Consumer decadence and credit market destruction: did the decline in the U.S. saving rate cause the new millennium financial crisis?

AuthorBroady, Kristen E.

    1.1 Background

    The Roaring '20s foreshadowed the Depression, while the Greenspan, Technology, and Housing Bubbles paved the way for the new millennium crisis. During both the Depression and the New Millennium Crisis, the U.S. government enacted policies to intervene in an effort to prevent asset prices from falling. Short selling was banned at the initiation and federal economic stimulus packages were introduced as a solution for both events (Keeler, 2001). In the years leading to the Great Depression, credit was very easy to obtain and many consumers found themselves in debt. Consumers borrowed to finance stock market investments. People purchased stocks at high prices, in hopes of selling them at even higher prices. Stock prices became inflated. At the end of the stock price bubble, stock holders hurried to sell and the stock market crashed. A seemingly comparable circumstance led to the recent financial crisis, particularly in the housing market (Ebeling, 2008).

    Along with the similarities there are several important differences between the Depression and the New Millennium Crisis. There is no longer a gold standard to restrict the expansion of the money supply. Credit cards and other forms of revolving credit that were not available at the time of the Depression have significantly contributed to the current national debt and the debt of many American consumers. Today, a much greater portion of the U.S. debt is owned by foreigners which allows for devaluing the dollar through the sale of Treasury bonds and dollar reserves.

    The general sequence of events leading to the New Millennium Crisis began with increased investment in real estate, which caused inflation of housing prices. Home equity borrowing increases liabilities and cash equally, initially leaving net wealth unchanged. When the borrowed funds are spent, cash balances fall, consumption increases, and net wealth declines. The marginal propensity to consume from net wealth can be positively correlated with housing debt. Many homebuyers obtained loans they would never be able to repay. As a consequence, when the housing bubble burst, many people were faced with foreclosure. News outlets and academic research have brought to view several contributing factors, particularly the government, mortgage originators and Wall Street, but fail to consider the role of the U.S. consumer (Liebowitz, 2009).

    1.2 Contributing Factors

    Allen & Gale (1999) identify a three-phase-pattern generally followed by financial crises. Phase One begins with financial liberalization by the central bank with the intent of increasing lending. This results in the expansion of credit and in increase in asset prices. Prices rise as the bubble inflates. Phase Two is characterized by the bursting of the bubble and the collapsing of asset prices. In Phase Three many firms and other agents default on loans that were used to purchase assets (Allen & Gale, 1999). One of the key factors in the housing market is the interest rate charged on mortgage loans. Since mortgage loans compete with other credit in the country's general finance markets, they tend to go up and down when the interest rates on other forms of credit go up and down, and all are influenced by the interest rate set by the Federal Reserve System, based on its assessment of conditions in the economy as a whole. This means that, like other interest rates, the interest rates on mortgage loans have varied widely over a long span of years--and sometimes within a relatively short span (Sowell, 2009). For example, conventional 30 year mortgage loans charged 7.44 percent interest in January 1973. That number rose to 18.45 percent by October 1981, and then fell gradually, with small scale ups and downs, to 5.19 percent by August 2009.

    A sequence of events led to the New Millennium financial crisis. The Community Reinvestment Act (CRA), enacted by Congress in 1977 was intended to encourage depository institutions to help meet the credit needs of the communities in which they operated, including low- and moderate-income areas, consistent with safe and sound operations. However, this act used the "stick approach" for compliance, which proved mostly unsuccessful (Spahr, 2009). Leniency in mortgage loan underwriting standards in the early 1980s led to increased homeownership, a house price boom, and increased demand. Housing speculators added further to the demand and price of housing. This was made possible partially by the separation between loan originators and the ultimate debt holder because of securitization. The end of the housing price boom more or less provided a free futures option with no downside risk for speculators, so they held when prices were rising and pulled out when they fell. In the mean time consumers borrowed more than they could afford, decreased their household saving, increased consumption, and were not prepared for the end of the housing price boom (Liebowitz, 2009).

