A concern about Positive Money

[botanic]

A concern about some unintended consequences of Positive Money.

I think that Positive Money would have some unintended consequences, arising in the housing market.

Normally far more people want to buy their own house than there are houses for sale, especially in the UK. Consequently people compete for houses by borrowing as much money as possible. This has made house prices very high.

What would happen if Positive Money was introduced?

Fewer loans would be available, so there would be less debt. This is just what the supporters of Positive Money want to happen. Then house prices would probably drop because there would be less loans pushing them up.

At first sight it seems that more people would be able to buy houses at the lower prices. However there is a paradox because the number of houses for sale would not increase. So what happens when more people can afford to buy houses than there are houses for sale?

If normal market mechanisms applied then people would compete once more. However with Positive Money in place they would compete for scarce loans as a way to compete for the scarce houses. Eventually people would end up paying the same mortgage payments as before, but less would go on the actual houses and more would go on the mortgage interest. In other words interest rates would climb through the roof!

There are some worrying consequences if this analysis is true.

There would be more usury after Positive Money had been introduced. In other words lenders would make more profit from lending than they do now.

It follows that wealthy people would be able to 'earn a living' through lending rather than working, to a greater extent than they can at present. Consequently labourers would get even less of the fruits of their labour.

The housing market would drive up interest rates regardless of other markets. This would make loans for productive uses much too expensive, especially in the short and medium term. Then businesses would shrink and employment would plummet.

I would find any of these consequences worrying but all three together would be awful!

[badger]

I don’t think you will get to the point where

more people can buy houses at the lower prices

– this is not consistent with your premise that fewer loans will be available. I think it will reach an equilibrium where the demand matches supply, but at lower house prices.

Lower prices means less demand for the limited supply of mortgages. If the supply of credit and the demand for credit both fall, won’t interest rates stay about the same?

[botanic]

Badger, I think you misquoted me when you wrote

more people can buy houses at the lower prices.

I didn't say that more people can buy houses. What I said was

At first sight it seems that more people would be able to buy houses at the lower prices. However there is a paradox because the number of houses for sale would not increase.

The difference is crucial and my point is that the demand for houses would stay the same as it is at present. The demand would be whatever people are prepared to pay to get a house, based on their income and the deposit they could afford. Meanwhile the supply of houses would stay the same as at present.

So the supply and demand curves for houses would not be altered by the introduction of Positive Money,

House prices would be altered but buyers don't get houses just by paying the price; they also have to pay the interest on the mortgage and this isn't fixed in a normal market situation. Indeed a big reduction in the supply of loans, together with no reduction in the demand for loans, would drive the price of loans (and indirectly the interest rate) through the roof.

[botanic]

I made a small mistake in the last sentence of my last comment. It is easy to make mistakes when the situation is complex because both prices and loans are involved. One way to reduce the complexity is to look at a particular example.

Suppose there are 4 houses for sale in a particular location at £100,000 each and suppose the interest payable on a mortgage for each house is £50,000. This means that the total cost of buying each house would be £150,000 to be paid over the whole period of the mortgage.

Now suppose there are only 4 people who want to buy these houses, who also have sufficient incomes to take on this mortgage. In that case the supply and demand for houses in this location would be balanced and there would be no pressure to push the house prices up or down.

Now we introduce Positive Money to see what would happen.

There would be less money to borrow across the whole country. So in time house prices would be pushed down. Suppose house prices generally fell by 20%.

Then our 4 houses would only cost £80,000 each. If we start off by assuming that interest rates would remain the same then the interest on each mortgage would only be £40,000 because the loans would be smaller. In that case the total cost of buying each house would only be £120,000 to be paid over the whole period of the mortgage.

However before the introduction of Positive Money we said there were 4 people who wanted to buy these particular houses, who also had sufficient incomes to pay £150,000 over the whole period of the mortgage. Common sense says that there would be extra people who also wanted to buy these houses, who would have sufficient income to take on the new mortgages, which would be £30,000 cheaper. So the supply and demand for the houses in this location would become unbalanced and there would be a pressure to push up the price of something.

The price of the houses cannot be pushed up again so the only price that can go up is the 'price' of the mortgage loan, in other words the interest.

How much would the interest go up?

It is clear to me that the supply and demand for the 4 houses would not be in balance until only 4 people had sufficient income to afford the whole cost of the mortgage. And this would only happen when the whole cost of the mortgage reaches £150,000. Consequently the interest on each mortgage would be pushed up over time until it reached £70,000.

Before the introduction of Positive Money we supposed that £50,000 interest would be payable on a mortgage for a £100,000 house. After Positive Money we see that £70,000 interest would be payable on a mortgage for a £80,000 house!

[peterv]

Botanic

Go back to the mid-90s, before the credit boom which pushed up house prices. (According to Vince Cable in "The Storm", average house price was 4.5 times earnings in 1995, doubling to 9 times by 2007).

