Spain: who is responsible for the property bubble?
As recession takes hold, European citizens are starting to ask questions about how they were led into this, the deepest downturn in three-quarters of a century. The leading Spanish daily El Pais published a very thoughtful article today asking how things had unravelled so quickly and so spectacularly in Spain, previously one of the fastest growing economies in Europe.
These are the same questions that one must ask in the United States, Britain and Ireland regarding their own property bubbles. And, in view of recent turmoil in Eastern Europe, I suspect answers will be sought there as well.
This first part in a series of articles lays out the statistics of bubble and bust, demonstrating the scale of the bubble in Spain and it also makes a number of suggestion as to how to prevent a recurrence. You should note that this article points out Spain’s helplessness due to its lack of control over interest rates as a key impediment to solving the problem. Below is my translation of the article:
This week, El Pais will begin publishing in the business section a series of reflections by a group of well-known economists about the origins and effects of the crisis in our country as well as specific and well-argued proposals to exit from it quickly and rejuvenated. Affiliated with universities and research centers in Spain and abroad, their common feature is extensive experience accumulated through research on the characteristics of our economy that make it particularly vulnerable to negative changes in the economic cycle. Fundación de Estudios de Economía Aplicada (FEDEA) served as a vehicle for channeling this initiative coordinated by Antonio Cabrales (Universidad Carlos III and Fedea), Juan José Dolado (Universidad Carlos III), Florentino Felgueroso (University of Oviedo and Fedea) and Paul Vázquez (Universidad Complutense and Feda) which will result in an eBook. The property sector, the labor market, financial institutions, fiscal policy, R & D and education are just some of the topics addressed in these articles.
A generation of Spaniards will lose their savings because they have spent to buy homes which are falling in price. So, in our old age and our children, we cannot count on what we hoped for. And many are so indebted that now they cannot cope with their debts. Moreover, we specialized in being masons, plumbers, electricians, truck drivers, glaziers, manufacturers of doors, beams, cranes, tile or sinks, gear, selling mortgages, appraisers, registrars and a host of occupations related to construction. And now that our experience is no longer valid and we must dedicate ourselves to something else.
In addition, the Spanish economic miracle was a mirage, because we were dedicated to building homes that we would not have wanted to build had we knon how little they would be worth in the future. A house is only valuable as something in which to live. And if no one wants to do so, then it is not worth anything. We have purchased flats which are still being constructed or which we visit only a few days a year, not because we were eager to consume housing, but because we thought they were a store of value for the future.
Further, our banks and building societies were dedicated to lending to developers and builders, and many of them now cannot repay the loans, which could lead to bankruptcy for banks and building societies — if they are allowed to go bankrupt. And municipalities have enjoyed unsustainable revenues due to land reclassification and the waste to which they have become accustomed is over. There are the cars that we bought, which we actually could not buy because we were not as rich as we thought. And from there led a complete distortion of the fabric.
Finally, as this kind of unsustainable activity has stopped, the economy has entered recession. To help understand the very adverse consequences of delirium, it is necessary to review the path house prices have followed in Spain, and their causes, their predictability and what could have been done to prevent it.
Growth in construction sector
The growth of the total construction has been high, 5% per year in 1996-2007. Between 1998 and 2007, the housing stock grew by 5.7 million, nearly 30%. In the third quarter of 2007, construction accounted for 13.3% of total employment, far above, for example, 6.7% in Germany or 8.5% in the UK.
Several factors have stimulated the demand for housing. They exaggerated the economic expansion (partly due to real estate boom itself) and the resulting fall in unemployment and cuts in mortgage interest rates after the integration into the euro, from 11% in 1995 to 3.5% in 2003-2005 –rates which were often negative after discounting inflation. Moreover, banking competition has facilitated access and improved conditions of mortgage credit. It has also increased the number of households, especially due to a massive influx of immigrants, about 4.2 million between 1996 and 2007. Finally, the purchase of properties by families not living in Spain has increased by a scale that is hard to calculate.
Supply responded to increased demand, as the data above demonstrates, but could not completely satisfy it, leading to large increases in housing prices: an annual inflation rate of 1% in 1995-1997 came to 18 % in 2003 and 2004. On average, between 1995 and 2007, house price inflation was nearly 10% annually.
In fact, to the extent that agents have expectations of future increases in housing prices and demand is positively influenced by them, for a time one can see a spiral of growing demand, supply and prices.
Has there been a speculative bubble?
A bubble is characterized by the presence of a high volume of transactions at prices different from the fundamental economic value. It is not easy to identify because of the difficulty in calculating the latter value well. Often, the identification is made retrospectively, after a sudden collapse in prices. However, in the real estate market, because of low liquidity, the collapse is slower than in the financial markets and is reflected initially more in quantity than price. In Spain, the sale of homes has plummeted in 2008. It is estimated that at the end of the year there were between 650,000 and 1.3 million unsold new homes.
In any case, the revaluation of property in Spain between 1997 and 2007 was 191% according to The Economist, the second highest in the OECD and higher than in countries where there is no doubt about the existence of a bubble, like the United Kingdom (168%) or USA (85%). As for the fall, according to INE, in the third quarter of 2007 house prices have risen a further 3.7% in interannual terms, and the price of previously-owned houses has fallen by 11.4%, compared to increases of 9.2% and 7.5% respectively a year earlier. The speed and magnitude of these changes point to a bubble.
