Monday, June 1, 2009

It's deregulation AND positional/context/prestige externalities

There have been two very important articles in recent days about key parts of what has devastated the financial security of the middle class over the last generation:

– Nobel Prize winning economist Paul Krugman's current New York Times Column, "Reagan Did It":

But there was also a longer-term effect. Reagan-era legislative changes essentially ended New Deal restrictions on mortgage lending — restrictions that, in particular, limited the ability of families to buy homes without putting a significant amount of money down.

These restrictions were put in place in the 1930s by political leaders who had just experienced a terrible financial crisis, and were trying to prevent another. But by 1980 the memory of the Depression had faded. Government, declared Reagan, is the problem, not the solution; the magic of the marketplace must be set free. And so the precautionary rules were scrapped.

Together with looser lending standards for other kinds of consumer credit, this led to a radical change in American behavior.

We weren’t always a nation of big debts and low savings: in the 1970s Americans saved almost 10 percent of their income, slightly more than in the 1960s. It was only after the Reagan deregulation that thrift gradually disappeared from the American way of life, culminating in the near-zero savings rate that prevailed on the eve of the great crisis. Household debt was only 60 percent of income when Reagan took office, about the same as it was during the Kennedy administration. By 2007 it was up to 119 percent.

– Cornell Economist Robert Frank's Guardian article, "Alpha Markets":

Sometimes individual and group interests coincide. But interests at the two levels often conflict.

Male body mass is a case in point. Most vertebrate species are polygynous, meaning that males take more than one mate if they can. The qualifier is important, because when some take multiple mates, others get none. The latter don't pass their genes along, making them the ultimate losers in Darwinian terms. So it is no surprise that males often battle furiously for access to mates. Size matters in those battles. And hence the evolutionary arms races that produce larger males.

Bull elephant seals often weigh more than five times as much as females. But their size is a handicap, making them far more vulnerable to sharks and other predators. Given an opportunity to vote on a proposal to reduce their weight by half, bulls would have every reason to favour it. But they have no such opportunity. And any bull that weighed much less than others would never find a mate...

The financial meltdown that caught Adam Smith's disciples off guard would not have surprised Darwin. One of his central themes was that because much of life is graded on the curve, wasteful arms races create conflict between individual and social interests. The good news is that unlike other animal species, humans can often resolve such conflicts through intelligent regulation.

The factors, or phenomena, discussed in these two articles are very interrelated. They have really worked together to do tremendous harm to the financial security and quality of life of the middle class over the last generation.

How so?

Positional/Context/Prestige externalities are extremely powerful. Before deregulation, when relatively responsible, law abiding middle class families entered bidding wars for homes in the safe suburbs with good schools, and with the community populated predominantly by other relatively responsible law abiding middle class families, the government limited their arms (borrowing) greatly.

Families were simply not allowed to enter these bidding wars with enormous amounts of borrowed funds at high interest rates and fees. Government regulation prevented it. Families could only get mortgages that were a small multiple of their annual income, not 10 times, or more. So devastating bidding wars for homes in middle class suburbs were not possible.

With Republican deregulation, however, financial firms could now offer low down or no down mortgages on homes 10 times the annual income of a family, and they could charge interest rates well into the double digits, with fees over 10% of the loan amount.

The result was that home prices exploded, devastating middle class budgets and financial security.

What else?

As Harvard Professor and Chairwoman of the Congressional Oversight Panel for Economic Stabilization Elizabeth Warren wrote in her book, "All Your Worth: The Ultimate Lifetime Money Plan" (which I think is by far the best personal finance book today):

If your dad wanted to buy a car he couldn't really afford, he couldn't get the car loan. If your mom wanted to rent an apartment that was out of balance with your family's income, the landlord wouldn't rent it to her. If your parents tried to take out a loan – say, for an addition on the house or just to make ends meet for a while – they had to meet with a banker, face-to-face, to explain why they wanted the money. The banker would have asked for pay stubs, tax returns, and all kinds of financial records, so he could evaluate the prospects for repayment. And if things looked out of balance, the banker would have rejected the loan.

As a result, in those days it was really really rare to spend too much on the basic monthly bills. Why? It's not because your parent's generation was smarter or thriftier or "more in touch with what matters" No, things were different in your parent's day because the rules were different. Your parents lived at a time when the government strictly regulated the banking industry...As a result, in your parents' generation there were no zero down mortgages. Almost no one was "house poor", spending too much on a home or apartment. There were no offers on TV to "cash-out" your home equity. No one had a car payment the size of Texas, and car leases hadn't even been invented...

In today's world, you can get a mortgage that is too big for you – and the banks will help you do it. You can get a car lease that chews up half your income. You can wind up with a student loan bigger than some mortgages. And as sure as the sky is blue, you can rack up credit card debt without blinking an eye, even if you don't have 50 cents to make the payments.

So, how does this tie in to what I've been talking about? It all added tremendous borrowed money, debt, ammunition to positional/context/prestige arms races and externalities. With deregulation, your neighbor can now get a loan for a $40,000 car instead of a $20,000 one if he wants to get something "special", where what seems special is extremely positional, and/or if he wants to really look prestigious. Another neighbor finds he can now get a home equity loan to put in granite countertops, that he could never have gotten before. A friend gets a home equity loan to put in wood floors and tile, instead of nice carpet and linoleum. A co-worker gets a new credit card and charges a $300 watch, when before he would have only been able to purchase a $150 one (but it would have looked just as prestigious, and given him just as much satisfaction, because his peers would have been similarly limited to wearing $150 watches).

All of this sets off what Professor Frank calls expenditure cascades (or positional/context/prestige cascades).

What's an expenditure, or positional/context/prestige, cascade? Hold that thought.

I wrote an article at about the peak of the recent housing bubble which explains this, and I think discusses these issues well. It's called, "Let's Cut the Ammunition to the Housing Arms Race Permanently". I've reprinted most of it in my next post...


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