By your argument, assuming the supply and latent demand were the same as now, buyers would have had more spending power to push prices up, and with less credit available, interest rates would have gone "through the roof". It's true that rates were higher then (around 7%), but 7% is not a disaster.

ref mortgage-x.com/trends.htm

First time buyers were able to get on the ladder without resorting to "suicide mortgages" or interest-only mortgages. Households had more disposable income in real terms.

If less credit is available post-PM, won't house prices and interest rates return to mid-90s equilibrium?

There are many other factors -
1 - total money supply won't change under PM, any drop in supply due to lower "credit" will be made up by debt-free seigniorage which should make it easier to save for a deposit
2 - if interest rates on mortgages do go up, it will attract more people to move their money into mortgage-related investments
3 - of all the places investors can put their money, probably mortgage-related investments would be the safest.

[botanic]

Peterv

No one could disagree with what you say about the recent credit boom.

Go back to the mid-90s, before the credit boom which pushed up house prices. (According to Vince Cable in "The Storm", average house price was 4.5 times earnings in 1995, doubling to 9 times by 2007). .........First time buyers were able to get on the ladder without resorting to "suicide mortgages or interest only mortgages.

This credit boom had much in common with all asset booms (e.g. Tulip Mania). People believed house prices would rise indefinitely and so make a profit. This led people to speculate with more of their income, which together with low interest rates, sent house prices soaring. I imagine that house prices will eventually settle back to about 4.5 times earnings under the current banking system.

So can we look back at the 1995 position to test my argument, as you suggest? In other words would the conditions after the introduction of Positive Money (PM) be similar to those in 1995?

By your argument, assuming the supply and latent demand were the same as now, buyers would have had more spending power to push prices up, and with less credit available, interest rates would have gone "through the roof". It's true that rates were higher then (around 7%), but 7% is not a disaster.

I agree with you that supply and latent demand for houses might well be the same. So the question hinges on the phrase 'with less credit available'. How much credit would be available under PM and would it be as much as there was in 1995? Banks created loans 'out of thin air' in 1995 and they won't be able to under PM. So I suggest that there might be far less credit available under PM. This would push the interest rates well above 7%. How much above and whether it would be 'through the roof' is a matter of opinion!

But in any case one of my main points is that allowing our large housing market to drive interest rates up would have bad effects on productive businesses and eventually on how many people might expect to get a job.

[peterv]

How much credit would be available under PM

M4 money supply is currently about £2trn, of which approx. half is in demand accounts, and half in term accounts. It is the money in demand accounts which forms our payments system, and it is this £1trn that PM propose to replace with debt-free money over a 20-year transition period. My simple understanding of this is that the amount of credit available would be halved compared to the current situation. However the demand for credit would also be halved.

Post-script
I thought the graph of interest rates was interesting, it shows an inverse correlation between the cost of housing and the cost of borrowing over several decades. This may well be due to the effect you describe.

I bought my first house (in Crookes) in 1979 and it cost me £12K - allowing for RPI inflation, that's £56K in today's money.
Even though (according to the graph) I was paying around 15% interest, I was still easily able to afford the 10% deposit and get on the housing ladder.

[botanic]

Peterv

You appear to have stepped away from the 1995 comparison and moved onto another argument similar to Badger's.

In your last post you talked about the credit that would be both available and required if PM was introduced into the current situation. However you have made an assumption that seems questionable. As you say the money in demand accounts would go into PM 'transaction accounts' and the money in term accounts would go into PM 'investment accounts'. At least this would happen initially. However one cannot assume that the situation would remain like this. Currently term accounts are included in the depositor guarantee scheme whereas PM 'investment accounts' would not be guaranteed, so some money would get moved across into the 'transaction accounts' eventually.

My concern with your approach is that it seems back to front. It takes house prices for granted and then concentrates on the supply and demand for credit. I know the situation is complex because the cost of buying a house includes the cost of the loan but I think one needs to incorporate both costs in the supply and demand curves for houses in order to get a true picture.

A fundamental principle of markets is that markets clear and that there is a clearing price.

If more people want houses and can afford them at a given cost (house price plus interest) than the number of houses for sale, then by definition the market has not cleared and the clearing price has not been established. However your arguement arrives at a position where the total cost of buying a house (price plus interest) is somehow less than the amount that people would be prepared to pay. It appears that people can get houses cheaper somehow. It would be nice if this could happen but the market just isn't like this!

[peterv]

I agree that, other things equal, if there is less credit available then the cost of borrowing is bound to be higher.

What I am disputing is whether this is a problem.

I am saying that in 1995, when the cost of borrowing was 7%, houses were more affordable, and in 1979 when the cost of borrowing was probably 15%, even more so.

