A European report says that Irish house prices should be left fall further to more sustainable levels but the Government should have acted years ago to cool the raging market. The report says that real mortgage rates in Ireland were zero or negative between 1999 and 2005.

Brussels-based think-tank, Bruegel in a report -A Tail of Two Countries - (could also be termed a tale!) says that the outlook for two of the euro area’s best performing economies to date, Ireland and Spain, has darkened dramatically recently amid severe downturns in housing markets. What do these countries’ experiences tell us about the functioning of EMU (European Monetary System)? it asks and says that the source of rapid growth was different in the two countries, but both experienced large inflows of migrants and significant housing booms. Against a backdrop of low one-size-fits-all interest rates in the euro area after 2002, housing markets overheated. These bubbles have burst and the slump in residential investment from elevated levels threatens to drag both economies from one tail of the growth distribution to the other.

The report says that the slowing Irish housing market will subtract four percentage points from Ireland's GDP growth this year and remain a drag on growth for several years.

The organisation, which focuses on international economics, says the housing boom and bust in Ireland and Spain holds lessons for the fast growing economies of new EU member states.

It says that since governments in the Eurozone cannot change interest rates in response to overheating housing and credit markets, they must learn to use other mechanisms, such as tax.

Bruegel suggests that mortgage interest relief should have been eliminated and capital gains tax introduced on the sale of primary residences to dampen the boom that began in 1996.

The analysis of the Irish market by Dr Alan Ahearne of NUI Galway for Bruegel shows that real mortgage rates in Ireland were zero or negative between 1999 and 2005 because inflation was much higher than in the rest of the Eurozone.

The positive interest rate environment coincided with greater competition between banks offering attractive mortgage packages such as 100% loans and interest only loans. Such competition led to what the report described as “irrational exuberance” in the Irish housing market that saw major investment in housing resulting in a tripling of house prices in Ireland compared to the rest of the euro zone which increased by just 50%.

The report says that there were signs of overheating from 2002 and the immigration of workers into the country had an impact on demand. Figures show, however, that the prices being paid for houses was not justified by the rents people were being paid. So, the study concludes, people were investing in housing as they expected to sell at a profit due to rising prices.

Now that the housing boom has burst, Ireland is again out of synch with most of Europe, with the drop in house construction depressing growth, while Germany’s economy is growing robustly.

The Government should now support non-housing parts of the economy, such as infrastructure, and provide incentives for insulation of homes to help the construction industry.

It says that some building firms will collapse and warns that the Government should not intervene like in Spain, where the state has ordered big social housing projects.

Other economies, such as those of new EU member states, can expect similar rapid growth as their economies reach EU averages. But the lessons from the Irish experiences are that governments must intervene early with tax measures to cool overheating.