Saturday, 27 November 2010

On broken promises

In 1990, before presidential election, Lech Wałęsa promised to turn Poland into “second Japan”. In 2007, before parliamentary election, Donald Tusk promised Poland would follow the path of Irish economic miracle and would become “second Ireland”. Both politicians have gone back on their promises and Poland has not taken a leaf from Japanese, nor Irish book. Now do not grumble, we should be grateful they have failed to put those economic miracles into practice.

What do those two countries have in common? The lie on different continents, both experienced periods of long lasting economic growth, both were held up as examples of excellent economic performance, both made quantum leaps, both have been going through severe crises and even despite being hit by them are now far higher developed then the moment they were in “square ones” of their growth path.

Japan got up of its knees over ten years after WW2. Thanks to easy borrowing terms, support from the government and protectionist measures Japan’s industry began to grow rapidly. Japan corporations relied on cutting-edge technologies and were highly efficient what helped the country boost its exports and flood markets of developed countries with high-quality and reasonably-priced products. In 1960s annual GDP-growth rate was running at above 10%, in 1970 it slowed down due to oil crisis, but Japanese economy soon adjusted to rising demand on energy-saving technologies and not only rode out the crisis, but even emerged from it stronger. The period when interest rates were low, pace of economic growth remained high and inflation low lasted until 1990. The last five years of boom were marked by surging stock and property prices – both tripled between 1985 and 1990. Companies and individuals eagerly borrowed money from banks to buy assets, since interest rates on loans were far lower than returns on stocks or properties. The bubble burst in 1990 and the economy of Japan slipped into a period of sluggish growth for a decade. Banks were hardly hit by write-offs on non-performing loans, individuals and companies struggled to repay the debts they had run up in the times of speculative frenzy. Customers were reluctant to spend, what caused the domestic demand to decline. Firms instead of investing in capital stock were paying back its debts. Interest rates were slashed to near zero to stimulate the economy, but neither banks could grant new loans, nor were the enterprises keen to take them out. GDP growth rate averaged out 1% in the 1990s. Adverse effects of bursting of sizeable economic bubble are felt until now.

Ireland in a relatively short period of time turned from backward agricultural country into one a modern, fast-growing economy. The economic miracle is often put down to Social Partnership under which government, employers and trade unions settled on taking a concerted effort move the country forward. They did bring it off, inflation was on decline, growth rate was on the rise, the country attracted outward direct investments owing to corporate tax cuts. For many years Ireland ran budget surpluses and consequently its public debt was decreasing. Good economic performance was fostered by low interest rates and deregulated financial industry, which caused the property bubble to arise. Banks were lending recklessly and bubble grew splendid before it burst. From then Irish banks reported huge numbers of defaults among borrowers, their capitals shrunk as a result of losses on non-performing loans, the government had to bail out most banks and the bail-out programme has caused the public debt to mount. Now not only Irish banks but also the Irish state is on the verge of insolvency.

So what do they have in common? Economies of both countries have been hurt by bursting bubbles. In both countries interest rates were abnormally low for an extended period of time (there was no need to raised them as there was no threat of rising inflation), banks loosened their lending criteria and foisted loans upon almost everyone. In both countries prosperity was brought to a halt by bursting bubbles.

But brush aside economic aspects of economic bubbles, take a look at them from psychological perspective. Bubble (as any other misfortune) inflates when people take for granted nothing bad can happen. Japanese and Irish banks took for granted the property prices would only go up, so even if a borrower failed to repay their debt, they would foreclose a property and recover the money. Individuals and firms also took for granted asset prices would only go up. When an economic bubble is robust almost everyone believes the boom will last forever. Voices of sceptics who claim the disaster is imminent are drowned out.

It is very hard to crack down on the bubble, because as long as it swells, it is convenient to everyone. Government gets higher proceeds from property taxes, property developers count up sky-high profits, banks make lots of money on mortgage loans, property owners are happy because their wealth is increasing, flat broke non-owners are over the moon because banks are leaning over backwards to give them 40-year mortgage for a tiny, dilapidated 30-square-metre flat. And the unemployment is falling, because construction sector needs more workers, who do not get paid worse than qualified workforce. And bear in mind efficiency in construction sector is low, so economic growth generated by it is in a way delusive.

