C
ColmFitz
Guest
Colm Fitzgerald gave a thought provoking paper on quantititive easing to the Society of Actuaries recently. I invited him to write a piece on Money and the Housing Bubble which I reproduce below.
Since we suspended speculation on house prices I have asked a few people to write a balanced review of the issues. Colm is the first to respond to the invitation.
As this is a well thought out and well written article, I would ask people to respond to it in a similar manner.
Colm Fitzgerald (DCU) is an Adjunct Lecturer in Financial & Actuarial Mathematics in Dublin City University. He has been developing and using financial mathematical models for trading purposes for the last 17 years and was previously Head of Quantitative Trading in Bank of Ireland Global Markets.
He holds an MA in Economics and is a qualified Actuary. He is an external consultant to Rosenblatt Securities and a founding director of Paragon Research Ltd.
Brendan Burgess
Money and the Housing Bubble
We all know money is important. Surprisingly, just how important it is, is often lost on some people.
Money is the principal means of exchange in countries. Most distortions in our economy, e.g. our recent housing bubble, can be easily explained by looking at things from the point of view of money.
Rightly or wrongly, the total amount of money in our country is not a widely publicised fact. Between 1996 and 2007, the total amount of money in Ireland increased by more than 540% - another not very publicised fact. In my opinion this was the result of extreme ineptitude by our Central Bank, our financial regulatory system and our Government.
Where did all the extra money come from you may ask?
Shockingly, the vast majority was effectively printed by Irish banks, AIB, BOI, Anglo etc. If a government prints money it’s considered bad – but letting banks print it, and in vast quantities, is disgraceful. Yet this happened with practically nobody in Ireland saying anything!
I will come back to how the banks did this later in the article.
But first, why was this important?
According to what is called ‘the Quantity Theory of Money’:
The amount of money in a country * the number of times it goes around the system
= the volume of all goods and services * average prices
Historically, if the amount of money in an economy increased (due to printing money say) - this would largely lead to price inflation.
If everyone in the world was given twice the amount of money that they already had, it would not make anyone better off as there would still be the same amount of goods and services – and their prices would probably double.
What happened in Ireland?
How come after the amount of money increasing by over a factor of five, that we did not have huge inflation? Quite simply it was because the price adjustment largely happened in the housing market! The prices of most of our goods and services are largely determined internationally and were less affected.
All the extra money printed by our banks caused the house price bubble.
The amount of money in Ireland has fallen by about 25% since 2007 – resulting in our housing market crash. Before I get into how did happened, I’ll first explain how the banks effectively printed so much money in the first place. It makes me sick thinking about how they were allowed to do this.
Historically, going back to the Renaissance, banks typically kept only about 10% of their money in cash. This 10% was to provide money to depositors as they needed it and to handle bad debts in times of recession.
Suppose you have a country where there is only €100 of cash. If this is all deposited in a bank, the bank keeps €10 (10% of €100) and will lend €90. Suppose this €90 is deposited in another bank, that bank then keeps €9 (10% of €90) and lends out €81. Suppose again this €81 is deposited in another bank, that banks keeps €8.1 (10% of €81) and lends out the remaining €72.9. This process continues so that effectively the €100 of cash has turned into €100 and €900 of loans and consequently €1000 of deposits. So effectively, €100 of cash was printed by the Government, and another €900 has effectively been printed by the banks !!
Ok there is some maths here, but stick with it – if you get this you will understand about what’s going on in our country much better.
What happened in Ireland in the 1990s and 2000s (and also in the rest of the world) was that banks were allowed to get away with keeping much less than 10% of money received in cash. At the height of the boom, the banks were only keeping about €2.50 for every €100 lend out.
This meant that in a country with €100 of cash, the banking system was creating €3900 of loans (>than the €900 of loans above). So effectively, by keeping less in reserve the banks were effectively printing massive amounts of money. This is due to the fractional banking system in both Ireland and most countries around the world.
It was seriously inept of the authorities to allow this to happen.
Firstly, when the burst came, the banks were looking at losses of about 10%, but they only had 2.5% in reserve so they were incredibly bankrupt. Why were they allowed to hold so little in reserve, it’s so shockingly inept how this was allowed to happen.
What’s even worse than this is that ‘prudence’ was then enforced on the banking system, requiring them to hold much higher reserves.
This effectively meant that the money ‘printed’ by the banks would effectively be destroyed !!
If there is €100 in cash and the banks have created about €3900 because they are holding €2.5% reserves – if they switch back to holding 10% in reserves, they are only creating €900 – so the overall amount of money in the economy crashes.
