The current money market and housing market problems are underpinned via a common root problem, so I will treat them together. Government plans to solve the woes of the money markets and housing market are short term tactics, probably designed largely to get the government past the next general election. These plans don’t recognise the underlying problem and its causes. Also late in arriving, they instead treat some of the obvious symptoms. So, as it is unlikely that the government will do what is needed, we must recognise how best we might adapt our plans. Although the root problem for both market systems is the same, the symptoms are different.
The Symptoms
The housing market symptoms have increasingly been affordability issues for first time buyers and recently price falls leading to the infamous negative equity trap for some. Government plans to tackle affordability for first time buyers by allowing them to own a fraction of a property exasperate rather than alleviate their problem. People will commit what they can to get a house, so enabling fractional ownership simply allows the same financial commitment for a fraction of a house. Obviously, this in turn increases the price for the whole house. No one wants to spend any money on buying a house, prices are dictated by how much people are allowed to spend by lenders. Fractional ownership simply increases that allowance. There are no direct plans to help those in the negative equity trap, which reduces the mobility of the workforce and so is bad for the economy.
The financial services industry has a crisis in confidence that has stifled the free flow of money. Money is a vector for the flexibility and growth of an economy, so this impediment will have far reaching implications for the UK and is the biggest single problem we face now. Government plans to restore confidence to the money markets using bonds in exchange for property backed debt are not solving the root problem. Instead this tactic dilutes the problem by spreading it over time and distributing losses to the public purse. Another possible tactic seeks a quick correction of the problem by compressing the problem in time and localising its effects. The latter tactic, although less intuitive, has a number of advantages, prime among them is returning the economy more rapidly to a better state. As a result, even those most impacted have time to recover and more obvious measures can be enacted to restore confidence, which is certainly one of the most important qualities of a market based system. Now the problem exists one of these tactics must be employed, as the over valuation of property has to be normalised, implying losses for those that bought in late. The only question is how much to dissipate and slow those losses. It should also be noted that as the government does not in fact have money reserves to back these bonds, so their effect is ultimately inflationary. Also the drawn out tactic using bonds disengages the debtor from the consequences of their poor judgment, which has obvious negative effects.
The Root Problem
The use of residential property as an investment vehicle is at the root of both the money markets and the housing market problems. There is a complex interplay of many causes, but the two most prominent are: Firstly, pension savings are inflexible, not protected and are subject to means-testing. The lack of confidence people have in pensions has encouraged them to find alternative savings vehicles. Secondly, poor understanding of investment markets by amateurs who have access to them with residential property. Profiteering using markets is as old as humanity, but amateurs using them with residential property is a bad idea. Stability of residential property supply is too important to allow it to be used as a tool for speculation which inevitably leads to the decoupling of prices from earnings.
So how should the government tackle this twin causes. Firstly, they must introduce a government backed flexible pension scheme linked to contributions that is not means tested. Importantly, these savings must be ring-fenced and protected in law to prevent misuse. This will provide a safe haven for people with savings and reduce the tendency to use inappropriate savings vehicles as pensions. Secondly, the residential property market is too important to be used as a speculative investment tool by people with a poor grasp of its consequences. Strong controls need to be applied to the total percentage of income and its sources used to repay residential mortgage debt. Naturally, to discourage the inevitable attempts to circumvent these controls significant penalties need to applied to transgressors. It will be difficult to fabricate this control and it will need continual tinkering with to perfect, but it is essential. The ideal time to apply these controls is approaching when we reach the bottom of a property price dip. This root problem will keep recurring until it is addressed by providing a sensible pension scheme and controls designed to strongly correlate residential housing prices with earnings.
What Can We Do
Given that the government is unlikely to see the light and tackle this problem correctly as I outlined above, what can we do for ourselves.
On housing, timing is important. There will be a bottom to the housing market price falls. If you are planning to get into the property market or move, the best time to do so is at the bottom a price slump. In the end it is not the relative price of a house that matters to you, it is the amount you borrow to pay for it. That amount is always going to be lowest at the bottom of a price dip. If you want a house that costs twice as much as your current house is worth, that is easier to fund if for example your house is worth £100,000 rather than £200,000. Naturally as we get further from the bottom the less good a deal we get, but caution need only be exercised where there have been years of house price rises above wage growth. This is very difficult to do when prices are rising rapidly, but that is the time to save until the inevitable price crash. Those who are brave enough, or have no choice can get in and try to get out when they feel a good profit has been made. However, this is a very risky venture because typically the sums of money involved are large relative to income. If you do try this approach, a mercurial nature is essential. On sensing the market is topping out, sell fast and strongly discount your price to ensure a quick sale. If the price is not good enough and you are left holding the property too long you will have to discount even further later.
