Mortgages on houses, and in fact all situations where the payment of a certain service is spread out over a period of time, change the laws of economics in a curious way that sometimes leads to grotesque results. The particular law I am talking about here is the law of supply and demand.
Occasionally, in order to clearly see the mechanisms of a process, it is necessary to isolate the elements involved and view them without extraneous factors. This leads to the “Thought Experiment” or gedanken in German. The Gedanken is a frequent tool in theoretical physics, and here I intend to use one in economics. I am going to imagine a particular scenario that is not theoretically impossible and examine the workings of that scenario to better understand the forces that we are interested in. An earlier example was my article on the Cost of youth. So here goes.
Image Credit: ocean.flynn
Imagine that we have an Island with a hundred people living on it. This island has only fifty houses however. The law of supply and demand has raised the prices of the houses to a particular level that allows only fifty people out of hundred to afford it. The rest will live in shacks, make shifts or find another alternatives. The important thing is that there are fifty houses, and all fifty of them are occupied by the richer half of the population. The fifty people are paying ready cash. No mortgages.
Under the circumstances, this is a fair arrangement. After all, everyone can’t have everything. Sad as it may be for the fifty people who are left out, it can’t get any better than this. Since space on the island is limited, more houses of the same sort cannot be built.
Now, imagine a twist in the scenario where people no longer need to have ready cash at hand, but can spread out their payments over a period of time. Perhaps over a period of 30 years. Suddenly a lot more people can afford the houses at the price level that was earlier set since they need not pay everything at once. Therefore, the demand for the houses goes up. Unfortunately, the supply being constrained cannot keep up with the demand. So what happens? The prices of houses go up. What initially cost a 100 units one time payment, now costs over 15,000 (say) units spread out over a period of 30 years. Again, the exact price will depend on how much the fifty richest people can afford to pay.
The end result is that the same fifty people now occupy the same fifty houses (since they are still the richest) but at a much higher price than they would have paid without the whole mortgage system. This is one side effect of the mortgage structure, in that it artificially raises prices to the level that you have to spread out payments over several years. But this by itself (ridiculous as it may be), is not really unfair. The real catch arises during an economic crisis.
Say now that the economy slows down and over 80% of the people lose their jobs. This means that out of the fifty richest people who were living in the houses and were paying monthly payments, forty of them can no longer do so. As a result, they get kicked out.
End Result: 100 people on island, and 50 houses. However, only ten houses are occupied! Forty houses are too expensive for anyone to afford. Is this possible? Is it logical? Is this not grotesque? The banks that foreclose the forty houses are reluctant to drop the prices since they incur a loss on their balance sheets if they do so.
What went wrong? Two things. First, the fifty houses artificially boomed the prices of the houses to unimaginable levels. Second, it lead to a situation where hardly anyone could afford anything.
Doubtless in the real world, there are many other factors that can either mitigate or aggravate this scenario. But that doesn’t mean that the forces at work in our imaginary island are non existent. The purpose of this article was to isolate and view in undiluted glare, the tendencies that arise due to mortgages. In my opinion, the idea that you can pay for something over a period of time is counterproductive and ultimately makes everyone’s life miserable because in the long run, prices increase because of it and the same people get the same goods that they would have got if the mortgage system wasn’t there.
I rest my case m’lud.
Related posts:
Blogs RSS feeds [
Mr Park,
Changing the method of payment from a cash basis to monthly increments is not what will cause the rise in price.
If the money stock in circulation is $10,000 then the most that can be paid for all 50 houses is still $10,000
The 100 residents can only bid prices up to equal the total amount of money in circulation.
Consider todays world to explain what I’m saying—-
If we are all paying $2.00 more per gallon of gasoline
then that’s $2.00 less that we have to bid up prices for other goods.
Back to your scenario.
If one of the residents printed up an extra $10,000 then the most that can now be paid for the same 50 houses just doubled to $20,000
I think we have to assume that we are talking of a closed economy on the island. That being the case, there is a limited supply of all resources, including land for growing food and fiber, materials for building huts and making tools and so on. The supply, demand and prices of everyting, including houses, is dependent and interrelated to those of every other resource.
Another assumption must be that there is a division of labor and different skill sets and productivity of the market participants. It isa monetary economy, so something has become the defacto money, whether it be coins, shells pieces of paper or accounting entries.
If someone is going to sell their house and all others are occupied, that person must have a use for that money that he gets for the house that is greater than the value he believes he gets from the house. If the seller holds the mortgage on the house for 30 years, that means it will take that long to get paid for it. During that time, he will have to go without something that he would have had if he had not held the mortgage.
If the price of houses increased, as you assume they would, given that the supply of money is constant, there would be less money left over in the economy for other goods. There would be a deflation in the prices of other goods to offset the inflation in the price of houses. The lower cost of other goods would increase the demand for those goods. The higher cost of houses would decrease the demand for houses.
If, however, there was a central banker who was in charge of making money, and could increase the money supply out of thin air, the price of houses could rise as you say without the decrease in the price of the other goods. That would cause a bubble market in the housing portion of the market, as easy money flowed into it. As people noticed the increasing prices, more and more people would try to borrow money to buy. The price of houses would be bid up.
Eventually, people on the island would realize that the price of housing was out of whack wth the rest of the economy. It would take too much of a sacrifice of real goods and wages to buy a home. The housing market would stagnate, and eventually collapse as people start defaulting on their loans because they over extended.
In the real world, we have a central banker called the Federal Reserve, who’s manufacture of money out of thin air is multiplied many times by the fractional reserve banking system. The run up in housing prices in the real world happened like it did on your island with the central banker making money from nothing.
The problem is not borrowing. That is just a rational trade off for people. For every mortgagee who gets money to buy a house, there is a mortgagor who forgoes his money in order to get a future return.
The problem is with inflationary money creation and an ustable banking system based on fractional reserves.
I would submit that the problem is not the mortgages (the promise to transfer a percentage of future earnings, secured by the asset), but rather the following:
1. Mortgages that don’t take into account unstable income- in our new economy, workers are more likely to work in spurts- perhaps earning a lot on a book deal one year, not much the next- as opposed to the old days of working for one employer;
2. Mortgages that are initially priced as taking, say, 35% of income, and then due purely to Federal Reserve policy, increase to 50% of income;
3. Mortgages that are provided based on false information, and then the consequences of providing that false information (i.e., upholding the rule of law) are unjustly withheld, either by market incompetence or government fiat;
4. Mortgages that are made in fixed dollar amounts against a depreciating dollar- because the supply of dollars is not growing as fast as the supply of goods and services.
Homebuilding is one of the many services now outsourced to people who make significant capital investments. Mortgages (credit) allows others to more fully utilize these assets and allow the investors to reap a larger return (by more fully utilizing these assets). And we can all agree that more fully utilizing construction assets is a good thing in pretty much any economy, can’t we?
This entire example is purely academic, because in the Western world there truly is enough housing for everyone. In North America, we also do not have the problem where we couldn’t build more houses because we don’t have room like your mythical island. Those who can’t afford a house don’t “make do”: they rent if at all possible. And the laws of supply and demand do, of course, “demand” that the price of houses in your example fall until demand rises enough so that all of them are owned once again.
Your fallacious example proves once again why handing control over to the government is wrong. If we outlawed mortgages, instead of allowing the capitalist concept of borrowing to continue, the government would be forced to buy all the unaffordable houses (because your example seems to think that houses are cheap to build and only cost a lot because of mortgages) and provide free or cheap housing for all the newly created serfs– on the back of the “rich” people.