Mortgage forgiveness and moral hazard

Stephen Kinsella of Limerick University popped up on Newstalk this morning to tell the country that concerns that the floated mortgage debt forgiveness might cause increased problems of moral hazard as absurd, or somesuch dismissive noun. His argument is put here.

It wasn't a complete or particularly coherent argument, which is forgiveable given the live radio context, but I feel a need to point out that Stephen's performance leaves me feeling that his is the absurd position on this issue. And he can't be given the same forbearance for his blog posting.
It is worth parsing his argument to see how poor it is, riddled with omission, straw men and simple appeal to emotion.

Stephen makes three supposed points referring to moral hazard, conveniently labelled one, two and three in his post. Let's look at them:

"First...the Irish economy has already been
 pumped full of moral hazard because of the bailout of Ireland’s banks
and bankers"

Well, I don't disagree with this, but point out that the bank bailout was stupid and most likely has increased moral hazard, but for lenders of risk capital. What is at issue here is whether to compound one immeasurable level of stupidity (the bank guarantee/bailout) with another (mortgage debt forgiveness) which would extend the exacerbation of moral hazard from risk capital lenders to the borrowers as well - a type of "why stop now?" type of argument. Strange indeed. Stephen's argument might also seem to imply that we should all be allowed our share of moral hazard, that it simply isn't fair or that households should not miss out on this fun. I would characterise that as a rather strange type of analysis of welfare economics.

"Second, the moral hazard existed at the point of sale–the bank
 selling the mortgage had more information about the likely evolution 
of the market...

...Recent research has shown that rising house prices were driven predominantly by increases in the size of mortgages that banks were willing to give, meaning the banks were the engine of the housing bubble, not interest rates or population. The average person just wanted a house to live in."

I don't know how to interpret this. He makes a claim and doesn't support it. To state that "the moral hazard existed at the point of sale" and was manifested through the lender, suggests that the lender had strong belief when they made the loan that they would not be made to bear the cost of any default, over and above their contracted security. Does Stephen have any proof of that? I am not aware of anything that suggests that banks believed they could rely on anything more than the ability of the borrower to repay and the strength of the backing collateral (the house). So this claim is just absurd.

But Stephen then confuses this non-argument by going on to claim that house prices were being driven by the size of mortgages (well, d'uh Stephen, it was a monetary and credit bubble), but doesn't make it clear how that matters for his argument. It is simply a well accepted fact; people wanted/needed larger mortgages to buy property and took increasing personal risk (gearing) to do so, banks wanted/needed to make larger mortgages available and took increasing risk (gearing) to do so. If Stephen has evidence that either side had some information that led them to believe they had some "get out of jail free" card in the event that something went wrong he should actually state it. Otherwise he has not pointed out any moral hazard.

And Stephen then descends into something which is pretty deplorable for an academic economist. He resorts to argument from emotion: "The average person just wanted a house to live in". But I don't give Stephen full credit here. This is even worse than an argument from emotion, it is just plain stupid. There was and is plenty of housing available. People could have rented a house or apartment. Would that have sated this desire of the "average person"??? Moreover, this average person could have found "a house to live in" at a rental yield so low that it made the very idea of buying over renting totally irrational - in fact it was.

So to number three:

"Third, the worry is that these bailed out homeowners would start
 taking out more debt, thinking they’d be bailed out again. Think about
 this for a second from your own point of view. Say a bailout happens 
for you and your wife with a 600,000 euro mortgage on your home. Say through some mechanism the bank forgives 200,000 euros of the mortgage, you keep your home, and you continue to pay a reduced amount to the banks. You and your wife have spent probably two years getting letters and phone calls from banks and solicitors, you’ve gone through the stress of nearly losing your home. A note about the debt forgiveness exists on your credit record. You are not going to start running up debt again, and
even if you’d like to, you’ll be stopped. The moral hazard argument is flawed and useless. We should discard it."