The financial sector has experts that understand their problems well enough. Unfortunately, those experts are not directing the businesses and so short-term and badly formed strategies still get used. It is in the interests of their directorships to ensure that directors and senior management making strategic and significant tactical decisions are well enough educated in the fundamentals of their business. General businessperson and salesperson types without the correct background simply do not have the depth of understanding required. In addition the board should sponsor multiple technical reports on the viability of any significant shift in strategy. They should also have clauses in the contracts of the most senior figures that prevent severance payments in situations where it is considered a poor strategy has lead directly to losses. This will not discourage good people from competing for these positions, in part because nobody takes one with the expectation of failure.
Understanding the Credit Crunch
This post documents my understanding of the credit crunch and its associated ructions thus far, along with some wider understanding of related important economic factors. In it I address: what are the problems, what caused the problems, what are the consequences of the problems, what is being done to fix the problems and what are the consequences of this fix.
What are the problems
The problems are manifold and the pressing problems for individuals such as elusive credit, falling house prices and job insecurity are really consequences of problems in a larger picture, so I will focus on that. That larger picture has two important players, the large financial institutions and state / central banks controlled by government(s), together they modulate economies. The main macro scale problem for the money lenders seems to be a lack of confidence in their ability to avoid collapse under the weight of bad debt. Specifically, it is the fear that much more than expected of what has been lent will not be fully recovered and lead to large enough losses to make the lender unable to continue in business. The main macro scale problem for state / central banks seems to be the possible collapse of money lenders, especially those that also provide savings services. The collapse of large financial institutions will have a negative effect upon the confidence of the whole financial system that could cause a cascade of secondary problems through an economy.
Certainly there is a poor position on mortgage debt and one does have to wonder how it was not obvious to the lenders that they were getting into it, but that does not mandate rampant defaulting on repayments. It was obvious to me for years that a property bubble was forming and would need correcting. I always assumed it was even more obvious to lenders and that they had calculated the best level of risk to accept in order to maximise profits, balancing those that would continue to pay with defaulters. It is rather a surprise and suspicious that they claim not to have seen it coming. Regardless, the lack of lender confidence slows down business as usual and perversely increases the probability that lenders will fail. It is the cessation of business as usual at the money lenders that is creating the dramatic economic effects. Unless we can identify the causes and find fixes for the problems the fear of failure will translate into actual failure and the problems will be amplified.
The credit crunch problems are exasperated by shortages of food and fuel causing steep price increases. These are a simple consequence of supply not keeping up with demand. Although their timing is unfortunate they are only related in so much as they restrict consumer spending patterns, which has a deleterious effect on business, slowing overall growth and confidence.
What caused the problems
Housing has increasingly been used for profiteering. It always has been used this way by architects, builders, mortgage providers, landlords, estate agents, solicitors and surveyors, among others. However, recently two classes of interested party have burgeoned. One class is the speculators. Speculators have no product and offer no service, they are simply there to profit and are the biggest cause of the problems. Speculators pump up what they have already identified as hyperinflation in prices. Some speculators may call themselves ‘property developers’, but they do little or nothing but profit from a bubble situation. Just to be clear, people who take out buy-to-let mortgages are also speculators, they differ from traditional landlords in that they must borrow to acquire property to let. This is obviously a risky practice and inflationary for property prices. The other notable problem class is those with meagre means being offered excessively easy terms to buy.
Property was bought with increasingly easy to obtain loans for increasingly tangential reasons; for example: buy-to-let property, holiday homes, weekend homes, university accommodation and just plain resale i.e. naked speculation. This combined with the demands of rapid immigration and a property supply that did not increase quickly enough, to cause unsustainable house price rises above wage rises. Housing, like pensions is too important to be used in that way, government should impose controls to prevent its misuse.
Some of this profiteering is long term, with people using it as a pension because of the poor quality pensions. The UK government does not provide a sound pension scheme, except naturally for themselves and other public sector workers. A good pension scheme should: be 100% underwritten by the state, have a guaranteed minimum growth rate, be contribution based, have a guaranteed minimum pension at the end regardless of contributions but based on time resident, be index linked, not be means tested, be ring fenced and protected by law. It seems the government believes that only the public sector are worthy of a good pension. They are, as ever, helping themselves.
So the causes seem to be increasing use of residential property as a means of speculation and pension savings combined with poor lending criteria. The problems only seem to have become visible when the inevitable increasing bad debt arranged with less financially solvent borrowers as mortgages on inflated property prices precipitated a collapse in confidence. That increase in defaulting was triggered by an increase in interest rates which were held low for a prolonged period to avert the worsening of the previous economic slowdown. During that period many poor loans were made that could never be sustained on a return to more normal interest rates.
