Why it makes economic sense to help the have-nots in times of a financial crisis

De Koning, Kees (2017): Why it makes economic sense to help the have-nots in times of a financial crisis.

Abstract

August 9, 2007 is often regarded as the starting date of the global financial crisis. BNP Paribas stopped trading in three of its investment funds exposed to the U.S. sub-prime mortgage markets as the liquidity in these markets had all but dried up. Liquidity considerations are a symptom of the supply side of funds: the lenders’ side. The latter could be banks, hedge funds, asset managers or pension funds, but equally rich individuals who would invest directly in these markets. The financial crisis of 2007-2008 was a lenders’ crisis. Generally, banks had insufficient capital to absorb the losses created by the reduced liquidity levels in the financial markets. Central banks had to step in to rescue quite a few of them. The fact was, however, that the underlying cause of the financial crisis was a borrowers’ crisis. In the U.S., over the years 1997-2007, households had to borrow an ever-growing percentage of their earnings in order to get themselves on the property ladder or rent a home. Long before 2007, in fact by 2003, the additional amount that a household had to borrow to get a home was equal to a full year of earnings. Average income growth and mortgage volume growth were on a collision course. Borrowers had to allocate increasing percentages of their earnings to servicing mortgage debts or renting a home. The notion that lenders will rein in their lending as a consequence of free market competition is a fallacy. The key is not the price of funds borrowed, but the volume of funds lend per time period in comparison to average household’ nominal income growth. The consequences of a borrowers’ crisis are different from a financial markets’ liquidity one. When households have to allocate an increasing share of their income to either buy or rent a home, fewer funds are available to spend on other goods and services. When households are subsequently confronted with foreclosure and ultimately repossession of homes, they lose most or all past savings accumulated in the home. The poor get poorer, both in income and asset values terms. The gap between the haves and the have-nots widens dramatically. Volume of lending control and to some extent rent controls can prevent a new financial crisis occurring. More measures are needed to overcome a borrowers’ crisis.

• Item Type: MPRA Paper
• Language: English
• Keywords: financial crisis, lenders' crisis, borrowers' crisis, income-house price gap, U.S. mortgage lending levels 1996-2016, annual U.S.housing starts, average U.S. home sales price, median U.S. annual household' income, economic versus legal solutions
• Subjects: E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E58 - Central Banks and Their Policies

References

• Andrew Ross Sorkin: Too Big To Fail, Inside the battle to save Wall Street, published by Penguin Books, 2010

• Federal Reserve Bank of St. Louis: Fed Funds rate; https://fred.stlouisfed.org/series/FEDFUNDS

• Bank of England, Financial Stability report June 2017; http://www.bankofengland.co.uk/publications/Pages/fsr/2017/jun.aspx

• Kees De Koning: How the financial crisis could have been averted. MPRA paper 77060, University Library of Munich, 22 February 2017 https://ideas.repec.org/p/pra/mprapa/77060.html