    During most of the 1980's and 1990s, the national average sales price of a home remained below six times the average per capita after-tax American income. By the peak of the boom in 2005, the average house cost nearly eight times the average income. The increase in asset prices made households feel wealthier, so they saved less and borrowed even more to finance their consumption. The value of property and equities rose even faster than personal debt, so households' balance sheets continued to look healthy. The price of urban residential land tripled between 1980 and 1990, lifting net household wealth (assets minus debts) from five times disposable income in 1985 to 8.5 times in 1990 (Goodman, 2009).

    Beginning in the early 1990's, banks were pressured to lend. The approach taken to increase home loans among targeted populations was leniency in underwriting standards. Creditworthiness standards were relaxed. Repayment standards were decreased. Closing costs were pushed down from 20% for conventional mortgages to as low as 3-4%, and income sources were expanded. Lenders no longer had an incentive to be strict, as they intended to package and promptly sell loans. Their profits came from the loan originator, not the stream of mortgage repayments. Therefore, there was no concern about low or no down payment loans (Liebowitz 2009). Banks and other lenders were pushing home-equity loans and lines of credit. In the 1990s, the average mortgage interest rate for a 30 year fixed conventional mortgage was 8.1 percent and banks drew new borrowers in by advertising no fees and free checking accounts. For many home owners, home-equity loans were the cheapest way to obtain quick cash. The rise in the market value of homes after the early 1990s led to a considerable increase in the level of housing wealth. The average single family home sales price more than doubled from $149,800 in 1990 to $311,600 in 2007. However, mortgage debt grew more rapidly than home values, resulting in a decline in housing wealth as a share of the value of homes (Greenspan Kennedy, 2008). As a result of the drastic decrease in house prices, many Americans now owe more on their mortgages than their homes are worth, a problem referred to as "negative equity." In addition, interest rate resets on select subprime and traditional loans will result in even higher mortgage payments for many families already struggling to make ends meet. (Sowell, 2009).


    2.1 Theory of Savings

    Keynes (1936) lists eight saving motives: precautionary, life-cycle, intertemporal substitution, improvement, independence, enterprise, bequest, and avarice (Keynes, 1936). Browning and Lusardi (1996) add a ninth, the down payment motive. According to Keynes, it is a "psychological law" that households increase their consumption as their income increases, but not as much as their income increases". One consequence of this "law" is that the proportion of national income represented by saving increases during periods of economic growth (Keynes, 1936). Therefore, during economic booms people save money in preparation for the expected bust.

    Keynes' theory of saving was generally accepted by his contemporaries. However, in 1942 Simon Kuznets examined Keynes' Absolute Income Hypothesis. Kuznets found that Keynes' predictions, while accurate in short-run cross sections, gives inaccurate predictions in of long run time series data. Kuznets used data to show that over a longer time span (1870s - 1940s) the savings ratio remained constant, despite large changes in income. This set the foundation for Milton Friedman's Permanent Income Hypothesis and Modigliani's Life-Cycle Hypothesis. Standard applications of both theories lead to the view that all sources of an increase in wealth, whether from stocks, real estate, or other assets, should have the same positive effect on household consumption, an effect derived from a long-run marginal propensity to consume out of wealth that is slightly higher than the real interest rate (Mishkin, 2007).

    The Life-Cycle Hypothesis (LCH), more suited to microeconomics, was elaborated by Modigliani and Brumberg in 1953 and 1954 in two papers, one dealing with individual behavior and the other with aggregate saving. LCH argued that the average propensity to consume is higher in young and old households, whose members are either borrowing against future income or running down life-savings. Along with income risk, marriage rates are also a determinant of home ownership for younger potential householders. Between 1980 and 2000 homeownership of households with heads between the ages of 25 and 44 declined substantially, recovering during the 2001 to 2005 housing boom. Fisher and Gervais (2009) suggest that the decline was due to the decrease in the incidence of marriage with mechanically lowers home ownership rates (Fisher & Gervais, 2009). While marriage is a factor for the younger generation, medical expenses are more of a factor in determining homeownership for...

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