Going back to our Quantity Theory of Money – a sharp fall in the money supply causes either a fall in the volume of goods and services and/or a fall in prices. But as the housing market took up most of the adjustment as money was being created in vast quantities, it has also taken a lot of the adjustment on the downside – hence our rapidly falling house prices. Ireland is a small open economy so our domestic markets often have to take the biggest adjustments.
In summary then, with very little if any publicity, our banking system created huge amounts of money over the space of about 10 years, resulting in huge house price appreciation. Due to the nature of the way this money was created, it was not going to be sustainable. There was always going to be a crash when the next recession came as the banks were being allowed hold less than 10% in reserve – so not only would they go bust, they would also cause a huge contraction in the amount of money in the economy, causing the housing market, and the economy, to crash.
It is really terrible that the authorities that allowed this to happen have got away scot free. It is sheer ineptitude what they allowed happen. Probably the worst element of this was when they got rid of the 2.5 earnings multiple for mortgages.
Typically house prices are about four times average incomes.
It is considered that a normal worker will be able to pay back 2.5 times his income over the course of his working life. In the case of a couple, who would typically buy a house, the limit was 2.5 times plus one times spouse’s salary. This meant with an often sizeable deposit, a couple could afford to buy a house with the help of a mortgage.
This regime should be sustainable and sound over the long term – as indeed it was.
It would be sheer lunacy to consistently lend more than these earnings multiples as, firstly the borrower may not be able to repay the loan, and secondly if they cannot afford to pay it back, the bank would be left with an asset that may be lower in value than the loan (houses are typically prices about four times average incomes).
At the height of the boom banks were lending at 7, 8 and sometimes 9 times salaries – for individuals to buy houses that were worth (in the long run) about 4 times salaries.
How could our authorities have been so stupid to let this happen?!?
Sadly, banks are still lending at nearly 5 times salaries so our housing market has further to fall. Most transactions that are going through at the moment are based on a mortgage so this is feeding through into prices.
In Dublin house prices got to nearly 18 times salaries at the height of the boom. They are back down to about 7 times. But alas they have further to fall to reach their long term levels.
There is very little rocket science in the article. Our financial regulators are supposed to be financially sophisticated so this should be relatively simple for them. But alas they were incredibly inept.
There should be much greater awareness of the total amount of money in our country – as distortions in it can have huge implications for us. Our economics journalists fail to report on this. This needs to change, the public needs to be aware of this.
It goes without saying that our regulators need to get their act together in a much bigger way – and let’s not forgot our politicians who we trust to run our country. Surely they too should understand how important the total amount of money in our country is !!!
Since we suspended speculation on house prices I have asked a few people to write a balanced review of the issues. Colm is the first to respond to the invitation.
As this is a well thought out and well written article, I would ask people to respond to it in a similar manner.
Colm Fitzgerald (DCU) is an Adjunct Lecturer in Financial & Actuarial Mathematics in Dublin City University. He has been developing and using financial mathematical models for trading purposes for the last 17 years and was previously Head of Quantitative Trading in Bank of Ireland Global Markets.
He holds an MA in Economics and is a qualified Actuary. He is an external consultant to Rosenblatt Securities and a founding director of Paragon Research Ltd.
Brendan Burgess
Money and the Housing Bubble
We all know money is important. Surprisingly, just how important it is, is often lost on some people.
Money is the principal means of exchange in countries. Most distortions in our economy, e.g. our recent housing bubble, can be easily explained by looking at things from the point of view of money.
Rightly or wrongly, the total amount of money in our country is not a widely publicised fact. Between 1996 and 2007, the total amount of money in Ireland increased by more than 540% - another not very publicised fact. In my opinion this was the result of extreme ineptitude by our Central Bank, our financial regulatory system and our Government.
Where did all the extra money come from you may ask?
Shockingly, the vast majority was effectively printed by Irish banks, AIB, BOI, Anglo etc. If a government prints money it’s considered bad – but letting banks print it, and in vast quantities, is disgraceful. Yet this happened with practically nobody in Ireland saying anything!
I will come back to how the banks did this later in the article.
But first, why was this important?
According to what is called ‘the Quantity Theory of Money’:
The amount of money in a country * the number of times it goes around the system
= the volume of all goods and services * average prices
Historically, if the amount of money in an economy increased (due to printing money say) - this would largely lead to price inflation.
If everyone in the world was given twice the amount of money that they already had, it would not make anyone better off as there would still be the same amount of goods and services – and their prices would probably double.
What happened in Ireland?
How come after the amount of money increasing by over a factor of five, that we did not have huge inflation? Quite simply it was because the price adjustment largely happened in the housing market! The prices of most of our goods and services are largely determined internationally and were less affected.
All the extra money printed by our banks caused the house price bubble.
