If There's No Real Estate Bubble, What Is Going On?

There is no real estate bubble in Israel. These are natural market processes, driven by the big gap between the growth in the number of households and the rate of housing construction. At least so says a report by The Macro Center for Political Economics, which was dished up to the Knesset last week. The director general of the Macro Center, Roby Nathanson, explained that the increase in housing prices is just a correction after the drop in the previous crisis.

It is dangerous to make predictions about Israeli property prices, but the report's authors probably have the right general direction. In purely financial terms, there is no real estate bubble in Israel. The bubbles in many developed economies of the west, including in the U.S., Britain, Spain and Ireland, didn't occur here.

A "real estate bubble" is created when the financial conditions enable land and housing prices to climb and climb, and borrowers base their decisions on the assumption that asset prices will continue to increase.

Throughout history, real estate bubbles have been characterized by a rapid increase in borrowing by buyers: They bring less and less equity to the deal, and borrow a greater and greater proportion of the home's value.

The so-called "subprime" bubble that grew undisturbed in the United States from 2002 to 2007 added another financial element to the stinking brew: The bubble-loan lenders didn't take any real risk. That's because they repackaged the risk into structured bonds and sold them to financial institutions around the world. Thanks to the wonders of statistics and the rating agencies' hunger for fees, these bonds were rated far better than the actual risk they bore. In other words, going by ratings alone, investors couldn't realize they were actually buying very risky stuff indeed.

These two elements, the heavy borrowing and the ability of lenders to pass their risk onward, don't exist in Israel's real estate scene. It is true that the leverage level (equity to loan ) has increased in recent years, but it remains lower than in the countries where real estate bubbles developed. Mortgage lenders in Israel keep the loans on their books, which means they bear the risk: They don't roll it over onto the general public through weird securitizations.

In other words, the chance that one fine morning a huge financial bubble will explode all over Tel Aviv, leading to a glut of homes and land for sale, and mass bankruptcies by borrowers and lenders - is small. We do not have the basic ingredients for a classic financial real estate bubble.

Having taken the possibility of an American-style property price collapse off the table, what we remain with is high property prices. We remain with hundreds of people, from young couples to aged retirees, who can't buy homes or even afford rent in areas near employment hubs.

Ergo, the problem isn't a real estate bubble. It's much broader: It is the growing difficulty of the general public to afford housing, because of the rapid increase in living costs, while output and wages rise much more slowly. No less disturbing than the difficulty is the widening despair: People look ahead and don't see a way to afford these things in the future, either.

You can rail but the stone will stand

The problem of the Israeli economy isn't financial bubbles, it's bubbles of insularity. Wide swaths of the economy are protected from change, efficiency, reform or even critique. They are closed off, unthreatened by financial bubbles. They are as stable as rocks.

Last week the Finance Ministry celebrated a great victory in the battle of the budget. But even the treasury chieftains know how picayune their triumph really is. Actually, the real winner is the defense establishment, again, as it has been in each of the last 25 years.

Fifteen years ago the Finance Ministry had a particularly belligerent official who went to the press with data on the flab in the defense establishment. Pay slips of officers were leaked, and corrupt, hedonistic practices were exposed. The nation rocked, for a few months.

A few years ago I asked that Finance Ministry official, Nir Gilad, who is now the CEO of Israel Corporation, what came of his battle against the defense establishment. "Nothing," he said without missing a beat. Nothing changed. The flab and rot stayed. The Finance Ministry is also continuing with life as usual, repeating the battle every few years, in vain.

The most insulated, and filthy, sector of them all is defense. It is riddled with over-staffing, it is opaque, it squanders money like there's no tomorrow. Billions of shekels are spent with no critique or public debate. Its lobby at the Prime Minister's Office has always prevailed. When Benjamin Netanyahu was finance minister, he said in private conversations that the filth and corruption in the defense establishment cried for change. Speaking with the press, he even provided examples. But when the shekel stopped with him at the Prime Minister's Office, he quickly turned into just another prime minister being extorted by the defense system.

An end in itself

It is hard to find any correlation between spending on defense and the threats Israel faces. Defense budgets have been cut not because the threat diminished but mainly but because of fiscal crises. If you think the peace process will reduce defense spending, you don't understand that like every other huge, powerful and monopolistic system, the army has long ceased to focus on protecting the nation: It is the end, in and of itself.

Seven years ago, America invaded Iraq and changed the map of threats against Israel beyond recognition. It took Israel's defense chiefs six months to find their wits, change their song and argue that defense budgets needed to be bigger than ever before, to counter the threat of Iran.

Dear reader, the defense establishment isn't a financial bubble. It is a bubble of stability and power.

The safest mortgage borrowers in the land are soldiers and people who work for the defense establishment, cutting huge coupons in its gigantic, secretive procurement system.

The Israel Electric Corporation isn't a financial bubble either. Bloated wage and procurement costs may have reduced it to bankruptcy, but don't fear that the light will go out. At the last second, the Finance Ministry will give it money or let it raise its tariffs.

In the private sector, you can find parallels of these insulated islands. Much of the economy is controlled by monopolies and cartels whose owners protect them from competition or reform, prepared to release a barrage of heavy fire on any threat.

Outside these private and government insulated spheres stand hundreds of thousands of families, without representation in these places where power is cultivated. These are the risky mortgage borrowers: people whose pay is low and whose job security is not great. Happily for the people inside the insulated spheres, most of the people outside don't get it.

Some may even think they belong to the upper percentiles, but one morning they will wake up and realize what it means to live outside the insulated spheres. They'll reach an age when nobody wants to hire them, and realize that their pensions aren't enough to sustain anything close to their present standard of living. Only then will they realize the true price of living in an economy controlled by insulated spheres, because market mechanisms - that could sound a warning ahead of time - focus on things like "output," debt, financial ratios, productivity and deficits, not on the long-term effects of the regime of the insulated spheres.

The collapse of the Greek bond market forced Athens to start fixing its budget. But there is no economic mechanism to warn that the education system is collapsing, that healthcare is deteriorating, that welfare and competition and productivity are trending down, all of which erodes Israel's economic potential. Somebody has to sound the alarm. But the very people best positioned to do so are, like the last and littlest of the market traders, busily obsessing over the results of the last quarter, not the future decades away.