This is flawed by not properly identifying where the issue of moral hazard is really concentrated. Increasing problems with moral hazard will come from all those people who will try to manage their financial affairs in order to qualify for a bailout. For example, we are probably talking large sums here, potentially multiples of gross annual earnings for individuals. People will be incentivised to make their financial position appear worse than it is, or heaven forbid actually deliberately make their financial position worse than it is (why bother with this saving lark, lets blow some cash on holidays etc.) as they reorder their priorities away from paying off their mortgage. Just like a lot of people tried to distort their financial position during the bubble in order to qualify for a larger mortgage, a lot of people will certainly try to distort their financial position in order to qualify for debt forgiveness.

And there is more. The moral hazard will in fact be most likely to affect the children of those people who get the bailouts, or those people who won't get the benefit of this bailout. They will be the ones watching risk being absolved and factor that explicitly or implicitly into their future decisions.

After that series of non-points Stephen then makes some intellectual doodles before signing off. They are all pretty specious, but I find this one probably the most unforgiveable for a supposed Economics professor:

"Fully cleansed, functioning banks, homeowners taken out of substantial negative equity and consuming and investing again, and a clear signal to the markets that Ireland has put its house–no pun intended–in order, may be worth it"

There is a serious ommission of fact that mortgage debt forgiveness will spark increased solvency problems for the banks - they are writing off yet more assets, OK - and not help to "cleanse" them, but require us to put more taxpayers capital into them under the current polices.

With that in mind I hope readers of this blog will immediately understand why I find this statement completely unconscionable. We are talking about a redistribution of wealth here. Ireland's economic problem is a hangover from a massive savings/investment imbalance. A mortgage debt forgiveness program will simply take capital from members of society and give it to some others - completely arbitrarily. Note that the capital might be "taken" via even more borrowing by government, which of course has to be repaid by taxpayers.

Back to Econ 101 for you Stephen. How does such a redistribution of capital either:

• increase the total amount of capital available, or
• increase gross saving in Ireland

It doesn't, unless the capital is coming from foreigners, say in the form of default on (foreign)bank bondlholders - but Stephen doesn't say that, nor does he show any indication that he understands that only with such an inward foreign transfer of wealth, would his argument hold water. That is a shocking, shocking piece of supposed analysis from an Economics lecturer.

No, our big mistake was the bank guarantee and subsequent bailout, as I have stated many times over. We should have taken AIB and Bank of Ireland under national administration at the earliest possible sign that they might fail (for "liquidity" or solvency reasons) and then recapitalised at minimum possible cost to the taxpayer, leaving shareholders and then bondholders progressively down the capital structure to take the losses. Thinking we can make debt somehow evaporate (when as I stated it is merely an act of transferring wealth) is seductive, but flawed and dangerous in equal measure. We risk merely compounding our problems and mistakes.

Let them eat cheese

If proof was needed that we have truly descended into the rabbit's hole, the Irish Government has helpfully announced their program to give away cheese to the masses. Of course, when I say masses I mean that elusive body of the population variously labelled as "the most vulnerable", "the poor", "those in need". In other words, that politically useful rhetorical devise; "the third person".

Once we all stop laughing and crying in equal measure, let's just turn to some economics to make some interesting observations and some random predictions.

• The cost of this scheme in terms of packaging and distribution, verifying that the recipients as indeed "the most vulnerable" etc. most likely rivals the costs of handing everyone who qualifies a €20 bonus in the welfare payment.

If the reports are to be believed, vis:

The cheese is available in 12 x 1kg boxes from stores in Clondalkin, Portlaoise, Kilmacthomas Waterford, Cobh and Togher Co Cork from November 15th with a “minimum of one box per collection”.

(a minimum of 12kg of cheese each!!) we will have a nice little arbitrage opportunity opening up. Prepare to see markets do their stuff. So:

• This could mean cheap cheese for everyone, as enough clever clogs see the opportunity to take a few boxes of their free cheese and sell it on. There may be attempts to restrict the sale of this cheese, but that is likely to futile as either nothing will be illegal about it, or a black market will simply develop.

