4.4 Debt relief

Is it an accident or direct cause that recession arose through excessive mortgage indebtedness?

During previous 10 years house prices were rising more than inflation. People were happy from the property boom, there was surety that house is the best investment and its value is steadily raising. This gave them feeling of safety and supported their buying spree. This feeling was however based on irrational basis.

If a family has one child, parents can say that increase in value of family house represents future inheritance, which is compensating higher price that this child will have to pay for his own home. It is however only weak remedy for total higher living costs. There is also the risk that value of property will go down and so the proceeds from sale of parent’s house will be lower than the price of his own new home. Main problem in this model is the fact that with only one child human society is destined to extinction. To maintain stable population, there is a need to have at least 2,1 children that is minimum two kids. So even with ideal economy developments, where house prices would be rising without interruption there would be no long term profit from that as society as a whole would be walking towards extinction.

If family have two children, when property prices are rising the value of family home is rising as well but during its sale and division of inheritance between two kids the proceeds per child are not enough to offset the increased price of new home that each child had to pay (offset is only 50%) and so the total balance of wider family is negative. Children have worse financial situation than their parents, because their buying power is smaller than their parents (due to higher mortgage installments).

With three and more children the situation is even worse.

Rise of property prices is very illusionary benefit. In reality it causes diminishing of buying power and it is binding it to bricks and mortar for decades.

So are the efforts to revive the economy by restarting the growth of property prices. This kind of thinking is evidence of not understanding of principles of causes of recession and how these sources are manifesting in the real life. To try and measure revival, green shots by increasing property prices is utterly counterproductive.  That’s how the recession started. 

The recession came because through consecutive rising of house prices there was also corresponding increase of mortgage installments and so the aggregate demand was diminished. Year by year. That decrease in buying power was temporarily replaced by loans (often backed by mortgage) but repayments of these loans were decreasing the buying power even more.

Every year in which the prices of property were rising more than inflation (and with it the salaries) the volume of permanent buying power, which does not have to be financed by loans, was decreasing.

The solution of the problem is the solution of its source and also its consequences. Through partial debt relief that is transfer financed from monetary stimulus or taxes the state will pay certain part of mortgages. The final effect is immediate and permanent increase of buying power of citizens, as decrease of mortgage installments is also permanent.

 This method can be used to improve financial situation in certain geographical location. It is possible to lower mortgage indebtedness in certain states, counties which are hit by the recession the most and so stimulate these areas which need it most.

If somebody starts thinking why we should repay somebody’s mortgages, just because they were not able to calculate that they will not be able to repay them the answer is the following:

Millions of people lost their jobs and roof above their heads without any fault of their own. Financial recession, caused by greedy and stupid banks ruined thousands of businesses and how is the problem being addressed today?

The very same banks that caused this are being bailed out, FED is providing them billions of cheap loans to survive and in spite of all this it is not working. Why pour the finances to the banks, where effect is only in strengthening the balance sheets, but is not contributing to missing demand? If bank gets cheap money, the only thing it can do with them is to lend them again

But during situation where our neighbors are losing jobs and houses the willingness to borrow is rather low. Even if people started to borrow, what they cannot repay back, we would be back to the square one. Cheap credit is getting only to speculators who are investing them to shares thus causing their prices to go up. The yield goes down, investors will be asking increase in profits which will cause pressure to inflation. With general decline of buying power the rise in inflation will cause further deterioration of living standards.

Instead of pouring money to banks it is suitable to put them to the second side of the equation – to mortgage saddled citizens. That will decrease their monthly installments and boost their buying power. Through partial debt relief the balance sheets of the banks will be equally strengthened, the similar way as through direct cheap loans from FED. But the final effect to growth is incomparable. It is also immoral to give extra loans to banks, which caused the crisis and not to provide them to people directly, as only people can start the economy moving again.  Partial repayment of mortgages is the same as providing the ultra cheap loans to citizens.

Correct approach should be to decrease indebtedness of citizens directly:

All these types of transfers (structural projects, family support, pensions support, debt relief) have similar effect – they are stimulating the economy as they are generating buying power of citizens which is causing increase of sales and ability to achieve the planned sales. Without their existence there is no possibility to achieve profit long term.

Limits of supply side stimulus.

It is important to again address the fact that some banks are being bailed out and some are not. This is viewed by wide public as highly unfair practice, one that is clearly stinking by oligarchic manners. If you are too big to fail, you can do any kind of stupid and risky deals and in the event things go wrong the taxpayers are left with the bill. Of course, if short term profits materialized OK, there would be no adequate profit sharing with public. We economists understand the need to preserve the functional banking system and the risk of massive systemic failure of it in case of inaction during such domino failures. But public does not. And also small banks that went under just because their clients were not able to pay their obligations because they lost their jobs en masse in the aftermath of financial meltdown caused by too big to fail feel that double meter was used. And what about the thousands and thousands of small businesses? Why they had not been bailed as well? Why secondary victims of financial crisis are left to the wolves and primary culprits are being saved? Sure, sure, too big to fail.

