Incorrect Thinking in the Financial Crisis

March 24, 2009 Graeme Codrington Ethics, Media tidbits, Recession solutions 1 Comment

The current economic crisis has seen a deluge of woolly thinking. At TomorrowToday we work hard to bring clarity in the midst of such defective views of the world. Here are just a few of the nonsenses being perpetrated on logic and reason:

There are many statements about consumers being “impacted by the credit crunch”. I have read this phrase in particular with reference to houses and cars.

House prices are currently in decline in most parts of the world – and most journalists (probably fuelled by estate agent press releases) perpetuate the nonsense that this is “bad news”. It’s about as much bad news as petrol, food or beer prices falling, isn’t it? There are a number of reasons why this could be a nonsense statement. For some people, their house is still worth more than what they bought it for (and more than they have borrowed in mortgage to pay for it). So, they are mourning the “loss” of an estate agent’s valuation, rather than any actual monetary loss. For others who overstretched themselves to buy their house, they are now in a “negative equity”. But unless they have to sell their house in the next few months, this should have no real impact on them. The only people for whom this crisis is, in fact, a crisis are those who have multiple properties in the “buy to let” market, and now have empty properties with no rental income but mortgages due.

As I said in my (2001) book, “Mind Over Money” (see it at Amazon or Kalahari.net or all my books listed here), the only time a house is an asset is if you are actually making money out of it. So, only those with “buy to let” houses should in any way be upset right now. The rest of us get to enter the housing market at more reasonable prices (how many times have you complained about how expensive houses are, while simultaneously thinking how clever you were for living in one?). If you need to move houses, there is no problem – you sell low, but you also buy low! So, where is the real problem here?

In the car market, an AA spokesperson recently said, “People wanting to get high-aspiration vehicles at an affordable price will have been hit by the crash in value of the cars”. Why? Can someone explain that statement to me. If I want to buy a new car, why would I be upset that it is now cheaper to do so. Fuzzy thinking indeed. Sure, a very few people who have bought cars as assets to realise a profit on resale might be struggling. But how many of those people do you know? This is certainly not a consumer issue.

The Spectator contributor, Ross Clark, explained it this way:

Yes, this remark really is as stupid as it seems, but first a little context. He was talking about a form of hire purchase called ‘Personal Contract Purchase’, whereby a motorist pays a deposit, followed by two years of monthly payments. At the end of this period, the buyer has two options: he can either pay a lump sum to purchase the car outright, or he can return it to the finance company which organised the deal. The size of the final lump sum demanded by the finance company is fixed when the buyer takes out the deal, based on what the vehicle is expected to be worth in two years’ time. For example, a motorist who bought a Volvo XC90 in December 2006 was told that in January 2009 he would have an option to buy the car for £18,775.

As it turns out, the predicted value was wide of the mark: thanks to the recession, the value of a two-year-old Volvo XC90 has crashed to £12,600. Therefore, the motorist would be pretty foolish to pay £18,775 and keep the car. He would be far better off handing the car back to the finance com-pany, then buying an identical two-year-old car on the second-hand market for £6,000 less. In other words, in no sense has the motorist been hit. Far from it: he is thousands of pounds better off. What the AA man really means is that the finance companies involved have suffered.

So, back to houses. Part of every government’s mandate is to keep inflation low. How can you keep inflation running at less than 3%, when house prices are increasing at over 25% per annum? You can’t, of course (well, you can, but you then have to manipulate how the numbers are measured and reported, thus making a mockery of them as useful statistics… oh wait, that’s what they did, isn’t it?). In August 2007, I vaguely remember a UK newspaper headline proudly proclaiming that house prices in London were increasing at a rate of of about £ 1 per hour! How did people think that was sustainable? To say that a reversal of this, allowing more (mainly young) people onto the housing ladder, is somehow a problem seems to be a remarkable worldview.

Ross Clark of The Spectator explains further:

Another headline which has begun to annoy me is ’75,000 people to lose their homes as recession bites’ attached to predictions that 75,000 properties will be repossessed in 2009. A huge number of the properties being repossessed, in fact, are not homes but buy-to-let investments, many of which have never even been lived in. In such cases, no one gets thrown out on the street: all that happens is that some get-rich-quick investors lose their dream of a fortune.

Equally irritating are some of the extravagant claims for the sums people have lost over the past year, not least the money which has vanished with Bernard Madoff’s Ponzi scheme. Sure enough, victims have lost a lot of money, but if you invest $10,000 with a fraudster who later tells you that your investment has grown to $100,000 before the scheme collapses and you are left with nothing, you haven’t lost $100,000; you have lost $10,000. The higher amount of money never existed and therefore cannot be lost.

The final bit of bad thinking relates to deflation or stagflation (stagnant economic growth combined with soaring inflation). Stagflation is certainly a huge concern. But is deflation, when prices (on average) fall? This is what you’d believe if you read the financial press. Yet, is the threat of falling prices really something that will destroy the economy?

The best analogy is the computer industry of my childhood. In the early 1980s, when home computers were new, their development happened at unbelievable speed. You really did need to upgrade both hardware and software about once a year. And every time you went to buy a new computer, you discovered that only was the new model vastly superior to your old outdated model, it was also unbelievably cheaper. Quality increased exponentially, while prices fell. This is what we are being told will be a nightmare for our economy. Yet, it didn’t do the computer much harm, did it?

The real danger of deflation is not that goods and services keep getting cheaper. The problem is that debts will grow in real terms and this would leave many of those in debt unable to pay their debts.

I will leave the final word of this mini-rant to Ross Clark:

But the biggest prize in the financial nonsense awards goes to all those folksy pieces about how we are surviving the credit crunch by recreating the wartime spirit. I am going to scream if I read one more newspaper article claiming that we can all ‘beat the credit crunch by growing our own vegetables’. There may be a shortage of credit, but our food supplies are not being attacked by U-boats and there is no shortage of cheap food. Growing your own fresh vegetables is all very nice, but unless you are going to do it on an agricultural scale you are not going to save money by doing so, or certainly not enough to pay off your mortgage arrears. You could save money by eschewing processed food and making your own from raw ingredients, but you don’t have to grow them yourself: a quantity of potatoes large enough to feed a family for a week can be had for a tenner. In any case most new houses, which tend to be the most heavily mortgaged, have tiny gardens or none at all, so where are these credit-crunched families supposed to grow their subsistence nosh?

Anyone caught out by the credit crunch would do better to take off the wellies and spend their time reading a book on basic economics. They might then learn, for example, that no, it wasn’t a good idea to buy ten buy-to-lets in Newcastle on a million-pound mortgage in the belief that tenants could be conjured out of thin air and that property prices only ever go up.