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Taxes will rise and incomes fall: that is the grim reality

By Brendan Keenan

In the end, the most significant bit of the new Programme for Government between Fianna Fail and the Green Party could be the bit about helping people who cannot pay off their mortgages or other personal debts.

In the beginning, most attention will focus on the effects of the new agreement on the December Budget. The important bit is the clause which says the overall fiscal targets remain the same. There is no new money - or, to be precise, no extra borrowing. More for some means less for others.

The calculation may not be that simple on the night. There is already significant slippage this year, with the general government deficit set to hit 13% of GDP. With national income expected to shrink by another 1.5% in 2010, there seems no chance that the Budget, however severe, can get the public finances back on track for the planned 10% of GDP deficit.

The Greens may be able to take credit for the extra borrowing, because of the extra spending on education, if credit is what they want. We will never really know, because Finance Minister Brian Lenihan can be expected to say that this was the borrowing requirement he would have gone for anyway.

This is where the public sector crisis and the private sector one meet, as the irresistible force of rising public spending meets the immovable object of declining private income. The private sector problem is ultimately the more serious, because the rest of the edifice is built upon it. This will become clear in due course, as the dire effects of the crash upon the incomes and balance sheets of Irish households emerge.

We got a glimpse in a recent report from the Economic and Social Research Institute of the likely incidence of 'negative equity' in residential mortgages.

It got plenty of publicity - not surprisingly, given its headline figure that almost 200,000 homeowners could find their house worth less than their mortgage. Even so, some of the details, and a lot of the implication, deserve further attention.

Two destructive, connected forces are at work. Taxes will rise, no matter how much weeping and gnashing takes place. For borrowers, disposable income will fall further, as the European Central Bank (ECB) raises interest rates and banks increase their margins.

This combination means there is still a way to go before house prices reach their historical turning point in terms of affordability - which seems to be about 20% of disposable income.

The actual level of house prices has an enormous effect on the numbers in negative equity. The ESRI's main assumption was a 40% drop from 2007 peaks. That gives a figure of 196,000 in negative equity. But if prices were to fall 50%, the number rockets to 350,000.

Even the first figure is proportionately twice as large as the numbers in negative equity in the UK in the 1990s.

As for the second. . . yet, though it is a great media favourite for obvious reasons, the effects on the economy of negative equity itself are far from clear.

Among the more surprising bits of evidence, from the UK, was the absence of any permanent 'wealth effect,' where people on negative equity cut down on spending.

They did so at the time - which is bad news for the current recession - but more than made up for it when house prices recovered, and were among the more exuberant consumers in the subsequent boom. A question of age and character, perhaps.

The big problem is labour mobility, with a household suffering £10,000 of negative equity found to be nine times less likely to move than one whose mortgage is covered. No surprise there, but it is probably more of a difficulty in large countries in this situation.

There is some reason to hope that, in Ireland, with people already used to long commutes in the main urban areas, the numbers unable to take a job because they cannot move house may be relatively small. Negative equity may, however, partly close the traditional Irish safety valve of emigration.

All of this applies to people who lose their jobs. The issue then becomes ability to repay the mortgage and the overhang of debt if they give up and the house is sold. It is not the number in negative equity which will matter so much, as the number in default.

Journalists regularly harried the Financial Regulator and the Central Bank about the wisdom of allowing an increase in 100% mortgages, when the bank itself was warning that the housing boom had reached a dangerous stage. Part of what the journalists were told turns out to be untrue: far from such mortgages being a carefully monitored minority, as claimed, they accounted for a third of mortgages in 2006 and a quarter in the following two years.

Ability to repay seemed to be almost the regulator's sole concern and maybe it was half right. That is no excuse for the lack of concern about the trap being set by the banks for their customers, but keeping the roof over one's head is more important than a paper loss on the household balance sheet. Other countries have already moved on the issue. The Americans have two schemes to help troubled borrowers by re-financing or modifying mortgages. The British have introduced 'debt-equity swaps,' to reduce repayments by pledging some or all of the value of the house to the bank.

No one could ever accuse the present Irish Government of speed, and all the agreement does is list these kinds of measures and promise to 'review' them. But at least it's a start. In typical Irish fashion, a lot of this kind of thing may already be happening between lenders and customers, but in secret, and unregulated.

The ESRI quotes research which finds that the best policies concentrate on reducing repayments, so that borrowers are less inclined to just walk away, but do not write-off the actual loans, thereby giving defaulters a better deal than those who keep paying. Most economists think the worst of the job losses are over, but the interest rate rises are yet to come, along with more tax rises and, probably, pay cuts.

It is disappointing that the ideas in the Programme for Government are still just ideas but something like them will surely, and sorely, be needed.


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