So there seems to be a correlation between cost of borrowing and affordability (as measured by ave house price / average earnings). The harder credit is to get, the more affordable houses are. It's just an observation, not an analytical explanation.

How did the market clear in 1979 and 1995?

[botanic]

Peterv

I would like to reply to this properly but I am semi-offline for about three days. I will return to the conversation when I can!

[peterv]

A correction to my last post

I said "there seems to be a correlation between cost of borrowing and affordability (as measured by ave house price / average earnings)"

I agree with you that "affordability" is NOT simply measured by price/earnings ratio, but must also include the cost of borrowing.

Still, I maintain that houses were more affordable in 1995 and 1979, at least for 1st-time buyers. Cheap credit seems to have disadvantaged 1st-time buyers, and benefited property investors.

[botanic]

Okay I am back online!

I agree that buying a house wasn't such a problem in 1979 and 1995 as it was in 2007.

Cheap credit combined with 'house buying mania' surely explains the difference between 1995 and 2007.

I suspect that the earlier difference might be explained by changes in the number of people wanting to become home owners and having sufficiently high incomes to achieve this (plus lots of encouragement from Maggie Thatcher). See the following link for the increase in the proportion of home owners over the whole period.

www.ons.gov.uk/ons/rel/census/2011-census-analysis/a-century-of-home-ownership-and-renting-in-england-and-wales/short-story-on-housing.html

My intuition is that increasing home ownership is likely to be relentless. More people want to live away from their parental homes and move to different parts of the country than they did in 1979. If this happens then the demand will increase without a corresponding increase in supply. Then the total cost of buying a house (price plus interest) will continue to be dependent on what people can afford rather than on house prices.

And in the end I am not so bothered about how difficult it is to buy a house. I am more concerned about the consequential rise in interest rates for productive businesses and the knock on effect of this for people's employment.

[peterv]

Thanks for the ONS link.

One final observation - in "The Grip of Death", Michael Rowbotham says that the percentage of owner-occupied houses that are owned without a mortgage fell from 51% in 1960 to 35% in 1996. Despite 36 years during which people have paid out crippling amounts on mortgages, the proportion of the housing stock owned by the banks has increased.

Anyway, I think we've done housing to death. I want to come back to your original point that

lenders would make more profit from lending than they do now.

Obviously low interest rates encourage high levels of debt, and vice versa. So the money lenders make profits either way (cost of borrowing times qty borrowed). Since virtually all our money supply is borrowed at interest we have no choice. It's win-win for those with money to lend.

Now what would happen if the banks created less credit but the shortfall was made up by debt-free money? What if we went back to 1960 when 21% of all money was created debt-free instead of 3%? What if it was 50% or 100%? How would that affect house prices, small businesses etc?

[botanic]

Yes I am happy to move on from housing. But let me summarise the results of our analysis of 1995 and 1979 first.

Houses were more affordable in both these years than at the height of the house buying mania. They may have been more affordable because there was less demand, especially in 1979. The 7% mortgage rate in 1995 seems reasonable but banks were providing mortgages with money created from 'thin air' at that time. I doubt whether the mortgage rate would have been so low under PM. The mortgage rate was about 15% in 1979 and mortgages were provided by old fashioned building societies using savers' money at the time. This rate seems very high to me, as it would also apply more or less to business loans. But to be fair the inflation rate was also about 15% in 1979, so this year doesn't really provide a fair picture of how things might be under PM.

Now to move on from housing!

Your question was

Now what would happen if the banks created less credit but the shortfall was made up by debt-free money? What if we went back to 1960 when 21% of all money was created debt-free instead of 3%? What if it was 50% or 100%? How would that affect house prices, small businesses etc?

I imagine that these changes would result in less money being lent in aggregate and money that was lent having higher interest rates.

You already know my opinion about the effect of this on the cost of buying houses: Whilst demand outstrips supply I think that the total cost of buying a house (price plus interest) would stay much the same.

What would the effect be on SMEs? It seems obvious that the number of SMEs would be reduced. However I am also interested in which SMEs would survive best. I imagine that well established firms would survive without loans best and maybe family firms that pass from one generation to the next would survive best of all. Also people who start with significant wealth would be able to buy established firms. So the SMEs that would experience most difficulty in the absence of reasonably priced loans, would be ones that people try to start and expand from scratch. Starting a firm by working hard and buying a house (which can be used as collateral) would no longer be an option if the loans simply weren't there or if the interest rates were too high to be sustainable. Overall this feels to me like a return to the 'good old days' which I happen to think were not all that good in some respects!

Well that is my first reaction to your question. I also guess that what you really want to move on to is the effect of having all that debt free money about and the wealth it is supposed to bring. I have something to say about that too but I will save it for a later post!

[peterv]

I agree pretty much with what you say about SMEs. Let's get interest rates debated first, then move on to SMEs?

I've started a new post on 'what might happen to interest rates', and would welcome your response.