Yesterday, with special thanks to Matt138, I introduced the writings of Frédéric Bastiat, a 19th century French economist. I always find it interesting when writings from many years ago resonate through the ages as if they were written yesterday. If you’ve never read Plato’s Republic, it has a similar resonance. Plato’s critique of the shortcomings of democracy are still just as valid today as they were 2,500 years ago when he wrote it. Usually, I feature recent news articles less than a few weeks old. Today, I am featuring an essay written more than 160 years ago. The fact that it resonates so well today shows just how farsighted his vision was.
Our obscure French economist understood the workings of credit and it’s impact on society in general. He would readily recognize the misallocations of credit caused by government loan guarantees in the housing market and distortions of reality used to justify it. He would probably be amused by the parallels between what’s happening in the United States today and what happened in France 160 years ago. Or perhaps not. He might be horrified that mankind has made such little progress in understanding the folly of government intervention in the credit markets.
At all times, but especially in the last few years, people have dreamt of universalizing wealth by universalizing credit.
I am sure I do not exaggerate in saying that since the February Revolution the Paris presses have spewed forth more than ten thousand brochures extolling this solution of the social problem.
This solution, alas, has as its foundation merely an optical illusion, in so far as an illusion can serve as a foundation for anything.
These people begin by confusing hard money with products; then they confuse paper money with hard money; and it is from these two confusions that they profess to derive a fact.
In this question it is absolutely necessary to forget money, coins, bank notes, and the other media by which products pass from hand to hand, in order to see only the products themselves, which constitute the real substance of a loan.
For when a farmer borrows fifty francs to buy a plow, it is not actually the fifty francs that is lent to him; it is the plow.
And when a merchant borrows twenty thousand francs to buy a house, it is not the twenty thousand francs he owes; it is the house.
This is the essence of asset-backed debt. When lenders broke the connection between the amount of the loan and the cashflow value of the house, they inflated a massive housing bubble which caused an enormous misallocation of resources as money poured into housing that we didn’t need.
Money makes its appearance only to facilitate the arrangement among several parties.
Peter may not be disposed to lend his plow, but James may be willing to lend his money. What does William do then? He borrows the money from James, and with this money he buys the plow from Peter.
But actually nobody borrows money for the sake of the money itself. We borrow money to get products.
Now, in no country is it possible to transfer from one hand to another more products than there are.
Bankers believe they can. They also confuse money with produce. They believe that if they print more money or come up with some “innovative” new loan program, they can actually create value. They don’t. Paper is paper. It has no value other than what we confer on it, and despite any short-term obfuscations and distortions, the total amount of money must equal the total value of goods and services a society produces. The excess — and there is always excess with a printing press — merely dissipates as inflation.
The federal reserve can print money out of thin air, and they have been doing so to the tune of $85 million for month for the last several months. This creation of money doesn’t match up with anything tangible, merely the bad loans — the illusory assets — polluting banks balance sheets.
Whatever the sum of hard money and bills that circulates, the borrowers taken together cannot get more plows, houses, tools, provisions, or raw materials than the total number of lenders can furnish.
For let us keep well in mind that every borrower presupposes a lender, that every borrowing implies a loan.
This much being granted, what good can credit institutions do? They can make it easier for borrowers and lenders to find one another and reach an understanding. But what they cannot do is to increase instantaneously the total number of objects borrowed and lent.
However, the credit organizations would have to do just this in order for the end of the social reformers to be attained, since these gentlemen aspire to nothing less than to give plows, houses, tools, provisions, and raw materials to everyone who wants them.
And how do they imagine they will do this?
By giving to loans the guarantee of the state.
Does this sound familiar? Politicians have worked to expand home ownership by guaranteeing loans through the FHA and the GSEs. The FHA has been around since the 1930s, and despite their best efforts, home ownership rates are no better in the United States than in countries with no government subsidies at all. As it turns out, you can’t give homes to everyone who wants one.
Let us go more deeply into the matter, for there is something here that is seen and something that is not seen. Let us try to see both.
Suppose that there is only one plow in the world and that two farmers want it.
Peter is the owner of the only plow available in France. John and James wish to borrow it. John, with his honesty, his property, and his good name, offers guarantees. One believes in him; he has credit. James does not inspire confidence or at any rate seems less reliable. Naturally, Peter lends his plow to John.
That is how the private lending market would work. An dispassionate evaluation of creditworthiness would determine who got loans and who did not.
But now, under socialist inspiration, the state intervenes and says to Peter: “Lend your plow to James. We will guarantee you reimbursement, and this guarantee is worth more than John’s, for he is the only one responsible for himself, and we, though it is true we have nothing, dispose of the wealth of all the taxpayers; if necessary, we will pay back the principal and the interest with their money.”
The FHA and the GSEs facilitate loans by guaranteeing investors repayment of principal and interest on a loan regardless of whether or not the borrower repays it. The positive impact of what’s seen is the new loan given to a low-income borrower. The negative impact of what’s hidden is the crowding out of more creditworthy borrowers and the pernicious effect on borrower’s attitudes and burgeoning entitlements.
So Peter lends his plow to James; this is what is seen.