Lessons to be learnt? Do not let property bubbles happen. In the long term they always do more harm than good. Imbalance in an economy will sooner or later cause a turmoil and those to pay for any possible bailouts will be taxpayers. Interest rates on mortgages should not be low (cheap corporate loans have positive impact on the economy in the long run)! Lending for housing purposes should be under supervision! Poland escaped the scenario of bursting property bubble. Property prices did double in some cities between late 2005 and late 2007, but the boom was not followed by bust. Interest rates were never too low, Polish financial supervision did its best to curb lending, particularly in foreign currencies. Banks’ profits in boom period were not as high as they could be, some applicants had their mortgage applications rejected, but Poland averted a much worse scenario. May we never try to repeat any country’s path to economic miracle. Mr Wałęsa and Mr Tusk did not know what they were saying. Their promises were made just before bubbles in Japan and Ireland burst.

Funnily enough, Poland was going through a property boom when Prawo i Sprawiedliwość was in power…

More on economic bubbles in 2011, after I graduate (in my MA thesis I explore the topic, some excerpts to be translated into English and published here after I “defend” it).


Pan Steeva said...

I would say that the Polish property was a boom followed by a bust. Indeed, I would describe it, at least in and around Warsaw, as an archetypal low supply/over supply/collapse 'bubble'. However, the important thing was that it was not a driving factor in the economy as a whole, rather a result of past growth and not strong or long enough to fundamentally affect overall trends. The vast majority of property owners, who were neither buying nor selling in what is not a highly liquid market, need never even have noticed the movement of prices, being left in 2008 property values roughly similar to 2005. The bubble bursting left the overall economy little different.

student SGH said...

I would argue there was no bubble on the Polish property market (I linked to wikipedia article as to a curiosity). And the argument to back my take on it is that there is no bubble without burst. Prices rose by 100% between late 2005 and late 2007, by now they declined by some 20% what is rather a fully-justified correction, not a big tumble.

Your description in the general economic context is of course up-to-the-point.

Property prices in 2008 similar to those from 2005. Excuse me but either I cannot get it, or you did not make yourself clear here. I can understand most property owners, who didn't trade in properties could have not noticed changing prices and the "intrinsic" values of their properties stayed the same.

Pan Steeva said...

I am happy to accept you know more about the general price levels. However, the price of existing, rather than new, flats in Warsaw when we were thinking of moving in 2004, doubled by early 2007 and collapsed to the 2004 level by the end of the year. I knew several other people in the same position.

I did not make myself clear. My reference to 'liquidity' here is that, since Polish people buy and sell built properties (new or old) comparatively rarely, they do not usually think of their home as a financial asset. I would contrast this to the US and England, where people are acutely aware of the value of their property, it's importance as a security for loans - not just house purchase mortgages - and a measure of their wealth. As just one piece of evidence for this, people here talk about the square metres of their house, rather than its unknown value. (OK, as a second - people didn't realise the risky nature of contracting to buy a new property when they had not sold their old one. Several people suggested I was being ridiculous when I questioned this approach.) If this is right - and I might well be completely wrong - the psychological impact of a correction/bubble on consumer confidence and the economy generally is much smaller in Poland than it would be elsewhere. It just affected the small number of people who were in the process of buying and selling.

Please be happy to disagree with me again, I'd love to hear your view.

student SGH said...

I do wholeheartedly agree with the second paragraph.

Regarding the flat prices. In 2004 a square metre of a flat in a decent location (Ursynów, near underground station) cost 5,000 or 6,000 PLN. I'll feel convinced if you show me a 50-square-metre flat in Ursynów that costs no more than 300,000 PLN.


Pan Steeva said...

Thanks very much for this, it led me to check what prices were advertised in my old area. They are now nearly back to the peak level. Interesting.