Monday, 11 February 2008

Recession, money, thinking and confidence

Many economists advocate that US economy is heading into recession. But few of them explain the reasons with the clarity of Charles McMillion, President and chief economist of MBG Information Services in Washington, D.C.

His article, “The Economic State of the Union 2008”, posted yesterday by itulip, explains that the US economy is heading into recession because the Bush administration borrowed heavily in order to favour the Finance, Insurance and Real Estate (FIRE) sector. This combined with a dramatic increase in war spending and a lack of interest in stimulating the industry and research is increasing the deficit and decreasing productivity.

The explanation is simple. If the government encourages private spending (for example, by cutting taxes) without stimulating productivity there will be an increase of prices. That is, if there is more money in the market and there is the same amount of goods to buy, then the money will loose its value and the prices of goods will go up.

This is happening with house prices. The Federal Reserve reduced interest rates; hence banks offer cheap money to buy properties (i.e., mortgages with low interest rate). This leads to an increase in borrowing, so more people started buying houses. If there are no incentives to build more houses, then the price of houses goes up. An increase in demand without a matching increase in supply generates an increase in prices.

In “Organised Thinking” I am interested in the thinking process of the banker that lends money and that of the buyer that borrows money. Why the banker takes the risk of not being repaid? Why the buyer takes the risk of not being able to repay the mortgage and loose his/her property?

The bankers’ thinking process is easy to infer. They think that lending money for an interest is their business. The best case scenario is that everything goes well; the borrower pays capital plus interest. The worst case scenario is that the borrower cannot repay. This risk is contemplated: banks will keep the property. Although selling properties is not the business of bankers and they try to avoid this situation, the benefits are higher than the costs; therefore, they lend as much money as the borrowers are willing to borrow. Moreover, bankers are organized and powerful; they can lobby to obtain compensation from the government if there are many foreclosures.

Understanding the buyers’ thinking process is a bit more difficult. The main component of their thinking process is confidence. Buyers are confident that they would maintain their current incomes, so they would be able to pay. In this case, there is no problem at all. However, there are many persons that borrow more money than they can afford. Not only have they borrowed money to buy a property but also to buy a plasma TV, a videogame console, a laptop, etc. At some point these people cannot afford to pay any more and they start borrowing to pay debts. In a continuously growing economy this may last for the lifetime of the borrowers. However, if the productivity of the economy does not grow, the bubble will burst at some point and lenders would not lend more money.
In psychological terms, recession is lack of confidence. While there is confidence bankers lend money, consumers borrow money and, most importantly, producers invest to increase their production and their productivity. A healthy economy is one in which the aggregate confidence of people matches their aggregate skills. More confidence than skills is as bad as less confidence than skills. In the case that people are more confident than what they should be, there is a high probability that there will be inflation, whereas when people are less confident than their skills there would be recession.

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