The Old Fallacies Return

Its less than eight years since the global financial crash. The basis of that crash was the build up, over thirty years, of astronomical levels of fictitious capital, the other side of which was equally astronomical levels of debt. A destruction of fictitious capital is simultaneously a destruction of debt. That is why the owners of that fictitious capital are so keen not to see such a debt write-off, even though it is a fundamental requirement of a return to strong economic growth and real capital accumulation. In fact, QE has been designed to keep those prices of fictitious capital inflated, at the cost of real capital accumulation. And, as stock, bond and property markets bubble across the globe, those same fallacies that led to the financial crash are being regurgitated.

So, for example, on CNBC, the other day, I heard some US pundit talk about US household balance sheets being repaired as a result of house prices there rising once more. But, that is nonsense. Some household balance sheets, in the US, may have been repaired, but it has nothing to do with rising house prices. To the extent that strong US jobs growth, over the last few years, has reduced unemployment, and started to cause wages to rise, that may help to repair household balance sheets. It means that, from these higher wages, some of the mountain of household debt can be paid down. Similarly, the fall in oil prices, which is calculated to have saved the average US citizen around $2,000 a year, will also have facilitated paying down some of that debt, and thereby repairing household balance sheets. 

But, the extent of US household indebtedness is huge. Student Loan debt, which cannot even be written of by declaring yourself bankrupt, alone stands at around $1.1 trillion. Students are probably the least likely group to benefit from rising wages, or reduced energy costs. Around the same amount is owed on credit cards. Although the measures undertaken after 2008, to keep people in their homes, wrote off some of the mortgage debt, the fact remains that this debt is still huge, and was run up to finance the purchase of properties whose prices had been inflated astronomically.

The idea that any balance sheet, be it that of a household, a company, a bank, or a country can be repaired or strengthened simply on the basis of an inflation of the assets contained on it, rather than by increasing income and reducing costs, is a fallacy. It is the same kind of fallacy that led to the crash of 2008, and in a different context, it is the same fallacy that stands behind the concept of historic pricing, as the basis for calculating the rate of profit.

The basic truth of any balance sheet is that it must balance. It places assets on one side, and liabilities on the other. If we take a simple household balance sheet, it may look something like this.

Liabilities		Assets
Mortgage	100,000	House	100,000
Total	100,000	Total	100,000

The household owes £100,000 to the bank, which provided the mortgage for the purchase of the house. If it needed to be repaid, the house could be sold, and the proceeds used to pay the bank. If members of the household have employment, and earn £10,000 more than they spend, they have this as disposable income, which is placed in the bank. It is the equivalent of the profit made by a company. It is a liability, for the household, because it is owed to those who produced the income, whilst the money in the bank is the asset, which enables it to be paid to them.

So,

Liabilities		Assets
Mortgage	100,000	House	100,000
Disposable Income	10,000	Bank	10,000
Total	110,000	Total	110,000

But, the money in the bank could be used by the members of the household to pay down some of the mortgage, this is like a company which reduces its gearing, by paying off some of its debt. So,

Liabilities		Assets
Mortgage	90,000	House	100,000
Disposable Income	10,000	Bank	0
Total	100,000	Total	100,000

This indeed would have helped the household to repair its balance sheet. Suppose, instead the market price of the house doubles. So,

Liabilities		Assets
Mortgage	100,000	House	200,000
Capital Gain	100,000	Bank	0
Total	200,000	Total	200,000

It appears that the household has miraculously become better off, simply as a result of the current market price of the house doubling compared to its historic cost. Previously, all of the hard work of household members only produced, for them, £10,000 of disposable income to use to pay off against the mortgage. Now, with no effort at all, the higher house price has generated an additional £100,000 for them. If they were to sell the house now, for £200,000, they could pay off the mortgage, and put the extra £100,000 into the bank. Isn't capitalism wonderful? Wealth from nowhere!

And that was the message that was being conveyed prior to 2008. It was the message that this pundit was conveying on CNBC the other day. But, it is, of course, dangerous nonsense. The basic idea goes back to the concept of a so called “wealth effect”. It proposes that, as people feel wealthier, because the price of their house or shares rise, so they will be more likely to spend more, and this extra spending raises aggregate demand in the economy, stimulating economic growth. The evidence for such an effect is, at the very least, debatable. There has been a huge rise in fictitious wealth, even since 2008, but it has not led to a significant rise in aggregate demand, or economic activity, in fact, the opposite appears to be the case, as liquidity has been drained from general circulation, and into further speculation in asset markets.

But, the idea that household balance sheets can be repaired by rising house prices, is not debatable. It is just plain wrong. The fact that it is just wrong can be seen by looking at why the household bought the house in the first place. They did so, because they needed a house of this kind to meet their requirements for shelter. If they sold the house, at its new inflated price of £200,000, they would have this money, but would no longer have a house! What are they going to do then, live on the streets? If they want to buy another equivalent house, to provide their needs for shelter, that caused them to buy this house originally, they will have to give up the £200,000, in exchange for it. They will, in fact, be worse off, because they will have paid out money for moving expenses. The supposed capital gain is a purely paper gain, that disappears as soon as they have to replace one asset with another.

In fact, one reason that people in the UK have been remaining in their existing homes, over the last few years, is precisely for this reason, because they cannot now afford to move up the property ladder. Someone who bought a house for £100,000 twenty years ago, might have aspired to eventually move up to a better, £200,000 house, having had time to save and improve their position. But, when their current house is inflated in price, from £100,000 to £200,000, the price of the £200,000 house, they aspired to, has risen to £400,000! Where previously, they only needed to cover a £100,000 difference, now that gap has risen to £200,000, and wages have not risen by anything like the amount required to bridge it.

But, the real situation is worse than that. The rise in the price of the house may be just a purely fictitious paper gain, but the additional costs that the household will face are very real. For example, the providers of household insurance base their calculations of premiums on the price that must be paid for a replacement house. The house itself is the very same house it was before, but, at its new inflated price, it would cost twice as much to replace, and so the insurer will double the insurance premiums. Rather than being better off, as a result of the house price rising, they are actually worse off, because their costs have risen, whilst the higher paper price of the house has done nothing to increase their income to compensate. In fact, because, in the wider economy, higher house prices also cause rents to rise, and some of this is facilitated by Housing Benefit, which causes taxes to rise, to cover it, the effect of the higher house price may be to reduce incomes after taxes.

The further argument is that, on the basis of this higher house price, the household could borrow more money, by remortgaging. But, taking on more debt, by remortgaging, does not repair a household balance sheet, it makes it even more shaky, and in need of real repair. Obtaining money by borrowing is not at all the same as obtaining money by increasing income – ask the Greek government! The former has to be paid back, with interest. The latter does not have to be paid back, and to the extent that it can be saved it earns interest, or by paying down debt, reduces interest servicing costs.

The idea that higher paper asset prices made anyone wealthier, or that the ability to borrow against those inflated assets is the equivalent of additional income, is dangerous nonsense. It is the dangerous nonsense that was peddled prior to the crisis of 2008, and the fact that it is being peddled now is probably an indication that the next, bigger, financial crisis is not too far away.