Balanced Economic Growth and Defaults

There’s going to be several narratives on what went wrong with the financial markets. Almost any of them are going to involve the large number of defaults. Chris Hayes catches something:

Much of what’s gone so wacky is simply that there’s too much money chasing too few good investment opportunities and that’s led to lots of risky schemes. Now, there’s a lot of reasons for all this capital suddenly appearing, but at least one thing to consider is that the distribution between labor and capital is totally skewed, and if labor were capturing more of profits, they’d be consuming, and saving in (relatively safe) commercial enterprises. Which is to say, broadly distributed economic growth is more stable and better over the long-run, than sharply unequal growth.

I want to elaborate on this because he’s onto something very important here. The current crisis is a direct result of the unbalanced growth and risk-transfered uncertainty of the current economic forces households face. This is a narrative progressives need to seize and develop.

There’s a narrative going around that this was the unintended consequences of government actions to get lower-income people loans. It feeds into our assumptions of subprime as a lower-class phenomenon – no income verification, food stamps as income, etc. But it’s one of the hidden stories of this mortgage crisis is that 27% of subprime defaults are from people who bought their house with a prime mortgage (Source). Whenever you think of subprime defaults as inner-city shakedowns (by banks or by borrowers), or no-money-down megamansions of the suburbs, remember that between a third and a fourth of the defaults are by people who had started off as a solid, dependable borrowers. The people who are the “we” when we speak of the “them” who have abused the mortgage process.

I first wrote about these people here (a year ago!). The odd econometric shadow they casted on the financial data was a key reason a lot of people thought the subprime defaults were ‘contained’ last year – Alt-As were fine. However they missed (and few caught) that the Alt-A were simply refinancing into subprimes, continuing a downward spiral.

You know their narrative. Job goes overseas, never to come back. Spouse gets sick, no health insurance. Tough post-Fordist breaks. You call your bank and say you are worried about defaulting on your (prime) loan. Your agent says: “No problem, let’s refinance you with a variable-rate subprime loan with great terms the first two years.” You can make the payments until, of course, you can’t, and you default.

I want to elaborate on three additional problems our struggling working and middle class families have:

1) Income Volatility. There is a big debate to what extent, why and how income volatility is rising. Hacker’s excellent book, The Great Risk Shift makes a solid argument it is the result of the changing labor structures in an information economy.

Finance nerd out for a second: One of the first applications of the Black-Scholes Model model in the 70s was thinking about debt and risk. In this seminal paper Merton proved a positive relationship between volatility and bankruptcy for firms. (This model was overhauled and survives today as the Longstaff Schartz Model.) Though these issues are usually covered by macro models, there is no reasons households can’t replace firms here (with their cash flows ‘traded’ by labor markets). And there is solid theoretical reason to believe, ceteris paribus, that an increase of income volatility will increase defaults. (I’ll elaborate on this in the future.)

2) Health Care. This is obvious, no? Nothing will wipe out a family’s savings quicker than a bad brush with our current health care system. For #2 and #3 here, I want to discuss this:

This is Professor’s Elizabeth Warren’s lecture on “The Coming Collapse of the Middle Class.” This made the rounds about half a year ago, but most people seemed to miss the real point. Megan McArdle was able to write several posts while missing her actual argument (and before, oddly, invoking DSR numbers to say Warren wasn’t on to anything – just income smoothing).

The point of her argument and her book was twofold: middle-class families are setting their debt level to more than either wage-earner makes – so if either one of them loses their job, they are done. And #2, that middle-class families have to do this not because they were spending so much money on luxuries or status competition or “keeping up with the neighbors” or to fill the void of their suburban lifestyles or whatever – but instead on basic staples – cars, housing, health care and education.

She finds a lot of statistics saying that we spend less on many luxury items than our parents did, like clothing (side: my grandfather drove the 63rd S Street Chicago bus his entire life and every picture I see him in he’s wearing a suit. I’ve worn a suit like, 4 times for non-work reasons). But we spend way more on health care. And housing. And she finds an alarming link between health care woes and bankruptcies. There’s need to investigate her empirics more solidly, but it is a solid place to start.

3) Education. Hidden in housing prices are school taxes. And hidden in schools are keys to replicating a middle-class existence across generation. Warren found some interesting stuff when she looked at housing controlled for size/rooms/etc. – a lot of the run up in housing prices are explained by school districts. And there’s evidence coming in from elsewhere that the odd numbers we see with returns to education can be explained by inequality in education results – that a college degree matters for nothing in itself. There is essentially an open auction for spots at elite schools based on housing, and every middle-class family has a reason to overbid into it.

Now there’s huge endogeneity issues with Warren’s research here (are people bidding up housing because schools are good, or are schools good because people are paying so much for housing?). Again though, as my cohort of friends start to hit their late 20s, they are increasingly thinking about the suburbs solely for the schools. And they are going to be willing to pay for every extra grade they can squeeze out of it – what else can they do?

This is, of course, a start for building arguments and research projects. And to argue in the popular imagination where middle-class sustainability is taken for granted and housing defaults are always associated with poverty.

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3 Responses to Balanced Economic Growth and Defaults

  1. ginandtacos says:

    This is really good.

    I think that your description of how this crisis played out – “Sure I can make the payments, right up until I can’t” – is the most succinct possible way of putting it.

    My foundational ranting point for the better part of two years is the underlying cause of this entire scenario – people just flat-out don’t make enough money. Consumption makes the engine go. For 30 years we have exerted downward pressure on middle-class and working wages, and the financial/political powers that be tried to cover up the stench with perfume, that being easy credit. Here’s a paycut, but here’s a Mastercard to make up the difference. It all works as long as people can make minimum debt servicing payments, but when even that becomes too much, bar the door.

    Compare what Gramps made for driving the bus to what the guy on the route today is earning. My paternal grandfather moved boxes around a warehouse and his wife worked on the line at a Plochman’s Mustard factory. They had a house, two cars, two kids who went to college, two annual vacations, and a pension.

    Today, the people in those roles don’t have any of those things. They are also in Guadalajara.

  2. Mike says:

    Thanks! I want to make this a series, this was a rough draft at an outline.

    And you are correct – any decent explanation of this will need to address this incredible chart:

    It’s so incredible to think my grandfather put 4 kids through Catholic school and owned a home and vacationed on a busman’s salary.

  3. Steve Sailer says:

    I quite agree. Our elites have used fears of “wage inflation” to drive down the earning power of the bottom 2/3rds of society through mass immigration, outsourcing, tariff-cutting, and the like. Moreover, importing millions of low-skilled immigrants has driven down the median human capital level and earning power, especially in the heart of the mortgage mess: California, Nevada, Arizona, and Florida.

    But, the elites wanted Americans to keep spending ever more. So, that meant more debt. But now we’re realizing that the debt can’t be paid off because of lack of earning power among the masses. Kaboom.

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