Keen on taking “The Pill” • George Warren
According to Australian economist Steve Keen, capitalism’s crises have always been a product of the financial sector funding speculation on asset prices rather than just funding business expansion and innovation. Regardless of the endless inducements from the finance sector to lead the consumer into debt, commitments by the public to necessary personal debt are generally related to and regulated by their personal income. Commitments to debt for the purchase of speculative assets, on the other hand, are related not to personal income, but to expectations of leveraged profits on rising asset prices–when the factor most responsible for causing the growth in asset prices is accelerating debt. In the early 2000s, homes became such an asset.
This allows financial sector profits to grow far larger than is warranted, on the foundation of a far larger level of private debt than society can support. That is where we are now with total private debt of $45 trillion, about three times our Gross Domestic Product. Such lending led to a positive feedback loop between accelerating debt and rising asset prices; leading to both a debt and asset price bubble. The housing debacle of the early 2000s is a prime example. The asset bubble must always burst–because it relies upon ever accelerating debt for its maintenance–but once the asset bubble bursts, society is still left with the mountain of debt. When asset prices fall, and the debt remains constant, this is referred to as being “under water.”
Last time, we discussed Keen’s idea of a Jubilee year, with the government paying off most consumer debt; countered with my idea of the government refinancing all owner occupied homes with simple interest loans payable at sale or maturity. Today we discuss Keen’s idea for fighting the battle against the real estate asset bubble caused by the credit accelerator in a credit based economy. According to Keen, aggregate demand is a result of the sum of income plus the increased change in debt. It therefore follows that there is a relationship between the acceleration of debt and the increase in asset prices. Some acceleration of debt is vital for a growing economy. But at the same time, the growth of asset prices is the major incentive to accelerating debt. This is the positive feedback loop on which all asset bubbles are based, and it is why they must ultimately burst.
This link between accelerating debt levels and rising asset prices is therefore the basis of capitalism’s tendency to experience recurring financial crises. That link has to be broken if financial crises are to be made less likely–if not avoided entirely. This requires a redefinition of financial assets in such a way that the temptations of the Ponzi scheme can be eliminated.
As it relates to the real estate bubble, Keen’s suggested solution is what he calls “The Pill.” At present, if two individuals are competing to buy the same real estate; and they both have equal amounts of cash equity; the one who can secure the largest mortgage wins. This reality gives borrowers an incentive to want the loan to valuation ratio increased, which underpins the finance sector’s ability to expand debt for property purchases. And as a real estate veteran, I can assure you that some appraisers will stretch to make a high appraisal; thus substantiating the purchase price and keeping everyone happy. This relaxation is in turn the factor that enables a house price bubble to form. Since the acceleration of debt drives the rise in house prices, we get the bubble, followed by the burst.
Keen’s suggested solution–The Pill (Property Income Limited Leverage).He would propose basing the maximum debt that can be allowed to purchase a home on the income (actual or imputed) of the property itself. This is in fact the method used by most pure investors when deciding to make such a purpose. What is the maximum amount of rental income the property might produce–if rented? Keen suggests that lenders should only be able to loan a fixed multiple of that amount–regardless of the borrower’s income or credit rating. A useful multiple for discussion might be 10 times. For example, if a house would conceivably rent for $30,000 per year, the maximum loan available would be $300,000.
Thus, if two parties were competing to buy the property, the one with more cash savings available would win the purchase. There would be a negative feedback relationship between leverage and home prices; an increase in home prices would generally mean a fall in total leverage. Such a system would have to be phased in slowly over time to prevent a concurrent fall in prices; unless a country (such as ours) had just experienced the burst with continuing falling prices, and was trying to recover.
I must conclude by saying that generally I reject the government intruding upon the free enterprise system, but I truly feel victimized by the greed of Wall Street; when I bought a property 20 years ago for about $48,000; saw its value rise to over $100,000; and then fall precipitously to $30,000. It is time we did some out of the box thinking about how our free market economy operates, and is regulated.
Printed in the January 17, 2013 edition.