And the socialists congratulate themselves, saying, “See how our plan has succeeded. Thanks to the intervention of the state, poor James has a plow. He no longer has to spade by hand; he is on the way to making his fortune. It is a benefit for him and a profit for the nation as a whole.”
Just as supporters of the FHA and GSEs pat themselves on the back for providing home ownership to those who wouldn’t be extended loans by private lenders.
Oh no, gentlemen, it is not a profit for the nation, for here is what is not seen.
It is not seen that the plow goes to James because it did not go to John.
It is not seen that subprime borrowers and others of dubious credit quality bid up prices so prudent borrowers have to pay more, or worse yet, prudent borrowers end up getting priced out of properties commensurate with their incomes and are forced to substitute down to lower quality properties. The borrowers who should not have been given loans are provided with nicer properties while the prudent are forced to accept lesser accommodations.
It is not seen that if James pushes a plow instead of spading, John will be reduced to spading instead of plowing.
Consequently, what one would like to think of as an additional loan is only the reallocation of a loan.
Furthermore, it is not seen that this reallocation involves two profound injustices: injustice to John, who, after having merited and won credit by his honesty and his energy, sees himself deprived; injustice to the taxpayers, obligated to pay a debt that does not concern them.
This is the central injustice of the housing bubble. By 2004, prudent borrowers were forced to chose between accepting a much lower quality property or wait for years for the imbalance to correct itself. Then, when the housing bubble collapsed, rather than gaining advantage of their prudence, those that didn’t participate in the housing bubble were forced to pay for bailouts designed specifically to keep them priced out of nicer properties and benefit the Ponzis and the stupid lenders that enabled them.
Will it be said that the government offers to John the same opportunities it does to James? But since there is only one plow available, two cannot be lent. The argument always comes back to the statement that, thanks to the intervention of the state, more will be borrowed than can be lent, for the plow represents here the total of available capital.
This economic fallacy is the entire justification for loan programs specifically designed to help lower income borrowers “afford” homes. In reality, it merely inflates the prices of entry level homes and deprives a marginal buyer an opportunity to own in favor of a less qualified buyer who meets the criteria of the program.
True, I have reduced the operation to its simplest terms; but test by the same touchstone the most complicated governmental credit institutions, and you will be convinced that they can have but one result: to reallocate credit, not to increase it. In a given country and at a given time, there is only a certain sum of available capital, and it is all placed somewhere. By guaranteeing insolvent debtors, the state can certainly increase the number of borrowers, raise the rate of interest (all at the expense of the taxpayer), but it cannot increase the number of lenders and the total value of the loans.
Do not impute to me, however, a conclusion from which I beg Heaven to preserve me. I say that the law should not artificially encourage borrowing; but I do not say that it should hinder it artificially. If in our hypothetical system or elsewhere there should be obstacles to the diffusion and application of credit, let the law remove them; nothing could be better or more just. But that, along with liberty, is all that social reformers worthy of the name should ask of the law.
Right now the law artificially encourages borrowing. We subsidize interest payments with the home mortgage interest deduction, and we guarantee the repayment of debt with FHA and GSE lending programs. In fact, when you consider the FHA and GSEs now insure more than 90% of the loans in the marketplace, we have completely nationalized home ownership. This will ensure the misallocation of resources and further injustices to borrowers through the capricious allocation of credit based on government policy rather than merit and character of the borrower. The negative impacts of these problems will reverberate for another generation. Perhaps our grandchildren will enjoy a free market, but I rather doubt it.
Better late than never
The former owner of today’s featured property was a reasonably responsible homeowner during the bubble. He dutifully paid down his mortgage right up until the peak when he extracted about $300,000 for personal consumption. His timing was great if his intent was to sell the property to the bank at peak prices.
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Proprietary OC Housing News home purchase analysis
$899,900 …….. Asking Price
$424,000 ………. Purchase Price
7/31/1998 ………. Purchase Date
$475,900 ………. Gross Gain (Loss)
($71,992) ………… Commissions and Costs at 8%
$403,908 ………. Net Gain (Loss)
112.2% ………. Gross Percent Change
95.3% ………. Net Percent Change
5.2% ………… Annual Appreciation
Cost of Home Ownership
$899,900 …….. Asking Price
$179,980 ………… 20% Down Conventional
3.48% …………. Mortgage Interest Rate
30 ……………… Number of Years
$719,920 …….. Mortgage
$166,863 ………. Income Requirement
$3,225 ………… Monthly Mortgage Payment
$780 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$225 ………… Homeowners Insurance at 0.3%
$0 ………… Private Mortgage Insurance
$81 ………… Homeowners Association Fees
$4,311 ………. Monthly Cash Outlays
($717) ………. Tax Savings
($1,137) ………. Equity Hidden in Payment
$198 ………….. Lost Income to Down Payment
$132 ………….. Maintenance and Replacement Reserves
$2,787 ………. Monthly Cost of Ownership
Cash Acquisition Demands
$10,499 ………… Furnishing and Move In at 1% + $1,500
$10,499 ………… Closing Costs at 1% + $1,500
$7,199 ………… Interest Points
$179,980 ………… Down Payment
$208,177 ………. Total Cash Costs
$42,700 ………. Emergency Cash Reserves
$250,877 ………. Total Savings Needed