Real-World
Economics

 

George H. Blackford, Ph.D.

 Economist at Large

 Email: george(at)rwEconomics.com

 

It ain't what you don't know that gets you into trouble.

Itís what you know for sure that just ain't so.
Attributed to Mark Twain (among others)

 

Home
Economic Papers
Political Essays
Bibiliography
Biography
Links

 

http://www.rweconomics.com/_themes/sandston/astonrul.gif

Wealth Transfers and the Crash of 2008

George H. Blackford © 2008

http://www.rweconomics.com/_themes/sandston/astonrul.gif

[We] begin with an examination of the kinds of wealth transfers that occurred as a result of the speculative bubble in the housing market that helped to bring us to where we are today.  (Andrews)

 

Suppose I borrowed $100,000 and purchased a house in 2004 that I lived in until today, and you did not own a house during this period of time.  What effect does the housing bubble and its bursting have on the two of us as housing prices increase to the point where my house is worth, say, $200,000 by 2007 and then the bubble bursts and housing prices fall to the point where my house is again worth only $100,000 today? 

 

The increase in the price of my house to $200,000 in 2007 made me richer in 2007 in that I owned a house that was worth $100,000 more than I paid for it.  In effect, I then owned half a house that I didnít have to pay for.  At the same time, this increase in housing prices made you poorer in that it then cost you $100,000 more to buy a house like mine than it would have if housing prices had not increased.  You were poorer in terms of houses by half a house.  The result of this housing boom was, in effect, a transfer of wealth from you to me, that is, from those who did not own houses to those who did own houses during that period of time.  (More precisely, it transferred wealth from those who held a smaller proportion of their wealth in the form of houses to those who held a larger proportion of their wealth in the form of houses.)

 

The result of a housing bust is a transfer of wealth in the opposite direction.  As housing prices fell to the point where my house was worth $100,000 today I became poorer than I was in 2007 in that I no longer own a house that is worth $200,000.  You, on the other hand, become richer in that you can now buy a house like mine for $100,000 again.  I became poorer and you became richer in terms of houses by half a house.  Thus, the result of the busting bubble was a transfer of wealth from me back to you, that is, from those who owned houses to those who did not own houses.  (More precisely, it transferred wealth from those who held a larger proportion of their wealth in the form of houses to those who held a smaller proportion of their wealth in the form of houses.)

 

These wealth transfers may seem ethereal, but they are very real as anyone knows who lived through the housing boom of the seventies:  Those who owned a house during that period found it very easy to sell their old house and move into a larger one because they could finance the down payment for the larger house with the equity that had accumulated in their old house due to the inflation.  Those who did not own a house during that period found it very difficult to come up with the down payment for a large house and had to settle for a much smaller one. 

 

Now letís see what the situation would look like if I had sold my house to you in 2007 for the $200,000 it was worth at that time, paid off my bank loan, and invested my $100,000 gain in a Treasury bill or just held it in the form of cash.  Now the house that I owned as its price rose from $100,000 to $200,000 you owned as its price fell from $200,000 to $100,000.  How does this fall in housing prices affect wealth?  

 

I have clearly gained by half a house as a result of the fall in the price of houses in that it now costs me half as much to repurchase my house than I sold if for.   How does this fall in the price affect you?  That depends on a number of things: 

 

If you paid in cash, you are clearly a loser.  You now own a house that you paid $200,000 for that is now worth only $100,000.  As a result, you have lost $100,000 on this transaction and are now worth $100,000 less than you were before.  The result of this housing bust is a transfer of wealth from you to me, that is, from those who own (hold a larger proportion of their wealth in) houses to those who do not own (do not hold a larger proportion of their wealth in) houses during this period of time. 

 

How does this situation change if you had financed your purchase by borrowing from a bank?  This doesnít change my situation at all since nothing has changed for me, but what it means for you, again, depends on a number of things: 

 

If you have a secure job and have not been the victim of a predatory lender who has talked you into a mortgage that you will not be able to afford when the interest rate resets, you still lose.  You still own a house that is only worth $100,000 and you are obligated to pay $200,000 for it.  Your net worth as a result of this transaction has fallen by $100,000 and you are $100,000 poorer than you were before. 

 

Suppose, however, you do lose your job or have been the victim of a predatory lender who talked you into a mortgage you will not be able to afford when the interest rate resets.  Again, this doesnít change my situation, but now whoever holds your mortgage (or insured your mortgage) is on the hook. 

 

In this situation the mortgage holder can foreclose on the mortgage, force you out of your home, and resell your house for $100,000, and write off the $100,000 loss.  You have lost your home, which is a horrible tragedy for you, but your wealth is unchanged (except, of course, for the loss of your down payment).  You lost a house you borrowed $200,000 to purchase, but this debt has been canceled.  In this situation the transfer of wealth is from the mortgage (or insurance) company to me.  The mortgage (insurance) company is now $100,000 (less the amount of your down payment) poorer than it was before, and I have still gained half a house.  

 

What happens if you default on the mortgage and the government steps in and purchases the bad mortgage from the bank in accordance with the bailout proposal passed by Congress?  The answer to this question depends on the price the government pays for the mortgage. . . .