More rigorously, the key factors mentioned above (the expansion, interest rates …) are not explained by price alone. Available estimates –for example, those from the Research Department of the Bank of Spain — indicate that the observed prices were well above levels justified by economic fundamentals. This overstatement is estimated at between 8% and 20% in 2003 and between 24% and 35% in 2004. Thus, it seems clear that a significant part of inflation in housing is due to speculative reasons: people bought houses as investments, because they expected them to be revalued. Furthermore, it was considered a safe investment compared to the risk of financial assets shown by the collapse of the stock exchanges in 2002.
It is worth noting that a bubble has nothing to do with states of collective optimism or pessimism that can be associated with levels of economic activity, high or low, but are transmitted through a mechanism of self-expectations. In the case of a bubble, prices do not perform their function as a mechanism for the proper allocation of resources and actual errors. If the bubble is big and durable, the misallocation of resources from savers, companies and workers can cause extensive destruction of real wealth.
Did we know that there was a bubble?
Since 2002, the Bank of Spain has warned about the overvaluation in housing — although it has been too optimistic about the likelihood of being “consistent with a gradual and orderly decline”, perhaps because it feared pricking the bubble. In 2003, The Economist estimated overvaluation in Spain at 52%. In 2004, the International Monetary Fund stood at 20% -30%. Among the Spanish economist José García-Montalvo 2003 figures by 28.5%, stating: “In short, it is very likely that the Spanish property market is a time bomb waiting to be detonated.” However, senior politicians and businessmen refused repeatedly and until recently to admit there was a bubble.
Were the politicians aware of the bubble?
The PSOE’s electoral gamble in 2004 spoke of “a new pattern of growth that is more robust than the current.” Its candidate for president of the Government, José Luis Rodríguez Zapatero, said: “Since we have an economic model based on construction and mortgages, Spanish families are now more indebted than ever in their history.” And then the coordinator of PSOE’s economic program stated: “The policy of renters which (…) prevents people from selling and producing a catastrophic collapse in prices, due to a change in expectations. Indeed, the then minister of economy of the Partido Popular said: “The truth is that we are living in a long cycle and low uncertainty. This is indisputable. And what is important is that a model is sustainable.”
Could something have been done to prevent the bubble?
Tackling a bubble is easier (technically) if you have the right tool: interest rates. It’s harder if you do not have it, as in Spain, who has left it to the European Central Bank (which has long kept rates too low for the needs of the Spanish economy). However, we believe that the following measures — designed to really know the level of housing prices and reduce tax distortions that made this type of investment artificially profitable — would have mitigated the bubble:
- Improve information on housing prices. Unlike other countries, in Spain there is no information on actual transaction prices. Only since 2008 are prices available from the registry and notary– only in index form, not of monetary value (perhaps due to suspicion about overstatement in written values). Up until then, there are only official in the Ministry of Housing developed from data supplied by companies that priced homes for customers, often in the granting of mortgages. For obvious reasons, this is not a reliable source. And the official information policy has been lamentable. For example, the ministry announced in October 2004 that it was suspending publication of data on housing prices, but later corrected itself. It then introduced a methodology bias into to the measurement that held prices down. At present, the ministry does not offer on its website any data prior to 2005 prices! And at no time sought to make the public aware of the possible overvaluation of housing. However, it would be possible to have information on the actual value of real estate transactions, for example, collected in one of the household surveys conducted by INE, or to conduct a survey specifically for this and use it to correct the measurement of changes in the price of housing quality.
- Reduce the the income tax deduction to shelter, which heavily skews investment decisions of households toward housing over other assets and, together with the law on leases, promotes home ownership (81.3% of households in 2005) compared to renting. In 2002, 79.7% of the gross wealth of households was related to real estate, compared to 75.5% in Italy and 38.4% in the U.S.. In 2005 the figure was 80%. In 1998, the Government of Partido Popular reduced the existing high relief, but after that no progress was made.
- Increasing the regulatory oversight on real estate companies and transactions. Recent estimates place in Spain between 2004 and 2005 as having the third-largest black market economy amongst developed economies (20.5% of GDP), after Greece and Italy. This percentage has been reduced by 2.2 points since 2000. Probably a large part of the hidden activity is channeled through the housing market. The Union of Technicians of the Ministry of Finance estimates tax evasion in the property sector at 8.6 billion euros per year (about 0.8% of GDP).
Why not attempt to stop the bubble?
First, because the construction sector is labor intensive, which is important in a country with a structurally high unemployment rate. Secondly, because an increase in the value of housing benefits the average voter, who is the owner of his home. And thirdly, because the real estate sector generates substantial revenue for the public sector at national, regional and municipal levels. For example, in 2004, it accounted for 60% of the budget (excluding liabilities and current transfers) of Valencia and 50% of Madrid.
The Partido Popular [People’s Party] government was wrong with its law liberalizing the land in 1998. It believed that with more land, housing would increaseand house prices would fall. Big mistake. Homes were bought and built not because they were cheap, but because they were expensive and one had expectations that they would be even more so in the future. Thus, the land law threw fuel on the bubble’s fire, triggering frenetic activity which reclassified thanks to local rulers who saw municipal coffers filled (if not their own pockets).
For their part, the PSOE government’s attempts to encourage housing and rent and their new land law of 2007 have been completely ineffective. In reality, it has only prevented us riding the bubble until its last death rattle.
Ultimately, both Governments have failed on one crucial issue: saving their citizens from economic excesses which carried off their savings, their jobs and their prosperity. It is a failure that must be learned for the future and for making appropriate accountability.
¿Quién es responsable de la burbuja inmobiliaria? – El Pais