A couple of nights ago before bed I couldn’t stop thinking about our economy and what medicine is needed to put us back on track. I recently wrote “Cutting Taxes on Millionaires DOESN’T Increase Economic Growth” in which I suggest that the American economy is driven by consumers demanding products (the argument deserves an entire post… perhaps soon). Dwelling on this truth, I began to think how demand is driven, how people access additional credit, and why consumers are not out spending money.
Well, of course some people are unemployed- but this is largely due to a lack of demand for products and services that has led to layoffs. So the simple answer points back to demand. What about credit, how do people obtain credit? Well, credit is largely based on three things, payment history, income, and debt liabilities. Demand for products is further derived from income and expectations of future income.
So when the housing market crashed, people’s asset values went down and their debt/equity ratio skyrocketed. People became over-leveraged and were unable to establish new credit through devices such as home-equity loans. One of the reasons we were moving fairly well through the mid/late-90’s and until the crisis had to do with rising home values. While wages stayed stagnant, home prices increased allowing people’s real incomes to rise when they refinanced their homes.
We know what happens with the value of ones home falls, credit dries up and their spending follows suit. So is the answer is to encourage home values to increase? Well not exactly, and here is where it gets sticky.
First off, most often a home is by far the biggest asset a family has – BY FAR. If their home’s value increases, their net worth increases and they can more easily access credit for purchases. However, a good investor has always stuck to the rule: don’t put all your eggs in one basket. And this is exactly what Americans have done, and because of the dream of home ownership, they will continue to still do.
So, if the value of homes increase, either A: people will stop being able to afford buying new homes and prices will drop to their equilibrium, or B: people will increase their leveraging to buy a house anyway with an even bigger chunk of their assets being put into the egg basket. (I suspect B to be the case.)
The problem we have with people pursuing option B is that with each “cycle” the problem becomes worse, and just like a big Ponzi scheme the people who are “in the game” require others to jump on board to stay afloat. When a crisis happens or people stop their housing binge the whole house of cards falls.
The only logical way to break this cycle is to cut the head off the snake. Reduce people’s leverage-ability by requiring higher down payments, as was always done, to buy a house. The result would be two-fold: people would reduce their dependency on the housing market and encourage households to diversify their investments. Less spending on bank interest from mortgages and required breathing room would give a boost to other consumer markets.
The second result isn’t so rosy, current housing prices will fall as there is a lack of ability for many potential buyers to put a sufficient down-payment on a new home. We then are hit with perhaps millions of homeowners being thrown back into insolvency.
To combat this, the government or banks would have to agree to a sort of padding for current homeowners. My idea is to allow the government to pay back any principle losses directly to the financial institutions, the result is people with home loans do not lose any equity or reduce their net-worth.
According to the census, there are roughly 75 million homeowners. Assuming housing prices fall 10% as a result of this policy, it would stick the government with a bill of $1.8 trillion. Of course that is a huge sum, which would have to be paid over time. But that is the cost the rogue financial system has footed America with.
Clearing American’s of this weighing burden that results in a vicious circle of banks reaping massive rewards while average Americans are leveraged and able to spend less and less should be a primary concern. If we really are a demand driven economy, then we desperately need to fix the housing and mortgage market to play by rules beneficial to America’s economic stability.