Chips versus Smiths (or, Main Street versus Wall Street)?
posted by Realist Theorist @ 10:23 PM
A tale of three homes: Consider this tale of three modest suburban homes on Adams Street (1). The one in the middle is owned by Mr. and Mrs. Chips who have lived there for 28 years. The homes on either side of them were bought more recently.
Mr. and Mrs. Chips, retired in 2000. Purchased in 1980 at $100K, their house was valued around $200,000 in 2000 [a nominal appreciation of 3.5% a year (2)]. They paid off their 30-year mortgage in 25 years, using a few extra principal payments when they could afford them.
Between 2000 and 2006, the market price of the Chips' home started to rise by 6-7%, then 8-10% a year. Finally, in 2006, similar homes were being sold for about $320,000! These higher valuations were of little use to the Chips. If they sold, they would have to buy something else at equally high prices. Then, in 2007, home prices began to fall; by Jan 2009 their home was valued somewhere around $220,000!
In terms of direct impact, the housing boom and bust made no difference Mr. and Mrs. Chips. It was as if it did not happen. It was like a storm they slept through. If prices in general flatten out (deflation-like) while credit-money contracts, they would be happy, because their savings will go the extra mile.
The Ketchums moved in next door to the Chips, buying a similar house for almost $300,000. Their home value has plummeted too and they feel terrible, because it is far below what they paid. Of course, their 30-year mortgage is unchanged. They had originally budgeted for certain monthly payments and can continue to meet those even if the economy turns down for a while. This would eat into the "buffer" in their budget, and they would have to scrimp, but they would pull through as long as things weren't too bad for too long.
The Smiths: The house on the other side of the Chips was bought by the Smiths. They suspected they could not afford it; but, they stretched to buy it. They lied about their income and borrowed 90% of the purchase price. Even while taking on a long-term commitment, they did not think of checking what interest rates were (say) 10 years ago; they took an interest-only ARM with extremely low introductory payments, and hoped it would not reset at too high a rate. They hoped that in a few years their home would have risen in value and they would refinance and end up with a better "cushion" of equity. The Smiths' plan did not work out. Their home value fell, ruling out refinancing. Meanwhile, their interest rate went up from their introductory rate. They are hurting. If things do not get better soon, they might not be able to afford their mortgage.
Freeze: On the continuum between the Smiths and the Ketchums are many, many people who did plan and were fairly responsible, but who were blindsided by the false prices signals brought about by various government actions. These people probably form the vast majority of those who are finding it tough to pay their mortgages. The stock market fell on the realization of what was going on. Having fallen, things have now frozen. Fresh capital is on the sidelines (and parked in U.S. bonds) awaiting the end of the current uncertainty of ever changing government action.
Government action: The Smiths vote. So, the government wants to see as few Smiths as possible. Therefore, the government wants to help the Smiths. The typical ways the government "helps" are:
"the National Private Asset Base (to coin a phrase) of $50 trillion supported about $25 trillion of private debt, corporate and individual. Given that almost half of us have small or no mortgages, this 50% ratio seems dangerously high. But now the asset values have fallen back to $30 trillion, whereas the debt remains at $25 trillion, give or take the miserly $1 trillion we have written down so far. If we would like the same asset coverage of 50% that we had a year ago, we could support only $15 trillion or so of total debt. The remaining $10 trillion of debt would have been stranded as the tide went out!"
"Given where we are today, there are only three ways to restore a balance between current private debt levels and our reduced, but much more realistic, asset values: we can bite the bullet and drastically write down debt (which, so far, seems unappealing to the authorities); we can, like Japan did, let the very long passage of time wear down debt levels as we save more and restore our consumer balance sheets; or we can inflate the heck out of our debt and reduce its real value. (In the interest of completeness I should mention that there can sometimes be a fourth possible way: to somehow re-inflate aggregate asset prices way above fair value again. After the tech bubble of 2000 Greenspan found a second major asset class ready and waiting – real estate – on which to work his wicked ways. This time there is no new major asset class available"
"Our path this time is likely to involve a hybrid approach: we will certainly take some painful debt liquidations; this crisis will almost certainly take far longer than normal to play out; and probably, before a new equilibrium is reached, we will see inflation rates that are well above normal."
