Sunday, March 16, 2008

Forgive us our debts, Part 2

A very stimulating response from "Caronte" to the earlier post on debt reduction, so I've taken the liberty to bring the argument out front here.

Caronte, you say:

Suppose it is believed with absolute certainty that every 50 years, say every year divisible by 50, all debts are forgiven. There would follow a bunching of loan demand as the forgiveness date nears, while willing lenders would simultaneously vanish. The market would no longer match credit demand and supply, total welfare would suffer. Debt forgiveness would only avoid this problem if it was done by stealth, unpredictably, once and for all and never again. Like forgiveness of tax evasion or illegal buildings. Difficult to persuade debtors, (or builders, or taxpayers), that forgiveness would not occur again. Lots of people would be encouraged to borrow beyond what they can afford (or evade tax) – the moral hazard implication. Unsustainable indebtedness would multiply rather than disappear. Moreover, a defaulting borrower does not need forgiveness if she genuinely cannot pay: can’t pay, won’t pay, period. If the defaulting borrower has some residual wealth, though less than the outstanding loan, who is to deprive the creditor of that? What legal or moral right would support state action without creditor compensation?

Would “debt cancellation (or rather, reduction) … be a suitable punishment for the principal offender”? True: “the relationship between mortgage lender and borrower is unequal. You have to live somewhere, and if you don't buy, you have to rent - and rents will tend to reflect the purchase price of houses.” No more than the relationship between employer and worker. There are various way to reduce this inequality, workers can form Trades Unions and cooperatives, and borrowers can found building societies – until New Labour wickedly de-mutualised i.e. privatised this form of social property which was not theirs to privatise. But the main reduction of the inequality comes from competition among lenders (and among employers).

“By adjusting the ratio of deposits to loans as it suits them, lenders can multiply the money supply”. True, there is a credit multiplier at work when banks re-lend their deposits and get some new deposits as a result. If they were prevented from re-lending – by law or by contract – they would act solely as custodians (as in the early days of gold-money) and would charge depositors for the service instead of paying interest. And any act of individual saving would instantly reduce total demand by the same amount and cause unemployment. Besides, the ratio of deposits to loans is regulated by law and is variable at will only when it is higher than a prudential limit. And banks face the consequences of their bad loans, they can go bankrupt and their shareholders can lose all their capital. That’s punishment enough. As long as they are competitive, there is not much of a reason to “punish” them by forcing them to remit those bad loans that still have a residual market value.

“Rather than prop up the worst of the lenders, let them go down. Why should the taxpayer assume the burden?” Absolutely right. “Pay off the depositors” – if the bank can, or if there is a state guarantee. But why “shrink the lending book” by debt remission? If mistakes are always to be automatically corrected ex-post when they are revealed as such, the market disappears and with it all the conceivable advantages that it brings.

An Australian economist whose name now escapes me once wrote an article mocking the theory of general economic equilibrium – with its complete system of futures markets – by imagining a system of “past” markets in which economic agents could undo their past transactions that with the benefit of hindsight turned out to be a mistake. Just imagine. Debt remission would have some of the same effects.

I say:

Caronte, welcome, and many thanks for the length and thoughtfulness of your response. I don't pretend to have your economic expertise, but I still think there's a debate to be had. I'll try to tackle some of your points, not necessarily in strict order.

I suppose that in ancient Israel, the economy was not so monetised as today, so the advent of the year of Jubilee may not have been so disruptive as it would today. I don't really advocate a periodic debt cancellation - though I'm beginning to wonder about the necessity of charging interest. (Isn't it the case that some Swiss banks do in fact charge you for looking after your money securely, instead of making investments with it or lending it out to others?)

Competition between lenders may help keep down interest rates, but it's the ballooning of asset prices - and the consequent increase in the size of mortgage required - that causes the damage. So many are now locked into monster mortgages that a significant rise in interest rates - which otherwise might be appropriate for tackling inflation - is politically very unfeasible.

I argue that the price of houses is pretty much beyond the buyer's control, except that there's a point where a purchase is either not affordable (we seem to have reached that stage) or, as with subprime, fudged at the outset with disastrous consequences later. So I suggest the expansion of credit (for which, as you say, regulators also share responsibility), and the terms set by fee-hungry lenders and intermediaries, are more to blame than the family that wants a roof over its head it can call its own. Finance for cars and consumer goods is something else; a house is a necessity, and surely, owning one is not an unreasonable aspiration.

Banks should be, but are not being made to face the consequences - look how governments are propping-up Northern Rock and Bear Stearns.

Debt reduction does not seem unreasonable to me. If a life insurance company fails, the book of life business can be passed on to another provider, who is only required to underwrite 90% of the outstanding life cover. So why not for lenders who (through greed and stupidity) have gotten their sums wrong? A 10% reduction in the capital only represents a couple of years' interest. Better a borrower who repays a reasonable proportion of the loan, plus interest, than simply mail back the keys and leave the bank with illiquid stock it doesn't know how to manage.

