Debt

There appears to be quite a battle going on in the blogosphere between economists who think we should increase aggregate demand through loose fiscal and monetary policy and those who think that, since these were precisely the things that got us into the mess in the first place, we should be focusing on reducing personal debt levels and sovereign deficits.

This raises a few questions that I want to explore; firstly I want to talk about debt.

Lets first set up a few parameters.

Broadly, economic actors can be divided into individuals, corporates, and governments. But governments and individuals are closely tied together. But a government is, in a sense, simply a collection of individuals. Governments raise income from its individual citizens (taxes) and ultimately its liabilities (debts) are borne by its citizens.

Individuals' ultimate aim is to consume. Corporations goal is to make profit for its shareholding owners so that these owners can consume. Governments aim is to look after its citizens and enact their will.

Why do these three types of entity sometimes choose to raise debt, or, to put it another way, why do these entities sometimes choose to save some of their income

Reason 1 is to smooth consumption over time. The most obvious example of this is the student loan, and its opposite, the pension. Obviously, since students earn nothing, and their future selves will earn a lot more, it makes sense to transfer money from one's future self to one's present self. This is an intertemporal budget decision, and you have to pay for the privilege of being able to make this decision, through the interest that the student loan company charges.

Reason 2 is to increase overall lifetime income. For example, somebody might borrow money to buy a BTL property. They are doing this because they believe that this will provide them with investment income. Which it will. But in order to borrow the money to fund this purchase they have to pay interest to the bank. If the investment income is more than the interest, then, simplistically, raising the debt will increase overall income.

For a corporate, reason 2 is the only reason to raise debt. A corporate may raise debt to invest in a factory, that will increase its output, or to buy a competitor, or perhaps to simply fund working capital for a loss making operation in the belief that in the future the company will increase its profitability.

Before I discuss governments, lets go into a bit more detail on the household balance sheet. Let's say that someone is 25, and earns £40,000 after tax per year, and has a debt load of £200,000, on which he pays 5% interest (£10,000 per year). It's been used to fund consumption, in the belief that the person will earn more in the future, which he will use to pay off debt.

Is this "too much debt"? Or, put another way, was it a good idea for this person to go into debt? Basically there are a few things to consider..

a) Is the burden of financing so big, that it's defeating the whole purpose (which was to smooth consumption). I.e. since 25% of the persons post tax income is going on debt financing, then clearly he's consuming less than he could have done. Going to absurdity, if he had a debt of £750k, paying £37,500 per year in interest, then clearly he's screwed up. He can't consume anything, so his consumption smoothing has completely failed.
b) Will the "income/interest" ratio go up over time? I.e. will he really earn more?
c) Is the interest rate fixed or does he bear interest rate risk?

What about someone who has borrowed £200k to buy a BTL flat? Well here the question is clearly very different, and quite simple, namely, is the total return (income and capital appreciation) from the flat higher than the interest burden on the loan?

This is the question that companies face as well (actually it's a bit more complicated than that, since for companies (and really for individuals) you have to take into account whether you could get a better return doing something else...)

For Governments, you can make a similar calculation. Simplistically, if you put in place a fiscal stimulus, funded by debt, this is basically "consumption smoothing", and also "investing" where the investment is essentially in making sure that people are working and therefore adding value. There are therefore 2 questions. Firstly, does the investment produce a return higher than the cost of financing (i.e. is the actual value added by people working rather than being out of work higher than the cost of financing the debt and paying back the debt), and secondly, is the economy in a situation where increasing the debt load and financing burden can be done without defeating the whole purpose of the stimulus, i.e. will consumption drop because of the debt load increase.

a) Is the burden of financing the debt so large that it is self defeating

The curious case of the owner occupier

There's always a bit of vested interest involved when talking about house prices. As a renter, I naturally have a vested interest in seeing prices drop. It's natural to assume that owner-occupiers all have an opposite vested interest - to see prices remain stable or rise. This is not necessarily the case. In fact for a lot of owner occupiers the house price boom has been a disaster - and for some a crash would be extremely welcome.

