Minsky's Theory of Financial Instability
Hyman Minsky, an American economist argued for a theory of financial instability which could predict events like the Great Depression. In his theory, private debt is a major economic factor in both economic expansion and collapse.
In prosperous times, Minsky argued, banks become exuberant, and less cautious about lending, and as a result certain distinct patterns of borrowing develop.
The first are financially conservative borrowers that Minsky calls the "hedge borrowers" who are able to, at the time the loan is agreed upon, pay back both interest and principle over the course of the payments on the loan. The hedge borrower is the classic responsible borrower but in a collapse because of changing economic conditions, even the responsible borrowers cannot often service the loan. More on this below.
The second is class of borrowers are the speculators. These can afford to pay the interest but not the principle, and therefore expect to resell the asset at a profit in order to pay off the original loan. The bank of course, knowing that there is additional risk, will price the interest a bit higher there. Some of these are intended to be short term loans, perhaps buying foreclosed properties and then holding onto them on the market for a bit longer than the bank would be willing to. If asset prices fall below purchase price, the speculator is in trouble.
The third class are what Minsky calls the "Ponzi borrowers." Ponzi borrowers are unable to afford the terms of the loan and even service the interest alone. This class of borrower depends on accessibility of credit and rising asset prices to continue to pay the interest of the loan, and in fact the amount owed will continue to increase over time. Sub-prime mortgage lending was primarily a way to make money off the ponzi borrowers.
When credit becomes restricted for ponzi borrowers, they cannot pay their loans, and this quickly cascades to speculators. The collateral economic damage then results in an economic slowdown which can unravel even hedge borrowers. Economist Steven Keen has more recently added a mathematical model behind Minsky's theory which appears to work quite well, and even without the math, Minsky's theories describe exactly the dynamics at work in the current global economic meltdown, or the Great Depression Jr as I like to call it.
The Roots of the Current Crisis
The current crisis has sprung like a tree on the global economy and like any tree it has many roots. The key one that many point to is the efforts on the part of Reagan, Clinton, etc. to get the poor to borrow money to buy houses. This is perhaps the largest and most visible root and it is the one I want to pay the most attention to here. The problem of course does not lie in pushing home ownership, but rather in the means used to do it, through loans subsidized by a central authority made to people who couldn't pay the loan back. You don't have to be either a Distributist or an economist to see that this is a bad idea. The result, quite predictably, was profiteering on the part of the banks, who had nothing, they thought, to lose because asset prices were rising rapidly due to the competition to buy.
There are several important Distributist critiques of the past programs which are usually missing in this debate, and some people have argued that the goal itself (a Distributist goal) is to blame when in fact the means to pursue it was entirely corrupt.
The first is quite obvious, namely that this was a program pushed through big businesses which have no real interest in seeing communities organically grow. The wealthy were paid by the powerful to push an agenda that inflated property prices on paper and thus, predictably, they turned the program to their advantage.
The second major criticism is that the theory behind this push was not sustainable. Inflation in housing prices was seen as creating wealth when in fact all it was creating was a capacity to borrow money, subsidized not by the past but by the future. Asset price inflation does not create the kinds of tools or environmental improvements that one might call real wealth from a Distributist perspective, but rather is just a bargaining chip when it comes to purchasing these things on credit.
Moreover as I mentioned, this capacity is borrowed from the future. When asset prices rise in inflation-adjusted terms, it drives up both prices to purchase or even rent such property in the future. This means an increasing portion of household income going to pay for housing. At some point this cannot be sustained and prices must come down, but when they do, they take many mortgage holders with them.
The Collapse
Paul Krugman has compared the Minsky Moment to the Coyote Moment in the popular children's cartoon show "Wile E Coyote and Road Runner." In that show Coyote often runs over the edge of a cliff and falls only when he looks down. So too the Minsky Moment occurs when bankers look at private credit, realize it is unsustainable, and tighten lending policies. This causes a collapse first of housing markets, and eventually of other economic factors as well.[1]
The reaction of course, rather than asking whether we need to rethink our banking system, has been to save the banks by infusing them with whatever money they need. In the US, the Fed put in more than an entire year's worth of GDP into the banks in a serious of secret loans later uncovered in a congressional audit. Banks get bailouts. Individuals get foreclosure and layoff notices.
This needs to be considered against an important additional factor though. Our financial system was already stretched to its limit keeping up an illusion of increasing prosperity. The feds had already lowered interest rates almost to 0 for the portion they had control over, and so the answer has been inflation, secret loans, and qualitative easing. If the debt can be inflated away, then the banks can have healthy balance sheets.
A second root that needs to be considered is the shift in spending away from basic necessities of food and a single family car and having our money go towards other things, such as more competitive housing, medical expenses, and higher taxes.[2] Money is drained from the middle and lower classes and given to the wealthy banks, pharmaceutical corporations, medical textbook publishers, and the like. These trends are more severe for divorcees and single parents than they are for married couples.
Home Ownership for the Poor: How To Get there
This doesn't mean we should write off home ownership for the poor as a bad idea as some have suggested.[3] Rather we need to be more careful about how we get there.
The obvious lesson is that centralized banking is a recipe for recklessness, and that the more we can write profiteers out of the equation, the easier it is to get people into their homes. I would propose a very simple solution: use taxation to encourage home ownership. I would suggest a significant excise tax on rental income for properties rented for one year or more unless certain exemptions apply. Those exemptions would include
- Leases convertable into rent to own agreements at no additional monthly rate, and only a modest processing fee
- Leases to extended family members
- Each household could exempt one additional unit from taxation, to prevent penalizing renting a place out temporarily during a temporary relocation and the like.
Such a plan would ensure that people who would want to buy could do so, and that the speculators and banks would be less able to interject themselves into the thick of things with the sorts of human consequences we have seen over the last few years.
It is still my belief that home ownership for the poor as a general policy makes sense, but it is one that must be pursued cautiously, with the awareness of all of the problems we have in terms of the practical tools commonly used.
Online Resources for More Information:
[1] Krugman, Paul, "After the Minsky Moment"
[2] Warren, Elizabeth, "The Coming Collapse of the Middle Class."
[3] Somin, Ilya, "Do We Need to Subsidize Home Ownership to Preserve our National Character?"
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