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.