But in this case we are not speaking about capitalism, or democracy.  What we have in here is pure corporate fascism. Some entities are getting preferential treatment because their size. This was case not just for banks, but also automakers and other financial companies like AIG. Without regard of success of such bailouts we must think about the future. The very democracy here is at risk. The issue is not how many jobs were saved by the measures taken, but the very fact that such measures were seen as inevitable to prevent total meltdown.

Because if the governments took such steps and they were truly necessary, then similar alleviations should had been provided fairly to all market participants. That would be fair, that would be democratic. And if we agree that government should provide relief to market participants to overcome the worst recession in modern history, that there is a reasonable point in logic that government should rather provide preventive aid to all market participants based on equal approach in order to prevent the crisis than consequent “firefighting” and more costly efforts.

What are we speaking about?

The post crisis bank saving measures by FED and other central banks around the world through pouring huge liquidity into banks and quantitative easing is in fact still help to the supply side only. And that in highly developed economies with mature markets might simply not be good enough.

Imagine a neighborhood, where there is high unemployment, low salaries, simply a poor neighborhood. And there is a place, perfectly suitable for a restaurant. Because there is this perfect spot and there seems to be a need for such establishment, as there is no other restaurant nearby, there comes this savvy entrepreneur and applies for a loan with the bank. He gets it and builds a wonderful place. But as the neighborhood is really short of excessive buying power, the restaurant is not prospering and eventually goes bust. Bank takes a hit and has to write off this loan. But during the time the restaurant was still struggling it was paying wages to its employees who in turn were able to spend and so was supporting the mini economy of their neighborhood.

After a time, another entrepreneur comes there and says: What an opportunity!
And so he goes the same route as his predecessor with similar results, and another bank suffers the loss. This scenario can repeat in many forms, scales and geographic locations, but the common ground is based on fact that there was a monetary stimulus provided to the economy in the form of business loan which generated employment, wages and from it stemming consequent additional buying power which contributed to profit making in particular area. But as the corresponding buying power which was expected to support the original business venture is not adequate and sustainable, it collapses and causes a loss of capital in the banking sector. The byproduct of such buying power injections are profits at some other businesses that benefited from increased overall demand, fuelled by wages of failed companies.

This is the nature of supply side of monetary stimulus. It provides wages, coming from bank capital, which are lasting for the duration of venture built with such bank capital. After the venture goes bust, bank capital takes a hit. Monetary stimulus provides new, cheap capital to the banks to start lending again, but it is not addressing the reasons why the venture collapsed and so caused the need for additional monetary stimulus.

Without the corresponding boost of demand, which would be permanently matching the new supply created, such new venture (supply entity) has no chance to survive or can survive only at the expense of another supply entity.  The examples are plentiful: Nokia, Blackberry surrenders to Apple, Sony and Panasonic are being beaten by Samsung… It is a dog eat dog world. It is a wonderful mechanism which brings about innovations and technological progress as only new and better, cheaper products are getting chance to survive. But is not answering the problem of increased or just sustainable consumption at mature, concentrated markets. After some time there is no one willing to build that “restaurant” business again as there is already wide spread knowledge that it will simply not succeed.  It does not matter how good the offering will be, there are simply no customers there with enough money to support it.

Banks are not willing to lend, as they are also fully aware of the fact of missing demand and regardless how pro-business they are, there is no sense of throwing money into black hole. This is the point in time, where supply side stimulus of cheap central banks money is not going to do any good to the economy as all participants are already in understanding that the problem is at the Demand side.

And if this is the case, then the preventive role of the government is to boost the overall demand of its citizens by any of above mentioned methods.  There is no point of permanently boosting the supply side only to see how ineffective these efforts are. Dog eat dog world is good in rapidly developing countries where new inventions are everyday reality. With mature markets, and massive unemployment there is a space for live and let live approach, which is facilitated by supporting the aggregate demand. The entrepreneurs should be given a chance to be rewarded for their risk taking by supporting the sustainable demand.

Which side to support, whether supply (through cheap credit) or demand (by supplementing demand) is easy to decide by level of unemployment and production capacities utilization. If unemployment is high and factories are not working at 100%, then demand side needs help. If unemployment is OK and economy is not significantly beyond its production potential then supply side should be given green to go.