explain why the boom didn’t trouble them. And the sight and sound of them troubled him. “Around the middle of 2006 all these former students of ours working for the banks started to appear on TV!” he says. “They were now all bank economists and they were nice guys and all that. And they were all saying the same thing: ‘We’re going to have a soft landing’.” The statement struck him as absurd on the face of it: real estate bubbles never end with soft landings. A bubble is inflated by nothing firmer than people’s expectations. The moment people cease to believe that house prices will rise forever, they will notice what a terrible long-term investment real estate has become, and flee the market, and the market will crash. It was in the nature of real estate booms to end with crashes—just as it was perhaps in Morgan Kelly’s nature to assume that if his former students were cast on Irish TV playing the financial experts, something was amiss. “I just started Googling things”, he said. Googling things, Kelly learned that more than a fifth of the Irish workforce was now employed building houses. The Irish construction industry had swollen to become nearly a quarter of Irish GDP—compared to less than 10 percent or so in a normal economy—and Ireland was building half as many new houses a year as the United Kingdom, which had fifteen times as many people to house. He learned that since 1994 the average price for a Dublin home had risen more than 500 per cent. In parts of Dublin rents had fallen to less than 1 per cent of the purchase price; that is, you could rent a million-dollar home for less than US$833 a month. The investment returns on Irish land were ridiculously low: it made no sense for capital to flow into Ireland to develop more of it. Irish home prices implied an economic growth rate that would leave Ireland, in twenty-five years, three times as rich as the United States. (“A price/earnings ratio above Google’s”, as Kelly put it.) Where would this growth come from? Since 2000, Irish exports had stalled and the economy had become consumed with building houses and offices and hotels. “Competitiveness didn’t matter”, says Kelly. “From now on we were going to get rich building houses for each other.” The endless flow of cheap foreign money had teased a new trait out of a nation. “We are sort of a hard, pessimistic people”, says Kelly. “We don’t look on the bright side.” Yet since the year 2000 a lot of people had behaved as if each day would be sunnier than the last. The Irish had discovered optimism. Their real estate boom had the flavour of a family lie: it was sustainable so long as it went unquestioned and it went unquestioned so long as it appeared sustainable. After all, once the value of Irish real estate came untethered from rents, there was no value for it that couldn’t be justified. The 35 million euros Irish entrepreneur Denis O’Brien paid for the impressive manor house on Dublin’s Shrewsbury Road sounded like a lot until the real estate developer Sean Dunne’s wife paid 58 million euros for the four-thousand-square-foot fixer-upper just down the street. But the minute you compared the rise in prices to real estate booms elsewhere and at other times, you re-anchored the conversation; you biffed the narrative. The comparisons that sprung first to Morgan Kelly’s mind were with the housing bubbles in the Netherlands in the 1970s (after natural gas was discovered in Holland) and Finland in the 1980s (after oil was found off its coast), but it almost didn’t matter which examples he picked: the mere idea that Ireland was not sui generis was the panic-making thought. “There is an iron law of house prices”, he wrote. “The more house prices rise relative to income and rents, the more they will subsequently fall.” The problem for Kelly, once he had these thoughts, was what to do with them. “This isn’t my day job,” he says. “I was working on medieval population theory.” By the time I got to him Kelly had angered and alienated the entire Irish business and political establishment, but he was himself neither angry nor alienated, nor even especially public. He’s not the pundit type. He works in an office built when Irish higher education was conducted on linoleum floors, beneath fluorescent lights, surrounded by metal bookshelves, and generally felt more like a manufacturing enterprise than a prep school for real estate and finance—and likes it. He’s puckish, unrehearsed, and apparently—though in Ireland one wants to be careful about using this word—sane. Though not exactly self-denying, he’s clearly more comfortable talking and thinking about subjects other than himself. He spent years in graduate school, and collected a doctorate from Yale, and yet somehow