And when this secondary, or black market for cheese develops, the demand for cheese via regular outlets, like supermarkets will fall. In order to prevent wastage, the price is likely to be discounted, potentially below cost in order to clear purchased stock.

Or, an alternative scenario:

• Clever supermarkets recognising this potential cheese glut curtail significantly their cheese purchases over the next month. That might lead to a shortage of cheese in supermarkets. Riots in the dairy aisle shopping mums and toddlers battle it out for the last 500 gram block of red cheddar.

And of course the medium term consequences:

• Cholesterol levels sour and heart disease takes off. The strain on the national health budget increases and our cheese binge starts to look like a big mistake.

Oh, how much fun it is to live in Ireland today. The comedy rolls on every day.

The Frankfurt dilemna - Ireland, hold on to your hat

So you think Ireland has some significant economic difficulties? Trying to manage our way off an explosive debt and deficit path for both the public sector specifically and the entire country generally is a painful adjustment.

Well, don't look now because things might get worse in the not too distant future. The reason is because short term interest rates might be on the way up before too long if recent trends continue, which if it comes to pass will make our adjustment even more painful and more difficult because the interest charge on the country's massive debt stock will rise too. Note that most of Ireland's total debt is subject to a variable, or short-term interest rate largely due to the concentration in variable rate mortgages of some description or another.

But why would interest rates increase? Surely it doesn't make sense. Well, tell that to those humourless suits at the Bundesbank who watch monetary aggregates like hawks. Those influential central bankers know that money supply figures have passed a clear turning point that means we should be ready to tighten monetary policy from its current sluice gates open mode.

Exhibit #1 - Monetary aggregates















M1 is narrow money, mostly notes and coins in circulation. M3 represents wider demand and interest bearing deposits in banks. Note what has happened to both in recent years. Before the full onset of the Global Financial Crisis (GFC) M3 was rising at a generous pace. People were borrowing from banks, that borrowing circulated back via economic transactions into deposits in banks. The Lehman Bros happened, at the point indicated in the chart. Initially it led to people putting wealth into cash (so M1 increased with an immediate spike) and then the ECB began cutting interest rates, promoting further growth in narrow money. M3 virtually stalled, as people didn't want to leave wealth on deposit with banks and the borrowing and deposit (known as money creation) cycle collapsed.

So this state of affairs continued. Until earlier this year. While M1 is still rising as monetary policy remains lax and interest rates remain low, M3 has started rising. The money creation process appears to have been rekindled. That is good news, because a continued downward money supply (M3) spiral would be a harbinger of deflation. However, it is also ominous in the sense that it indicates that the type of emergency low interest rates and lax monetary policy (including generous ECB repo lending and open market operations - e.g. Irish government bond purchase) may not be deemed appropriate any longer. That means higher ECB reference rates (the Refi. rate), which in turn will push up interbank rates and hence lead to higher retail rates, especially (say it softly) tracker and variable mortgage interest rates in Ireland.

Exhibit #2 - Euro monetary aggregates recent rates of growth
















This chart shows the most recent rates of growth, annualised rolling quarterly growth rates. M3 is now growing for the first time in over a year and not much below 5%, which would be within a range considered to be consistent with the long term inflation target of the ECB - 2%.

Exhibit #3 - Euro monetary aggregates annual growth rates















Even the annual (year on year) rate of change of M3 has turn positive, while M1 is growing at rates that would only be acceptable for short periods of time.

Ireland had better watch out, because nobody seems to be talking about this big smelly elephant at the moment.

Ireland versus Greece - the fiscal comparison

Budget silly season is now in full swing in Ireland. There are two gigantic myths that appear to be circulating generally, fed to the media who chew and the regurgitate without so much as thinking. The two I had in mind are:

1. The much trumpetted and imminent 4 year fiscal plan is the initiative of the current coalition government to somehow rescue the economy, and


2. Ireland has been and will continue to lead the way on fiscal austerity programs, in particular putting Greece in the shade.

Both are pure unadulterated fiction.

