WHY MORTGAGE DEBT AND HOUSE PRICES ARE SKY HIGH AND WHAT'S GOING TO HAPPEN NEXT

In this Google seminar on debt and asset price inflation, Steve Keen gives the following explanation of the massive growth in consumer debt relative to income that has occurred in most western economies over the last 40 years: lending increases house prices and increasing house prices, by providing additional collateral, give rise to additional lending, the process continuing, if not ad infinitum, at least to an absurd extreme. This is a manifestation of what Keen calls Ponzi capitalism.

I am not sure things are that simple. In the early seventies, in Vancouver, one could buy a nice four bedroom house on a fifty foot lot in Point Grey for eighty thousand. The thing was, the rate on a first mortgage was 18%. With 25% down, that meant a carrying cost of $10,800, or 43% of average family income, which is more than a mortgage lender would have allowed at that time.

Today the same house would cost, maybe $1,600,000, average family income is around $68,000 and mortgage rates are 4%. So with 25% down the carrying cost would be $48,000, or 70% of average family income.

So yes house prices are up relative to income, but the rise over the last 40 years in the ratio of housing debt to income is primarily a consequence of lower interest rates. One can see what Steve Keen means by describing the phenomenon of rising house prices as a result of Ponzi capitalism -- the growth of investment without economic return. And insofar as mortgage lending practices have been predatory (minimal down payments, a life-time or more to pay, etc.) odium is deservedly attached to the mortgage lenders. However, Greenspan's savings glut, leading to low interest rates, is a reality and this, plus an increase in nominal family income, explains most of the 20-fold increase in Vancouver house prices since the early 1970's.

But even if Vancouver's housing market is not as crazy as some people think, the financial implications of house buying today are very different from those in the 1970's. In the 70's when interest rates were high, house prices relative to incomes were low but the direction of mortgage rates was down, whereas wages were rising: a favorable situation for buyers, since it meant that paying off the capital would get easier with time. Today, the capital repayment is huge relative to incomes, the direction of change in interest rates is more likely to be up than down, and incomes are flat or falling, which suggests that it may now be much wiser to rent than to buy. This is not necessarily the case, however, for if we were to experience a period of high inflation, house prices might continue to escalate.

On inflation, Steve Keen appears to takes the same view as Michael Shedlock, who points out that, in the United States, despite a doubling in base money last year from approximately $1 trillion to $2 trillion, the effect on prices, including asset prices, has been more than offset by credit contraction. According to Keen, the US Government would have to print $10-20 trillion to create inflation, a possibility that he seems to rule out. But I don't see why. US unemployment continues to rise, any alleged economic expansion is attributable solely to government stimulus spending, and Obama is America's most unpopular president of the last fifty years. What, then, has he to lose by adopting a policy of large-scale Helicopter finance? It's easy enough for the the US Government to print dollars and easy enough to spend them. No doubt Wall St., which owns the President and Congress, can get a decent cut, and the 25 million unemployed will be glad of a job on some make-work project.

What's the downside? I don't see any, other than for those who are retired or who are approaching retirement and who have saved what should have been enough to cover their needs during their final years -- plus America's foreign creditors. So apart from the true middle class, who are screwed without compunction by every government, inflation's a win-win-win for Obama, Wall St. and the homeless or jobless masses. The suggestion that inflation will cause an unacceptable increase in interest rates seems implausible. Greenspan's savings glut is a reality. What's more, if no one wants to buy US Government debt any longer, who cares. New debt can just sit on the books of the Federal Reserve accumulating interest at whatever rate best suits the Government's purpose.

As to the foreign creditors, I have previously suggested that some of the Fed's loans to foreign central banks would have the effect of saving those banks from losses in the event of a dollar devaluation. The mechanism seems simple enough. The Fed prints dollars and loans them to the Chinese central bank. The Chinese central bank then invest those dollars in non-US currencies, commodities, or other real assets, thereby creating a hedge against dollar devaluation. If the dollar does go down the profit, in dollar terms, on the real investments will offset future losses on China's holdings of US T-bills.

Money printing leading to dollar devaluation would eventually revive the US economy by lowering real US wages and thus lowering the wage advantage of Asian competitors. For the small investor wondering what this means for them, the real problem is with timing and scale. Inflation of 5% is one thing, inflation of 100%-plus per year is quite another. Thus the dynamics of relative price changes is likely impossible to predict without inside information on what is in the works. After the event, when Goldman Sachs is handing out the biggest bonuses ever, the reason for what happened will become clear. For the rest of us, diversification offers the best hope of not losing everything.

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