retained an almost childlike curiosity. “I was in this position—sort of being a passenger on this ship”, he says. “And you see a big iceberg. And so you go and ask the captain: Is that an iceberg?” HIS WARNING TO his ship’s captain took the form of his first ever newspaper article. Its bottom line: “It is not implausible that [Irish real estate] prices could fall—relative to income—by 40 to 50 per cent.” At the top of the market, he guessed, prices might fall by a staggering 66 per cent. He sent his first piece to the small-circulation Irish Times. “It was a whim”, he says. “I’m not even sure that I believed what I was saying at the time. My position has always been, ‘You can’t predict the future’.”As it happened, Kelly had predicted the future, with uncanny accuracy, but to believe what he was saying you had to accept that Ireland was not www.cecaust.com.au Vol. 18 No. 18 4 May 2016 Australian Alert Service 17 some weird exception in human financial history. “It had no impact,” Kelly says. “The response was general amusement. It was what will these crazy eggheads come up with next? sort of stuff.” What the crazy egghead came up with next was the obvious link between Irish real estate prices and Irish banks. After all, the vast majority of the construction was being funded by Irish banks. If the real estate market collapsed, those banks would be on the hook for the losses. “I eventually figured out what was going on”, says Kelly. “The average value and number of new mortgages peaked in summer 2006. But lending standards were clearly falling after this.” The banks continued to make worse loans, but the people borrowing the money to buy houses were growing wary. “What was happening”, says Kelly, “is that a lot of people were getting cold feet.” The consequences for Irish banks— and the economy—of the inevitable shift in market sentiment would be catastrophic. The banks’ losses would lead them to slash their lending to actually useful businesses. Irish citizens in hock to their banks would cease to spend. And, perhaps worst of all, new construction, on which the entire economy was now premised, would cease. Kelly wrote his second newspaper article, more or less predicting the collapse of the Irish banks. He pointed out that in the last decade the Irish banks and economy had fundamentally changed. In 1997 the Irish banks were funded entirely by Irish deposits. By 2005 they were getting most of their money from abroad. The small German savers who ultimately supplied the Irish banks with deposits to re-lend in Ireland could take their money back with the click of a computer mouse. Since 2000, lending to construction and real estate had risen from 8 per cent of Irish bank lending (the European norm) to 28 per cent. One hundred billion euros— or basically the sum total of all Irish bank deposits—had been handed over to Irish commercial property developers. By 2007, Irish banks were lending 40 percent more to property developers alone than they had to the entire Irish population seven years earlier. “You probably think that the fact that Irish banks have given speculators €100 billion to gamble with, safe in the knowledge that the taxpayers will cover most losses, is a cause for concern to the Irish Central Bank”, Kelly wrote, “but you would be quite wrong.” ... It wasn’t until almost exactly one year later, on 29 September 2008, that Morgan Kelly became the startled object of popular interest. The stocks of the three main Irish banks, Anglo Irish, AIB, and Bank of Ireland, had fallen by between a fifth and a half in a single trading session, and a run on Irish bank deposits had started. The Irish government was about to guarantee all the obligations of the six biggest Irish banks. The most plausible explanation for all of this was Morgan Kelly’s narrative: that the Irish economy had become a giant Ponzi scheme, and the country was effectively bankrupt. But it was so starkly at odds with the story peddled by Irish government officials and senior Irish bankers—that the banks merely had a “liquidity” problem and that Anglo Irish was “fundamentally sound”—that the two could not be reconciled. The government had a report newly thrown together by Merrill Lynch, which declared that “all of the Irish banks are profitable and well-capitalised.” The difference between the official line and Kelly’s was too vast to be split. You believed either one or the other, and up until September 2008, who was going to believe this guy holed up in his office wasting his life writing about the effects of the Little Ice Age on the English population? Boomerang: The Meltdown Tour is available in hard copy and Kindle from Amazon.com; it is also available through most on-line bookstores.