 

Even though we have used an example of wealth transfers that resulted from the price rise and fall of a $100,000 house, we are not talking about hundreds of thousands of dollars here.  We are talking about trillions of dollars of transfers that took place during the housing bubble that burst in 2007 and its subsequent collapse.  Whatís more, the housing bubble fueled a bubble in the stock market as well.  The combined value of both financial and nonfinancial assets owned by households increased by some $22 trillion from 2002 through 2007 and then fell by $11 trillion by the end of 2008óan increase in total wealth of more than fifty percent from 2002 through 2007 and a drop of more than twenty percent in the single year 2008 that wiped out half of the increase since 2002.  (FR)  This kind of volatility in wealth and the wealth transfers that result are extremely disturbing to those who play by the rules and are taken by surprise when they lose the wealth they thought they had.  The result is the kind of anger that undermines the very fabric that holds society together. 

 

The greatest gainers from these two speculative bubbles were those who purchased stocks and real estate at the beginning of the bubbles and sold toward the end, the mortgage originators who made billions creating the toxic mortgages that fueled these bubbles, the securitizers who made billions securitizing toxic mortgages and selling them to unsuspecting investors, and the owners and managers of financial institutions that created this mess and are being bailed out by the government.  The greatest losers are those who purchased stocks and real estate toward the end of the bubbles and taxpayers to the extent that the government must increase taxes or debt or cut back government services to bail out the financial institutions. 

 

In addition, even those who owned stocks and houses throughout this period and did not buy or sell with an eye to making a speculative profit feel cheated.  Even though the wealth they thought they had Ďearnedí by virtue of the increase in the value of their houses and financial assets during the boom was ethereal, and they may appear no worse off than if the speculative bubbles had not occurred, they are worse off to the extent the illusion of wealth at the top of the bubble allowed them to arrange their lives and plan their futures on the basis of this illusion.  When the bubble burst their lives and plans were disrupted in ways that would not have occurred if there had been no bubble.

 

Whatís more, this is not a zero sum game where one personís gain is equal to anotherís loss.  As this crisis turns into a recession there is a net loss to society as a whole.  The major source of wealth for most people is their human capital as determined by their earning power.  For most people simply being employed during a recession is potentially a gain as asset prices fall, but for those who lose their jobs the loss in wealth from the fall in the value of their human capital is devastating.  The same is true for most business owners:  Simply staying in business during a recession may lead to a gain as competitors fail, but for those who lose their businesses the loss in wealth is devastating.  The losses in wealth by the unemployed and bankrupt business owners are much greater than the gains of the survivors since these losses are accompanied by a fall in the total output of goods and services available to society as a whole.  These losses are measured in terms of real investments forgone and reduced productivity in the future; food, clothing, and shelter not produced; and ultimately in the homeless not sheltered, the sick not treated, and the hungry not fed. 

 

Finally, it should be noted the story of wealth transfers created by the government bailout of financial institutions does not end with the abstract notion that these government induced transfers are from taxpayers.  It makes a huge difference which members of our society these transfers are from: 

 

If these transfers are financed by the government by issuing government debt they are from our children and grandchildren to the wealthiest members of our society. 

 

If these transfers are financed through cutbacks in social programs such as food stamps, welfare, public education, Social Security, Medicare, Medicaid, unemployment compensation, a national health insurance program, the earned income tax credit or by increasing sales taxes, excise taxes, user taxes and fees, and increasing tax rates on lower and middle-income taxpayers the net result will be huge transfers of wealth from the poorest and moderately well off members of our society to the wealthiest members of our society. 

 

By the same token, if these transfers are financed by increasing the highest marginal tax rates, cutting back on corporate subsidies, enacting a financial transaction tax, and increasing the capital gains tax the net result will be huge transfers of wealth from the wealthiest members of our society to the wealthiest members of our societyóthat is, among the wealthiest members of our society. 

 

Needless to say, this last financing option is the one least favored by those who profited from the housing bubble and the subsequent collapse of the financial system since it is the only option that puts at risk the speculative profits and incomes they gained from this bubble.  The only thing that could make it worse is if an increased in the estate tax was added to this mix so they cannot pass their windfall gains on to their heirs.  This is the course we should follow as we attempt to recover from this crisis.  To those who complain that following this course is class warfare, I can only respond call it what you will, it is the economically sound thing to do, it is the right thing to do, and it is the only fair thing to do.  After all, how did we get in this mess in the first place? 

 

Over the last thirty years we have cut income and capital gains and estate taxes paid by the wealthiest members of our society; increased sales taxes, excises taxes, and user fees paid by the least well off members of members of our society; and cut back on government programs that serve the lower and middle-income earners in our society.  At the same time we have deregulated both the real and financial sectors of the economy; refused to enforce the Sherman Antitrust Act to the effect of increasing the concentration of economic power in almost every sector of the economy; eliminated usury laws and allowed credit card companies to change our bankruptcy laws; and provided massive corporate tax breaks, loopholes, and other corporate subsidies all to the benefit of the wealthiest members of our society and to the detriment of just about everyone else.  (Krugman Saez Piketty Harvey Frank)  And what have been the consequences of all this? 

 

The consequences have been a dramatic deterioration in public schools, highways, bridges, parks, safety, health, welfare, and the environment; the creation of a corporate welfare state supported by the taxes of lower and middle-income people; the concentration of wealth, income, and economic power in the hands of fewer and fewer people; a ten trillion dollar National Debt that threatens the economic future of our children and grand children; and a financial crisis that threatens to create a worldwide economic catastrophe on an order of magnitude that could dwarf the disaster of the Great Depression.  If we are talking about class warfare here we are talking about a war that started sometime in the 1970s and in which all of the fighting has been by one side.  If the other side doesnít take a stand soon this war is likely to end in a Carthaginian peace from which we may never to recover.  (Frank Harvey Mayer N Klein Domhoff Krugman)

Hit Counter

 

Home Economic Papers Political Essays Bibiliography Biography Links