Yesterday there was a pow wow between the most important political parties in the Dail (plus the Green Party) to discuss an advance copy of a much trumpetted 4 year plan. The claim made by the government of the day is that this is of national importance and that some form of cross party consensus is needed on its content. I won't comment on that (it is complete political bollocks), but just note that the requirement for this medium term fiscal plan is enshrined in the Maastricht Treaty under Stability and Growth Pact. Ireland, like Greece needs to submit for approval by the European Commission a "Stability Program" that explains how the general government deficit will be trimmed to less than 3% of GDP by 2014.

Point 1. This is a legal requirement, not some admirable piece of national governance.

Next to how we mighty Irish are showing up those lazy Greeks. The general government deficit in 2009 was estimated at 11.7% of GDP (output), or in my preferred numeraire for Ireland 14.2% of GNP (income) - it makes a difference, doesn't it. For Greece the number was 13.8% of GDP and essentially the same as a proportion of GNP.

The first myth running around Ireland and sold to the rest of the world (as only the Irish can) was that Ireland had already introduced the most massive fiscal adjustments, while the Greek government had been sitting on its lazy bum.


Exhibit 1. - Comparable primary deficits


















Source: European Commission, Greek Ministry of Finance


The primary deficit excludes debt interest, so it is a measure of budget items under the direct control of government. Well, knock me down with a smoked kipper. It looks like those lazy, profligate Greeks have been significantly more masochistic than our own bunch assorted teachers and country solicitors.

Hopefully more people will note this and not wonder why the streets of Athens were turned into a type of European Beirut, while the Irish electorate were characterised by the local media as being "docile in the face of much more draconian fiscal measure". Let's agree right here and right now that this type of statement was and still is a bare faced lie. Regardless of the economic merits of such a fiscal contraction being implemented by Greece, there is no case that Ireland was making more significant budget adjustments. I know that a new raft of expenditure cuts and tax increases are about to be announced in Ireland, but even €5 billion in measures will amount to about 4% of GNP would only, at best, represent catch up with the measures already being implemented in Greece.

Of course these are primary deficits and they do not include interest on the stock of government debt. In the case of Greece , such interest costs amount to more than 7% of GNP and mean that they won't have completed the necessary fiscal adjustment until the primary balance is in significant surplus (that 7% of GNP deficit including debt interest would keep Greece on debt death spiral). However, that is irrelevant to the point being addressed here. The Greek government has been far more courageous (or stupid, depending on your point of view) than the Irish government to date.

Damien Kiberd ... aaaahhhhh!!!!!

Another Sunday, another self inflicted hair loss. To be honest, it is my own stupid fault. Why can't I resist passing over Damien Kiberd's weekly rantings of ignorance in the Sunday Times.

How this man, who by all appearances is just some chancing journo, equally qualified to be writing about this season's womens' Autumn fashions as economics or finance continues to get access to national media is the comic indictment of ongoing economic failings of Ireland. Idiots in charge at all levels.

In his latest rantings Kiberd keeps beating his drum about "confidence" and "consumer spending". He goes so far to advocate an extension of the car scrappage scheme because it would "increase tax revenues". Words fail me how stupid and dangerous this man is with regard to issues concerning the economy and our future welfare.

Ireland as an entity - that means Irish people in aggregate - has consumed far far far too much. We have consumed everything we have and everything we will manage to earn over the next couple of decades. This goes for the government who has done the same on our (taxpayers) behalf. Kiberd is saying that we should build an even larger stock of personal debt and/or spend savings in order to hand money over to a government who needs to cut spending.

I imagine Kiberd would probably retort something along the lines of "well, at least everyone will have a nice shiny car in the driveway". Yeah, brilliant Damien. We can park them in one of the numerous shiny new housing estates that lie empty around the country. Don't think for a moment Damo that we forget your enthusiasm for the property boom, right up to the point the bubble imploded. Why, I believe you are in print claiming Ireland would be suffering a severe housing supply shortage in 2008. Unbelievable.