This is not a problem limited to a single bank -and anyway, there are far fewer these days, and they are much larger, so one failure could really rock the boat. At worst, we could now be facing the prospect of mass bankruptcy, the crash of the credit system and general economic carnage. It's worth coming up with some fudge to keep borrowers and lenders going.

Here in the UK, you can enter an agreement with creditors and as long as you keep up the scheduled payments, interest charging stops altogether. Maybe that would be another way forward - the monthly repayment would be lower and the borrower would see his equity in the house increase over time.

We've been watching enslavement by money-owners who have been licensed to print almost unlimited amounts of their own money, but the poor man only feels it going past and can save none, so remains in debt-bondage. Better any reasonable rearrangement, than "I owe my soul to the company store".

2 comments:

Caronte said...

Is there a “necessity of charging interest”? Positive interest rates are indeed a necessity in a world where resources can more than reproduce themselves over time – as long as their physical productivity is not offset by a price fall. It is also rooted in human impatience and shortsightedness, the fact that we would rather have a bird in hand than two in the bush. Even in the Soviet Union in the late 1960s mathematical economist Leonid Kantorovitch, distinguished by the award of both the Lenin Prize and the Nobel Prize, wrote in the Communist Party Journal Kommunist an article justifying the interest rate on the ground that it was “the price of time”.

True, “some Swiss banks do in fact charge you for looking after your money securely”. They can do it not only because of safe custody but because they provide anonymity, financial re-cycling and laundering, security from detection and prosecution, liquidity, international mobility and other services. You could think of these services as a form of interest in kind. That’s something else. But Swiss Banks don’t charge you on your deposit “instead of making investments with it or lending it out to others”. Indeed they do lend and make investments with your money anyway. The prohibition on re-lending, necessary to prevent the multiplication of credit that you dislike, would force all banks to charge on deposits.

“… it's the ballooning of asset prices - and the consequent increase in the size of mortgage required - that causes the damage.” “the price of houses is pretty much beyond the buyer's control”. Yes, but equally it is beyond the seller’s control. A seller’s market is a misnomer for a situation in which at current prices there is excess demand; all it means is that prices are poised to rise. But no market is ever in the power of either sellers or buyers – except for the rarest cases of absolute monopoly, whether of demand or supply.

“… a significant rise in interest rates - which otherwise might be appropriate for tackling inflation - is politically very unfeasible.” In the last twenty years, since the doctrine of independent Central Banks focussing exclusively on inflation targets became fashionable, the problem is the opposite. Excessively high interest rate are being charged in the futile effort of holding down inflation even when this is caused by a major global re-distribution process – to monopolistic oil-producers from the rest of the world – over which no interest rate rise can have any effect other than inducing or aggravating a recession. Pace Monsieur Trichet. The Fed is different, they are statutorily required to target not only inflation but also long run interest rates, employment and the exchange rate.

“…the expansion of credit (for which … regulators also share responsibility), and the terms set by fee-hungry lenders and intermediaries, are more to blame than the family that wants a roof over its head it can call its own. … a house is a necessity, and surely, owning one is not an unreasonable aspiration.” Certainly. Unfortunately economics is not the science of reasonable aspirations but that of hard budget constraints budgets. Council houses, building societies, rent subsidies or controlled rents, a minimum guaranteed income, are/were all better ways of realising that reasonable aspiration.

On your two final points one can agree wholeheartedly. First, that “Banks should be, but are not being made to face the consequences - look how governments are propping-up Northern Rock and Bear Stearns.” Except that, wearing another hat, we are nearly all both borrowers and investors, and dislike the direct and indirect effect of a financial meltdown (or at any rate both categories deserve some concern). Second, that some automatic debt reduction of the order of 10 per cent – rather than total debt cancellation – may be a superior solution to chain defaults both for the potential defaulters and for the creditors. However, when this is indeed a superior solution there is nothing to stop creditors and debtors to get together to make such an arrangement.

SACKERSON said...

Thanks, Caronte, another meaty response.

Richard Daughty makes the point that with a fixed quantity of money and gradually improving productivity, the purchasing power of cash would rise over time. Wouldn't that be a reward for lending? And the risk is minimised by attaching assets, which of course used to be in much better ratio - no 100% mortgages.

And I agree that neither buyer nor seller can control the price of houses generally; but the expansion of credit floats the whole market, and for that, banks, regulators and governments are responsible. Wind the clock back 7 or 8 years and houses were more affordable, no need to be content with council houses.

Don't you think the government could have a role as marriage-maker, in helping lenders and borrowers to renegotiate terms?