The amount of money in Ireland has fallen by about 25% since 2007 – resulting in our housing market crash. Before I get into how did happened, I’ll first explain how the banks effectively printed so much money in the first place. It makes me sick thinking about how they were allowed to do this.
Historically, going back to the Renaissance, banks typically kept only about 10% of their money in cash. This 10% was to provide money to depositors as they needed it and to handle bad debts in times of recession.
Suppose you have a country where there is only €100 of cash. If this is all deposited in a bank, the bank keeps €10 (10% of €100) and will lend €90. Suppose this €90 is deposited in another bank, that bank then keeps €9 (10% of €90) and lends out €81. Suppose again this €81 is deposited in another bank, that banks keeps €8.1 (10% of €81) and lends out the remaining €72.9. This process continues so that effectively the €100 of cash has turned into €100 and €900 of loans and consequently €1000 of deposits. So effectively, €100 of cash was printed by the Government, and another €900 has effectively been printed by the banks !!
Ok there is some maths here, but stick with it – if you get this you will understand about what’s going on in our country much better.
What happened in Ireland in the 1990s and 2000s (and also in the rest of the world) was that banks were allowed to get away with keeping much less than 10% of money received in cash. At the height of the boom, the banks were only keeping about €2.50 for every €100 lend out.
This meant that in a country with €100 of cash, the banking system was creating €3900 of loans (>than the €900 of loans above). So effectively, by keeping less in reserve the banks were effectively printing massive amounts of money. This is due to the fractional banking system in both Ireland and most countries around the world.
It was seriously inept of the authorities to allow this to happen.
Firstly, when the burst came, the banks were looking at losses of about 10%, but they only had 2.5% in reserve so they were incredibly bankrupt. Why were they allowed to hold so little in reserve, it’s so shockingly inept how this was allowed to happen.
What’s even worse than this is that ‘prudence’ was then enforced on the banking system, requiring them to hold much higher reserves.
This effectively meant that the money ‘printed’ by the banks would effectively be destroyed !!
If there is €100 in cash and the banks have created about €3900 because they are holding €2.5% reserves – if they switch back to holding 10% in reserves, they are only creating €900 – so the overall amount of money in the economy crashes.
Going back to our Quantity Theory of Money – a sharp fall in the money supply causes either a fall in the volume of goods and services and/or a fall in prices. But as the housing market took up most of the adjustment as money was being created in vast quantities, it has also taken a lot of the adjustment on the downside – hence our rapidly falling house prices. Ireland is a small open economy so our domestic markets often have to take the biggest adjustments.
In summary then, with very little if any publicity, our banking system created huge amounts of money over the space of about 10 years, resulting in huge house price appreciation. Due to the nature of the way this money was created, it was not going to be sustainable. There was always going to be a crash when the next recession came as the banks were being allowed hold less than 10% in reserve – so not only would they go bust, they would also cause a huge contraction in the amount of money in the economy, causing the housing market, and the economy, to crash.
It is really terrible that the authorities that allowed this to happen have got away scot free. It is sheer ineptitude what they allowed happen. Probably the worst element of this was when they got rid of the 2.5 earnings multiple for mortgages.
Typically house prices are about four times average incomes.
It is considered that a normal worker will be able to pay back 2.5 times his income over the course of his working life. In the case of a couple, who would typically buy a house, the limit was 2.5 times plus one times spouse’s salary. This meant with an often sizeable deposit, a couple could afford to buy a house with the help of a mortgage.
This regime should be sustainable and sound over the long term – as indeed it was.
It would be sheer lunacy to consistently lend more than these earnings multiples as, firstly the borrower may not be able to repay the loan, and secondly if they cannot afford to pay it back, the bank would be left with an asset that may be lower in value than the loan (houses are typically prices about four times average incomes).
At the height of the boom banks were lending at 7, 8 and sometimes 9 times salaries – for individuals to buy houses that were worth (in the long run) about 4 times salaries.
How could our authorities have been so stupid to let this happen?!?
Sadly, banks are still lending at nearly 5 times salaries so our housing market has further to fall. Most transactions that are going through at the moment are based on a mortgage so this is feeding through into prices.
In Dublin house prices got to nearly 18 times salaries at the height of the boom. They are back down to about 7 times. But alas they have further to fall to reach their long term levels.
There is very little rocket science in the article. Our financial regulators are supposed to be financially sophisticated so this should be relatively simple for them. But alas they were incredibly inept.
There should be much greater awareness of the total amount of money in our country – as distortions in it can have huge implications for us. Our economics journalists fail to report on this. This needs to change, the public needs to be aware of this.
It goes without saying that our regulators need to get their act together in a much bigger way – and let’s not forgot our politicians who we trust to run our country. Surely they too should understand how important the total amount of money in our country is !!!