Here's an example - I may have missed something crucial here - feel free to point this out!

Consider five people, Andrew, Bob, Charles, Dave and Edward.
Consider three times - 2002, 2007 and 2010 (dates picked purely as an example)
Lets assume that all house prices doubled between 2002 and 2007.
Lets also consider 2 scenarios for 2010, one where house prices remain stable, and one where prices drop 40%. I.e in the latter scenario a house which cost £100k in 2002 would go up to £200k in 2007 and drop to £120k in 2010.

In 2002, Andrew is still at university, Bob is a first time buyer currently renting, Charles and Dave are owner-occupiers and Edward is looking to sell out and go travelling round the world on a yacht.

In 2002 Bob buys Charles' 2 bed London flat for £200k. Charles buys Dave's 4 bed house for £500k and Dave buys Edwards palatial mansion for £1m. Edward goes off into the sunset and Andrew is getting drunk in student bars.

By 2007, Andrew is now a renter in London. The rest are still living in the same houses. Bob's 2 bed flat is now worth £400k, Charles' 4 bed house is worth £1m and Dave's mansion is worth £2m. Everyone is a happy bunny because of the money they've "made".

By 2010, Andrew is ready to buy, Dave wants to go off Yachting, and Bob and Charles want to move up the ladder.

Which scenario is better for these four? The one where there has been a crash or the one where house prices have remained stable?

Lets consider the stable situation. Andrew buys Bob's 2 bed flat for £400k. Bob gets £400k for this and has to spend £600k more to buy Charles' 4 bed house for £1m, and Charles gets his £1m and spends £1m more to buy the mansion from Dave for £2m. Dave takes £2m and goes off Yachting.

In the crash situation, Andrew buys Bob's 2 bed flat for £240k (400 - 40%). Bob gets £240k and spends £360k more to buy the 4 bed house for £600k. Charles gets £600k and spends £600k more to buy the mansion for £1.2m. Dave takes £1.2m and goes off Yachting.

As can be seen, everyone benefits from the Crash apart from Dave, since they all have exactly the same houses in each scenario, but the people at the beginning and the middle of the chain have to shell out much less money to get to their end state.

The only people who will genuinely suffer from a house price crash are those who go into negative equity and can't get out of it. They will have lost money and won't be able to move. Those who are in negative equity on their houses but CAN get out of it will be fine.

Consider situation 3 where, instead of house prices going down by 40% they go down by 60% by 2010.

Andrew buys Bob's 2 bed flat for £160k (400 - 60%). Bob gets £160k. He's lost £40k on his house purchase price. However, lets assume that he has £80k of savings, and so is able to move. He buys Charles' house for £400k,(£1m - 60%) i.e £240k extra. Lets ignore the savings - they are just a mechanism I introduced to enable Bob to move. So in the 40% crash scenario, Bob spends, in total, £200k for his first flat, and £360k extra for the new house = £560k total. In the 60% crash scenario, Bob spends £200k for his first flat and £240k for the next house = £440k total. Even though as an owner-occupier his house went into "negative equity", Bob is still better off with a huge price crash.

Weddings

I'm going through a bit of a wedding lull at the moment. Essentially this is because I know very very few people who are in a serious long term relationship with someone they've met after university, so any time in the last 8-9 years. Those that are don't look like they are in any rush to tie to knot (the one exception was someone who met someone, got married and then divorced in a three year period - not a shining example). Since all the university couples have already got married, my pipeline has dried up somewhat.

Anyway, last weekend I was at a wedding party for someone in their forties - I'm pretty sure I was in the youngest decile of the guests, and also pretty uniquely single. This is not a situation I'm usually in - I just don't hang around late thirties/forties marrieds much. It was surprisingly enjoyable. There's something particularly ego-boosting about being hit upon by attractive women who have left their husbands and children behind and are looking for a night out talking to someone new..