This man is worse than a fool (someone who speaks beyond their capacity), his media prominence on both radio and print make him a dangerous one.

"Capitalism" to the rescue

I really shake my head at the persistence of failed Socialist views of the world. The supposed values that leftist thinking is supposed to bring is almost universally trumped by market-based solutions, which come from allowing personal and economic freedoms combined with just the right amount of regulation and law where it is needed (and no more)

One of the last places you would look for evidence of the massive benefits of this wonderful system might be the recent Chilean mining rescue. Have a read, it is revealing stuff.

So you want to become an internet squillionaire...

The first thing to do is to learn some economics. Alternatively you might be naturally endowed with all the right sort of intuitive skills to help you make the correct commercial decisions.

Have a look at this review of the new Facebook movie that documents (to greater or lesser historical accuracy) Mark Zuckerberg's development of the ubiquitous social networking site. How did this not only become so successful, but also something of such commercial value? Here is a clue in the movie, if it is indeed true:

He resisted bombarding users with advertising, believing it best to let the service reach its natural market size without offending them. This is accurately portrayed in the movie; his early business partner Eduardo Saverin insists the company has to immediately "monetize" and Zuckerberg refuses. He still believes that growth is more important than short-term monetization.

A nice exposition of two important concepts; "switching costs" and "network externalities". Take the second first. The phrase network externalities refers to positive indirect effects that accrue to third parties. Elsewhere I have blogged on the more talked about negative externalities, but here is a case of positive ones.

A Facebook with two users provides very little "utility" or value for either of its users. If two more people join then instantly the value to the existing users increases. Why? Because of the additional connections, contributions etc. that those additional people bring. Let's say that the users find the larger Facebook network with twice as many contributors twice as interesting/useful/fun and that feeling is shared by the other users. The size of the network has doubled (from 2 to 4 users) but the value of the network has increased from 2 x 1 = 2 to 4 x 2 = 8; a multiple of 4!! That is network externalities at work; a network gains its value from the number of connections.

Zuckerberg was perfectly correct to resist those urging an early commercialisation of his network, realising (supposedly) that its value would grow exponentially relative to its size. The return to being patient was potentially - and subsequently proven to be - enormous.

What about the other concept - "switching costs". Not only did Zuckerberg appear to realise the need to wait and let the implications of network externalities run their profitable course, but he was reputed to have been concerned about "offending his users". Again, wise to the economics of his website. What is implicitly recognised here is that regardless of how much value the users of Facebook (customers) personally derived from being a member of the network, the only amount that he as owner of Facebook could extract from these same users was the cost any user would bear from leaving - that is each user's "switching costs". And when Facebook was smaller, before the Network externalities had really kicked in and there were other similarly sized and even larger networks around, the switching costs of Facebook users was probably very small. Any actual or perceived cost imposed on Facebook users at that time - for example a user fee or even annoying advertising, could have led to mass desertion of Facebook users to one of the other popular networking sites of the time. Imagine how easy it is to jump ship from a Facebook with 10,000 members, compared to jumping from one with 500,000,000 members. For one thing, there is no alternative...

But Zuckerberg held his nerve and allowed Facebook to grow to the point that it was big enough that:

1. The exponential growth via network externalities made Facebook very valuable to it users and
2. That same size and associated network effect increased the switching costs of users to something meaningful; users would now be willing to tolerate some advertising or funnel some money into their use of Facebook.

These are two simple concepts that have been exploit knowlingly or otherwise by Internet winners (Microsoft, Google, Facebook etc.) and not understood by a myriad of losers.

Just a final note. Again something that the astute reader should have picked up. These two concepts together mean that network type industries or businesses will tend to be "winner take all", or natural monopolies. It is no accident that technological, informational or network industries are more commonly dominated by a small number of large participants compared with production or cost driven industries like manufacturing.

For the astute and most likely wealthy readers, there is a lesson for investing here also. Don't try and pick winners in this space. Simply try and cover the field so that you will have some money on the eventual winner.