Conefrey, Thomas

FitzGerald, John

English

Research Papers in Economics

MANAGING HOUSING BUBBLES IN 
REGIONAL ECONOMIES UNDER 
EMU: IRELAND AND SPAIN 
*Thomas Conefrey and John Fitz Gerald 
Economic and Social Research Institute, Dublin, Ireland 
 
 
 The international financial crisis has inflicted substantial damage on many 
economies around the globe. In Ireland and Spain, the impact has been 
particularly severe, due largely to the collapse of housing bubbles in both 
economies. The significant economic instability caused by the abrupt ending of 
such housing market bubbles highlights the importance of developing policy 
instruments to manage housing markets and to prevent dangerous bubbles 
from emerging. Our recent paper** shows how the advent of EMU relaxed 
financial constraints in Ireland and Spain, allowing for a more rapid expansion 
of the housing stock in those countries to meet their specific demographic 
circumstances. If this process had been properly managed there would have 
been significant benefits for both economies. However, because the housing 
boom was not controlled by governments these two economies have suffered 
serious damage. Due to the idiosyncratic nature of housing markets, monetary 
policy, as implemented by the ECB, cannot be used to manage housing 
markets within regional economies in EMU. However, the paper argues that 
fiscal policy instruments can and should be used to manage housing bubbles 
and thereby avoid the severe damage caused to economies by their collapse.  
 
 The rapid rise in house prices in Ireland over the past decade has meant that 
adults continued to share accommodation (either with parents or friends) to an 
extent that was unusual by EU standards at a time when living standards, 
measured in terms of real disposable income, rose dramatically. The natural 
increase in the adult population alone means that around 20,000 additional 
dwellings a year are needed in Ireland to take account of the rising number of 
adults. The role of demographic factors, in addition to variables such as 
disposable income, the per capita housing stock and the user cost of housing, 
is reflected in the model of house prices for Ireland and Spain which is 
specified in the paper.  
The Drivers 
of the 
Housing 
Market  
 
 
* thomas.conefrey@esri.ie; john.fitzgerald@esri.ie 
 
   ESRI  Research Bulletin 2010/2/1            The advent of EMU had a major impact on the cost and availability of credit 
in many member states of the Euro Area., Prior to EMU countries such as 
Ireland and Spain faced a significant exchange risk premium attached to 
borrowing in their own currency relative to borrowing in Deutschemarks. This 
raised the cost of capital for housing in these countries relative to Germany 
and meant that, prior to EMU, even with similar income levels and 
demographics, the optimal long-run stock of dwellings would have been lower 
than in Germany or the Netherlands. The advent of EMU, reducing the cost 
of capital permanently for households, raised the optimal long-run stock of 
dwellings.  
EMU and the 
Cost of 
Capital 
 
The liberalisation of credit markets following EMU had a second important 
implication. It allowed the domestic banking systems in Ireland and Spain to 
borrow substantially from abroad without any exchange rate risk. This 
borrowing from abroad, as reflected in the rapid increase in the net foreign 
liabilities of the banking system after 2003, was used to finance the domestic 
housing booms in both Ireland and Spain. This increase in foreign borrowing 
through the domestic banking system was the counterpart to the major 
increase in the balance of payments deficit which emerged in Ireland after 
2003. It should be noted, however, that while EMU played an important role 
in relaxing credit constraints in Ireland and Spain, the wider liberalisation of 
financial markets also had an effect in countries outside the Euro Area.  
 
  The rapid expansion of the building and construction sector in Ireland and 
Spain resulted in a sharp increase in the share of housing investment in GDP. 
For Ireland and Spain, housing investment in 2005 accounted for record shares 
of GDP of 14 and 9 per cent respectively compared to a more normal 5-6 per 
cent of GDP in countries such as France and Germany. The housing price and 
output booms in Ireland and Spain had a major impact on both these 
economies. High prices for housing and the enhanced profitability of the 
sector resulted in a dramatic increase in the labour force employed in that 
sector. While an influx of immigrants moderated the impact on wage rates, it 
was not sufficient to prevent wage rates throughout the two economies from 
rising much more rapidly than in the rest of the EU, so that both economies 
lost competitiveness. The crowding out of the tradable sector of the economy 
by the building and construction sector was reflected in the rapid decline in the 
export market share for both economies and in the increase in their balance of 
payments deficits.  
The Role of 
Building in 
the Economy 
 
 Prior to EMU, countries could use monetary policy to manage the domestic 
housing market. However, under EMU monetary policy is targeted at the Euro 
Area inflation rate and, because of the idiosyncratic nature of the housing 
sector across the Eurozone, the stance of monetary policy will only help to 
control housing bubbles by accident. While more vigilant financial regulation 
should play a crucial role in ensuring the stability of the financial system, in a 
financially integrated world where banks operating in one economy are 
regulated by different national authorities, better financial regulation may not 
be sufficient to manage the domestic housing market. This paper argues that, 
under these circumstances, the best instrument available to governments to 
manage regional housing markets is fiscal policy. For countries such as Ireland 
Managing 
the Housing 
Market under 
EMU: Policy 
Issues 
       
and Spain, this may entail a shift in focus away from the Stability and Growth 
Pact target of not running a deficit to the requirement to run large surpluses 
for a number of years where there is a housing boom. In addition, more active 
use of taxation would manage risks to the wider economy arising from housing 
market bubbles by specifically targeting the housing sector. 
 
 
 
 
**CONEFREY, T., J. FITZ GERALD, 2010. Managing Housing Bubbles in 
Regional Economies Under EMU: Ireland and Spain, National Institute Economic 
Review No. 211, January 2010. 
 
 

Managing Housing Bubbles in Regional Economies Under EMU: Ireland and Spain

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