(PS: This is not an endorsement of Grantham as such.)
Wall Street vs. Main Street: Our current economic situation has often been described as "Wall Street versus Main Street". This is not merely how the "left" sees it. Many on the "right" see it the same way. Witness, for instance, the suggestion that John Rich's populist song "Shutting Detroit Down" could be the anthem of the "tea-parties"(3). Any song that vilifies "Wall Street, in that New york city town, while in the real world they're shutting Detroit down", is based on the same populist thinking that created this mess in the first place.(4)
The culprit in today's mess is the government's promotion of home-ownership over many decades (and every voter who supported those subsidies over many elections is culpable). It is the government that created mortgages deductions, the CRA, Fannie and Freddie. Finally, it is the government that kept money rates down after the Internet bust.
Nevertheless, even suppose we ignore the main culprit and look for the chief accomplice. Then too, we do not find "Wall Street" as such. Rather, we have a few financial companies who were accomplices and the vast majority who were not. And, we had a few Main Streeters, like the Smiths, who were accomplices, and the vast majority like the Chips (and Ketchums) who were not (5). The "Main Street versus Wall Street" idea is false and unjust. Any policy built on that foundation will likely be wrong. The Main Street vs. Wall Street idea must be strongly rejected.
Parallels with the Great Depression: The great depression was started by Republican President Hoover. In 1929, the stock market plummeted. Instead of letting it rebound, as it would surely have done, he decided to go into "freeze" mode. This was the exact opposite of what was required. He convinced businesses not to drop wages. This led to extremely high unemployment. He championed the Smoot-Hawley tariffs, when just the opposite was needed.
Notes:
(1) Serves as demonstration, but is fictional
(2) The CPI more than double from 1980 to 2000, so their home actually lost value in real terms. This is quite typical for real-estate.
(3) Here's a blogger who objects to that characterization
(4) Analysing that song could be a blog-post on its own.
Mr. and Mrs. Chips, retired in 2000. Purchased in 1980 at $100K, their house was valued around $200,000 in 2000 [a nominal appreciation of 3.5% a year (2)]. They paid off their 30-year mortgage in 25 years, using a few extra principal payments when they could afford them.
Between 2000 and 2006, the market price of the Chips' home started to rise by 6-7%, then 8-10% a year. Finally, in 2006, similar homes were being sold for about $320,000! These higher valuations were of little use to the Chips. If they sold, they would have to buy something else at equally high prices. Then, in 2007, home prices began to fall; by Jan 2009 their home was valued somewhere around $220,000!
In terms of direct impact, the housing boom and bust made no difference Mr. and Mrs. Chips. It was as if it did not happen. It was like a storm they slept through. If prices in general flatten out (deflation-like) while credit-money contracts, they would be happy, because their savings will go the extra mile.
The Ketchums moved in next door to the Chips, buying a similar house for almost $300,000. Their home value has plummeted too and they feel terrible, because it is far below what they paid. Of course, their 30-year mortgage is unchanged. They had originally budgeted for certain monthly payments and can continue to meet those even if the economy turns down for a while. This would eat into the "buffer" in their budget, and they would have to scrimp, but they would pull through as long as things weren't too bad for too long.
The Smiths: The house on the other side of the Chips was bought by the Smiths. They suspected they could not afford it; but, they stretched to buy it. They lied about their income and borrowed 90% of the purchase price. Even while taking on a long-term commitment, they did not think of checking what interest rates were (say) 10 years ago; they took an interest-only ARM with extremely low introductory payments, and hoped it would not reset at too high a rate. They hoped that in a few years their home would have risen in value and they would refinance and end up with a better "cushion" of equity. The Smiths' plan did not work out. Their home value fell, ruling out refinancing. Meanwhile, their interest rate went up from their introductory rate. They are hurting. If things do not get better soon, they might not be able to afford their mortgage.
Freeze: On the continuum between the Smiths and the Ketchums are many, many people who did plan and were fairly responsible, but who were blindsided by the false prices signals brought about by various government actions. These people probably form the vast majority of those who are finding it tough to pay their mortgages. The stock market fell on the realization of what was going on. Having fallen, things have now frozen. Fresh capital is on the sidelines (and parked in U.S. bonds) awaiting the end of the current uncertainty of ever changing government action.