What are the consequences of the problems
Debt is used as money i.e. the potential to recover money at a profit from loans is being treated as money. This works well enough if you know that the loan will be repaid with interest. Unfortunately, not all loans are repaid, some fail and money is lost, but as this is statistically at an expected level its effect of reducing the value of the rest of the debt can be taken into consideration. When that rate of failure jumps, confidence plummets in the value of the loans and they are less valuable alternatives to money. The loss in confidence in their own loans and those of other lenders who were similarly unwise, tends to restrict them from lending to all classes of borrower, including each other, to reduce risk. This has the effect of reducing the number loans made, how adventurous lenders are, how high the repayment rates are and how much collateral is required. Those changes in turn make it difficult for business to borrow for expansion and ride out problems and so employment and the greater economy suffers. Also, reduced borrowing by consumers slows spending, with the effect of reduced opportunity for businesses to profit from sales.
We may wish to consider the sustainability of economies built upon the premise of continuous growth in consumption. Large disparities in the relative sophistication of economic development must be sustained and the more sophisticated economies need to retain the perception that their economic model is best. If they fail in either part, people will stop pursuing the growth model. Debt has potential for significant further expansion providing lenders can consolidate to drive economies of scale and operate on tighter margins and apply pressure to keep interest rates low enough that borrowing is the only obvious route for many purchases.
What is being done to fix the problems
Firstly it is rather worrying and suspicious to me that the state / central banks seem to have been as blind to these problems as the money lenders claim they also were. Can they really be surprised that many years of house price growth above wage growth fuelled by low cost loans would lead to problems when interest rates rose. It seems so stupid that I would be quite credulous if a plot of grand proportions to profit under the guise of the credit crunch was revealed to me.
Anyway the government tactic to solve this problem is to get the state / central bank to lend money to the lenders. That should enable the lenders to keep trading, as their confidence of surviving problems is increased and the whole system stabilises. There are still a lot of loans that will take time to become worth what was lent, as property prices can take years to normalise, or they can be normalised quickly but catastrophically for some. Unfortunately, the government doesn’t have any money to lend, in fact it is itself a big borrower. So as neither has any immediate money the government has offered bonds (which currently are sufficiently sound to be considered as good as money) in exchange for quality debts of the lenders, proving certain guarantees are made. This is following the drawn out normalising process, rather than the rapid normalisation process. The former has the advantage of apparent stability in the short term, but the disadvantage of producing a tardy correction for the medium term and so slows the economy as a whole. The latter is better in the medium term as it affords all parties more time to recover, even the worst hit, but is worse in the short term for those in the worst positions and for general confidence if the effects are not well isolated. Both approaches will be equal in the long term as normalisation must occur.
One feels bound to ask here: who has the money. It seems that everyone is borrowing money, somebody must have some. An interesting question and to answer it one needs to remember that money is just a vector for production i.e. work done multiplied by efficiency; twice as efficient gives twice the production for the same amount of work. So the question should be: is there enough production to pay for the debt. One buys things with ones own productivity, but that includes recycling the productivity of others; specifically in creating the basic inputs to ones own work. If there were a finite amount of productivity in the world then clearly there could be no growth and so any debt should remain static. However, increasing populations and efficiencies, particularly in currently low technology economies, provide the continued growth in productivity. That is likely to continue and so debt levels can also increase, but they should not increase faster than the rate of increase in productivity.
Whether productivity is increasing or not, what level of debt can be sustained? Can it be as much or even more than the level of production? I think the answer to these questions is in confidence in the stability and predictability of the economy, markets and debt arrangements. As long as we have confidence that a debt will be repaid as arranged we can increase debt. If sufficient confidence exists then there is no reason why debt could not be arranged that could span whole lifetimes or even generations. The obvious inference from this is that we can have more debt than earnings, so long as we can sustain confidence in the stability and predictability of the economy, markets and debt arrangements. I would suggest that we are already in such a position and that explains the state / central bank conservative tactic of protecting the status quo as the least risky but otherwise least sensible option. Clearly a strategy for preventing the situation is preferable. That would imply a clutch of strong measures and checks to provide the required stability.
What are the consequences of this fix
Normally the government sells bonds to raise money. Bonds are a promise that the government will repay the money in the future; in the interim they will pay interest on the loan. The government (tax payer) must pay interest to the bond holders and in this case gets in exchange for those bonds another less reliable form of debt from the lender, rather than money and that makes the lenders more confident. Unfortunately, the country now owns the poor quality debt instead of money and is paying interest on it. In fact as we know the value of the mortgage debt the country has now acquired is over rated, not only is the country paying interest for these loans, it will have to wait years for them to be worth their face value. The net effect of all this is that the profits of the lenders in the bubble years have been protected by the government at the expense of the tax payer. Greater government debt must be paid for by taxation or cuts in services. Although this is a terrible deal for the people as a whole the government is essentially arguing that it is better than a collapse of financial institutions with potentially catastrophic ramifications. However, it may be that a better deal for the tax payer is a tactically managed collapse where the worst institutions are isolated and made to carry the whole burden.
A proper strategy to avoid us getting into this kind of situation would of course be preferable and that needs a slew of measure to check for abuses and imbalances. Unless such a system is put in place we face the probable repetition of this situation in the future.