Collective Household Economics and the need for funds approach The 2007-2008 financial crisis and its effects

The three main economic philosophies (Classical, Keynesians and Monetarists) did not help in preventing the 2007-2008 U.S. financial crisis. Why not? The Classical economists focus on free markets, free of government interference and free of monopolies. They missed the point that when about $10 trillion of the funding in the U.S. housing market is based on borrowed funds, the housing market is no longer free, but depend on what happened to the borrowers. The Keynesians emphasized the need for government interference to counteract recessions by increasing government spending above tax receipts. The U.S. experience over 2008-2015 has shown the fastest growth rate of government debt for a long time, but this did not help individual households to repay their mortgages. Keynesians also believe in the control of money supply but they do not link prevailing interest rates with the affordability of such rates to individual households. The Monetarists believe that banks can and should control the supply of money. It will be clear from this paper that banks did not control their mortgage lending levels in the run up to the financial crisis. Monetarist’s emphasis is on supply level of money rather than on the ability of households to repay outstanding loans, especially those of a long-term nature, out of the incomes earned. All in all a major rethink of policies is required. Why was the financial crisis not foreseen? House price inflation based on excessive lending levels was not regarded as a threat to economic growth, contrary to the threat from cost price inflation. The latter occurs when wages growth or costs of raw materials, intermediate goods and imported goods push up inflation levels. The second reason was that it was not recognized that the supply of mortgage funds as provided by the banks and the financial markets does not necessarily match the needs (or demand) of the collective of individual households. The needs are based on population growth levels, changes in family size and changes in accommodation taste patterns. In the U.S. about 1.8 million new homes are needed every year. The needs of the collective of individual households are also based on income growth, the affordability level. The latter is especially important for lower and median income families. Wall Street thinks in terms of profitability, while Main Street thinks in terms of affordability. The third reason was that the level of the Fed’s base rate sets the funding cost base for banks. Competition for customer deposits adds an additional cost level for banks. The price setting for mortgages is a one sided process whereby banks, and indirectly the Fed, decide what to charge to their customers. As set out in this paper mortgage customers need a “dynamic stability” in their mortgage obligations, one that is linked to the annual CPI level and income growth. The paper proposes a scheme to break the link between the cost of mortgages as set by the banking sector and the mortgage interest costs paid by individual households, with the latter instead being based on the CPI level plus a margin. Such a scheme will stabilize the financial position of individual households both at high and low inflation levels. In some years a surplus will be created between what individual households pay and what the banks receive; in other years there will be a shortfall. The U.S. Treasury could accommodate such temporary surplus/shortfall as a tool for creating stable economic growth, in what could amount to a type of individuals’ quantitative easing. As a further tool for putting the collective of individual households first, rather than the financial sector, a traffic light system can be implemented to slow down the volume of mortgage lending when needed. A future financial crash linked to the housing sector can be avoided if the separation of mortgage interest charged by the banking sector and interest levels paid (based on CPI inflation levels) by the household sector is combined with the traffic light system. ‘Collective Households Economics’ may be a new variant of economic thinking. The need for funds approach is based on the different parameters for the collective individual households than the ones that rule the banking sector. It is paramount, if one wants long-term economic growth to continue, that the need for funds approach prevails. It is based on the needs of the individual household customer base, rather than on the profit levels of the financial markets. Bridges can be built!