The Winners in the Housing Crash

Every day is bringing worse news in the US credit/housing disaster. I'm more and more convinced that the US is in big trouble. I'm also convinced that we won't be far behind.

Its tempting to think that when houses decline in price, people, in general, are "losing money". This isn't quite right however. What's being lost is wealth. No money has been created or destroyed!

Let's look at the flow of cash in housing.

Let's imagine a new build in California.

The land is orginally owned by a landowner, lets call him Albert.

A developer, lets call him Bob, pays Albert a sum of money for the land, "$A". The developer then builds a house on that land. This costs him labour and materials "$B" and "$C". In 2005 he then sells that house to a random punter, Charles. Since its at the peak of the boom, Charles pays a high price, "$D" for this house.

Now, again, since we're in a boom, D will be greater than A+B+C, i.e. the developer makes a profit, "P", where P=D-A-B-C .

Bear in mind also that, since it's boom times, there's a lot of building going on, so A, B and C will also be higher than you would expect in usual times. We'll come back to this later.

Charles, the purchaser, goes to a bank to borrow money. Lets imagine that he gets a 100% mortgage, with a standard variable interest rate (i.e. he's a prime customer).

The Bank basically gives Charles the whole purchase price, "D", which Charles then gives to the developer.

Fast forward 3 years and suddenly the house is worth a lot less. Let's assume that its dropped 30% in value, and is now worth 0.7D.

Theoretically this fall in value has been borne by Charles, the owner, who has "lost" 0.3D in equity. What actually happens of course is that Charles hands back his keys. The bank respossesses and then resells the property at 0.7D, losing 0.3D.

Obviously this is a very bad thing for the bank, and, on the face of it it looks as if that 0.3D has genuinely disappeared. This is not the case. In fact the 0.3D loss is perfectly counterbalanced by a 0.3D gain. Where is this? Well it's in A,B,C and P - i.e. its in the money that the landower, the building labourers, the providers of building materials and the developer made. All of these were higher than the would have been if the newbuild had originally been sold for 0.7D.

The question is where has this money gone? Here's where the real problem lies.

The money has, in most cases, been spent, either on locally produced or imported consumer goods. (O.k, they may have saved some of it.... but this is the US!)

The bank's loss of 0.3D has been transferred to these consumer goods manufacturers, resulting either in higher overall domestic GDP growth than would have been possible with a lower original selling price, or more profits for foreign manufacturers.

This is the real problem. The US has, overall, spent the wealth "generated" by the housing price boom, and therefore there isn't any offset to the huge inevitable asset based write offs. Oh dear.

BUT, lets not forget that the developers, labourers and landowners managed to consume a lot more in the past 3 years than they would have done under non-bubble circumstances. There were some winners...

EU referendum - does ANYONE understand this?

The UK parliament has just rejected plans for a referendum on the Lisbon treaty, the replacement for the binned EU constitution. The government claims that the treaty differs from the constitution (and is watered down enough) to mean that a referendum is no longer required. The tories (and significant numbers of Lib Dems and Labour MPs) disagree.

I doubt that there are more than a few hundred people in the UK who have read and understand the two documents. I am certainly not one of those.

The issue for the government is that any referendum which is marketed as a pro vs anti Europe vote (which it will turn into, whatever the details that are actually being voted upon) is almost certainly going to be won by the anti Europe side. Should our government really be spending their time trying to avoid having to implement the peoples' wishes?

Housing woes

It's appropriate that my first entry should be about housing. I've got a little bit obsessed about it. Housing and house prices are a fairly depressing aspect of economics to get obsessed about, for a large number of reasons.

1) House price economics is actually pretty complicated. There's a large number of things that will determine whether buying a house will be a "good decision" or a "bad decision", including future interest rates, inflation, how many houses get built, immigration, the health of the economy in general - predicting house prices is a difficult task. Trying to explain it to people usually results in headaches, both for you and for them.

