How the U.S. financial crisis could have been averted

In the U.S., the 2007-2008 financial crisis was caused by a lack of understanding of the implications of households committing to use future incomes for a purchase of a home. Committing future income flows to acquire goods and services in the current period requires households to make a judgment about future interest rates, about the household’s ability to earn an income in future years, about a possible future state of health and about growth in income levels and changes in future inflation levels: a near impossible task! On top of this, households have absolutely no control over the amounts other households borrow, notwithstanding that such collective borrowings can have a major impact on the shift from an income based financing to borrowing against the values of the assets: the homes. The choice –demand- for goods and services is infinitely simpler when current income is being used to buy such items. If only current income is being used, the choices of what to buy are limited by the level of income and savings. Economic theories and economic models have given too little weight to the difference between committing current or future incomes. It is not just individual households who have to struggle with such a choice; also governments have to make such judgments in their spending behavior. This paper will focus on the mortgage borrowing levels in the United States over the period 1996-2016. The paper will examine the factors that drive the supply of funds as the supply side totally determines the outcome of the mortgage borrowing levels. Households are for 100% dependent on the willingness of lenders to commit funds. The major drawback of this dependency is that lenders not only find their security in future households’ income levels, but also in the values of the assets: the homes being financed. As this paper will demonstrate, the volume of funds lend can and often does affect the price developments of all homes and it is thereby a factor which can cause a major deviation from the only factor which matters: the ability of households to repay such mortgage borrowings out of future income levels. As the statistics will show, the financial crisis for U.S. individual households already happened in 2003, long before the banking crisis of 2007-2008.