Why the Spanish housing bubble was partly Germany's fault

Another European Union conference, another round of 'prudent' Germany shaming eurozone underperformers like Spain. Why won't anyone acknowledge Germany's role in creating economic beartraps like the Spanish housing bubble?

The foundation of the bubble, most of us can agree, was the convergence of European yields leading up to the creation of the euro.  But I would argue that the extended weak growth in Germany made the ECB error on the low side on rates, in the attempt to prop growth up. This created a prolonged period with negative real rates in Spain, sending housing prices into orbit.

The convergence
Look at Chart 1 below, and notice the interest levels in Spain, Italy and Portugal.  They came rushing down from the +12% level  in 1995 to around 4% in 1999. This was a massive drop – and it had huge effects on their economies.

Now look at Chart 2, where you see the drop in long yields - in this case represented by government long yield in the early timeframe in the chart – began to lift the yearly price increases on houses from +0-2% to a level of +5%. This creates a shift in the housing market.

If you are able to lend money at a yield lower than the price increase, plus you have inflation, then investing in real estate becomes a no-brainer. Everybody will want to “participate” either as a spectulator or buying to occupy. The second effect is that you will go for as much leverage as possible, as this just makes the investment much jucier for you.

Germany's role in creating the bubble
In the current environment, some of us tend to forget that Germany was in dire straits for more than a decade after the reunion with the former East Germany. The formation of the united Germany in 1989 was made on outrageous terms. For one - equal salaries for those living in the former East Germany, even though productivity was 10% of what it was in the old West Germany! This took a toll on the country, and was still felt in the new millennium. This put the ECB to the test, and the low rate to help Germany was made at the expense of risk put on other countries in the Eurozone. The monetary mishaps in this period are what we see the consequences of in the markets today.

The ECB had to create a one-size-fits-all interest rate, and for a prolonged period they took the stance to prop up the weakest link – Germany. The interest rate was based on the terrible GDP growth Germany was to able produce in approximately 2001-2007 - an average of 0.5% percent, see blue box in chart 3.

Offering life support for Germany had some dire consequences for countries like Spain. Looking at chart 3, it is obvious that the ECB rate in the early 2000s and the low rate in the late 1990s was below the Spanish inflation rate! This is really not good policy and shows that one-size-fits-all does not necessarily really fit all, at least not all the time. This period took over from the convergence of the long bond yields as the negative real rate kept the pot boiling.

The extreme real estate boom
In chart 4 you can see how the real estate boom just kept rising as if it was going to the moon – Houston calling! From a level of 20k a month in the 90s the millennium really had the construction boom taking over. The increase in the monthly output was from 20k to almost 60k per month! This was an enormous growth.

Look now at Chart 5 - it appears that in the period from 2000 to 2010 in the range of 3m too many houses were built in Spain. It is going to take many years to absorb this overstock.

Debt explosion
Banks were eager to participate in the boom by lending money out. In chart 2 we see the yield dipping as low as at 3.5-4 percent and the banks were at least able to fund themselves at ECB rates, or somewhat below.

In Chart 6 we see that financing of real estate for housing rose from about €100bn to around €650bn over the course of 10 years. In comparison, nominal GDP rose only a bit more than two times.

This is one of the real burdens on the economy today, as the banks badly under-priced the risk! At the time banks might have thought this margin was sufficient, but we see today it was definitely not, see chart 7. All in all there is not capital enough today to take the setback in the housing market. The level of debt from doubtful debtors has exploded, to say it mildly, from less than €20bn to above €150bn in under 5 years and this is what is killing the banks at the moment.

Conclusion
ECB interest rates were set low for Germany's convenience, but their impact on the  Spanish economy over an extended time frame set the stage for a very large and extended housing bubble. Looking at the long term trend, it seems as if there are about 3m houses too many in Spain at the moment. The willingness from the banks to lend out money has now come back to haunt them. We are in for a prolonged period of hard times in Spain as this mess is untangled.