Government action: The Smiths vote. So, the government wants to see as few Smiths as possible. Therefore, the government wants to help the Smiths. The typical ways the government "helps" are:
- change the contract (the Smiths' mortgage), or -- more within the law -- lean on banks to do so
- tax the Chips and Ketchums and give the money to the Smiths, to help them pay their mortgage; or, give the money to the banks to cover some of their losses from the Smiths
- use money-creation, so that the Chips and Ketchums don't complain about higher taxes, and if prices rise a few years from now... deal with each election as it comes up
"the National Private Asset Base (to coin a phrase) of $50 trillion supported about $25 trillion of private debt, corporate and individual. Given that almost half of us have small or no mortgages, this 50% ratio seems dangerously high. But now the asset values have fallen back to $30 trillion, whereas the debt remains at $25 trillion, give or take the miserly $1 trillion we have written down so far. If we would like the same asset coverage of 50% that we had a year ago, we could support only $15 trillion or so of total debt. The remaining $10 trillion of debt would have been stranded as the tide went out!"
"Given where we are today, there are only three ways to restore a balance between current private debt levels and our reduced, but much more realistic, asset values: we can bite the bullet and drastically write down debt (which, so far, seems unappealing to the authorities); we can, like Japan did, let the very long passage of time wear down debt levels as we save more and restore our consumer balance sheets; or we can inflate the heck out of our debt and reduce its real value. (In the interest of completeness I should mention that there can sometimes be a fourth possible way: to somehow re-inflate aggregate asset prices way above fair value again. After the tech bubble of 2000 Greenspan found a second major asset class ready and waiting – real estate – on which to work his wicked ways. This time there is no new major asset class available"
"Our path this time is likely to involve a hybrid approach: we will certainly take some painful debt liquidations; this crisis will almost certainly take far longer than normal to play out; and probably, before a new equilibrium is reached, we will see inflation rates that are well above normal."
(PS: This is not an endorsement of Grantham as such.)
Wall Street vs. Main Street: Our current economic situation has often been described as "Wall Street versus Main Street". This is not merely how the "left" sees it. Many on the "right" see it the same way. Witness, for instance, the suggestion that John Rich's populist song "Shutting Detroit Down" could be the anthem of the "tea-parties"(3). Any song that vilifies "Wall Street, in that New york city town, while in the real world they're shutting Detroit down", is based on the same populist thinking that created this mess in the first place.(4)
The culprit in today's mess is the government's promotion of home-ownership over many decades (and every voter who supported those subsidies over many elections is culpable). It is the government that created mortgages deductions, the CRA, Fannie and Freddie. Finally, it is the government that kept money rates down after the Internet bust.
Nevertheless, even suppose we ignore the main culprit and look for the chief accomplice. Then too, we do not find "Wall Street" as such. Rather, we have a few financial companies who were accomplices and the vast majority who were not. And, we had a few Main Streeters, like the Smiths, who were accomplices, and the vast majority like the Chips (and Ketchums) who were not (5). The "Main Street versus Wall Street" idea is false and unjust. Any policy built on that foundation will likely be wrong. The Main Street vs. Wall Street idea must be strongly rejected.
Parallels with the Great Depression: The great depression was started by Republican President Hoover. In 1929, the stock market plummeted. Instead of letting it rebound, as it would surely have done, he decided to go into "freeze" mode. This was the exact opposite of what was required. He convinced businesses not to drop wages. This led to extremely high unemployment. He championed the Smoot-Hawley tariffs, when just the opposite was needed.
Then came Roosevelt, inheriting this depression, and he extended the depression for many more years. One feature of Roosevelt's term was the president's vilification of businessmen in class-warfare terms. We must learn from that history.
Notes:
(1) Serves as demonstration, but is fictional
(2) The CPI more than double from 1980 to 2000, so their home actually lost value in real terms. This is quite typical for real-estate.
(3) Here's a blogger who objects to that characterization
(4) Analysing that song could be a blog-post on its own.
(5) To repeat, this is not to suggest that everyone who is trouble now -- bank or borrower -- was irresponsible. When the government interferes with the market, it is hard to know what is irrationally risky and what is irrationally cautious. So, while some borrowers and lenders were irresponsible, many were victims themselves.
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