2) Forecasters are often wrong about house prices. This is partly because of the number of factors in play, but also because house prices (in most economies) are highly prone to bubble behaviour - i.e. house prices will rise (and fall) above (and below) "economic fair value" prices, (whatever they may be - see 1) ! ), driven by speculative behaviour. Predicting house price changes is highly risky.

3) Housing markets work slowly. They take a long time to rise and a long time to fall. Claiming at a dinner party that "houses are overpriced and will fall" is a claim that will only be conclusively proved to be right or wrong years after the event.

4) There are lots of vested interests in housing. I'm one of them. I currently rent, and would like house prices to go down, since, in the long term, I want to make an investment in a house. Most people (in the UK at least) have vested interests the other way around. They want house prices to go up, since they own one. Estate agents want to drive prices up as much and quickly as possible in a boom (to encourage people to buy and sell), and as down as much and quickly as possible in a bust (again, to encourage people to buy and sell). Mortgage lenders always want prices to go up, so they can lend more money, and so the value of their security goes up, while politicians desperately want to maintain the "free" wealth creation (and stimulus to consumer spending) that house price inflation brings.

So in summary, being obsessed with housing just brings pain and suffering. There's nothing you can do to influence the housing market, you'll probably be wrong in all your predictions, and even if you're right, no one will thank you. Great.

Anyway - I'm highly bearish on UK property at the moment. The price of a house asset over the past 10 years has gone up to true bubble levels - there are absolutely no fundamentals that support current prices. I'll perhaps come back to this in another post, but right now I wanted to talk about what happens when things go wrong.

This has been prompted by the recent reaction of US policy makers and central bankers to the US housing crash and its fallout. Ben Bernanke has recently advocated some extremely odd responses to the fact that many households are under threat of repossession due to a combination of excessive monthly payments and an inability to reduce those through refinancing (since the value of their houses is now going down, rather than creating equity by going up). He is essentially recommending that, rather than repossess, lenders write off a proportion of the debt, potentially in exchange for gaining a claim on the equity appreciation upside in the future.

For example, if somebody had purchased a house 3 years ago for $300k using a dodgy sub-prime deal, and it was now worth only $250k, the original lender would, for example, write down the borrowers mortgage to $200k. The loan could then be refinanced on more normal terms. The bank takes some sort of credit to enable them to claim back their writedown when the house price starts going up again, and doesn't have to reposses the house, which is an expensive and socially destructive policy.

There are some good aspects to this. Repossession is undoubtedly a waste of resources (although the waste is not the same as the repossession process cost, since there is an advantage in repossession in allocating assets to those who can afford them). The problem is that if the banks really thought that this was a good deal for them, they would be doing it anyway. If Ben wants to get involved and add something useful than it has to involve either some kind of government guarantee, or taxpayer funded refinancing, both of which amount to a taxpayer subsidy to homeowners and banks.

I certainly hope that nothing like this gets proposed in the UK when the crash starts happening in earnest. Both homeowners and banks need to learn that borrowing/lending huge amounts of money to purchase an overpriced asset using large amounts of leverage is an exceptionally risky business. That riskyness brings great rewards, as can be seen from the people who have made large amounts of money from BTL (and selling out), but should also result in some casualities, in particular shareholders of overstretched mortgage lenders (Northern Rock shareholders should get nothing) and anyone who purchased in 2006/7, especially if they purchased a stupidly priced new build flat in any large city. Without some truly unforgettable pain, this whole destructive cycle of house price boom and bust is doomed to continue.

Testing, testing

So I thought I'd enter the blogosphere. This will basically be a place where I can put random musings. I don't expect anyone will actually read this, but as I get old and forgetful I'm thinking it would be useful to have a place where I can record thoughts. And I'd just lose a diary....

Topics are likely to include economics, politics, finance, philosophy, sport, restaurants, bars, films, TV shows and travel. Yup, its going to be pretty tightly focused. It might also get pretty pretentious at times, since I'm a pretty pretentious kind of guy.