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Rate Reductions Will Do Little



November 30, 2007 – Comments (4)

There is a saying that we borrow the Earth from our children.  The same is also true of debt, debt is borrowing the future economy.

The ability of reducing interest rates worked at first because it did free up disposible income for the masses.  Read my post, "Low Interest Rates, As Destructive as Usury?"

In some ways that post is too nice.  What I mean is whenever the topic of how hard it is to afford a home comes up those in the 10-15 years older than me age group always refer back to how hard it was when interest rates when up to about 20% around 1980, the period I worked in the banks.  There is no question that some people lost their homes, but it was fairly limited to newer home owners and people only renewed their mortgages at those rates for a year.  There is no question that people saw huge declines in disposible income, but they'd also been through an era of 5-7% wage increases and for most their income had grown substantially compared to when they'd first taken out a mortgage.  Two years later mortgage rates were manageable again. 

I was always told that when you buy a home, it is only hard for the first couple years because your wages go up relative to your debt.  That was so true back then and what the many of them saw was their disposible income go back to how hard it had been when they first bought, but it only lasted a couple years.

If you compare Canada and the US, Canada slowed down on wage increases ahead of the US.  Vancouver in particular has had anemic wage increases for the past 20 years and wages have fallen behind the cost of living since then.  In Vancouver there is an enormous division of wealth between those who won the "home equity lottery," and those who have had no hedge against the increasing cost of living.

Here's how lowering interest rates boosted spending for the masses.  When interest rates started to decline the masses had higher interest rates.  Renegotiating mortgages freed up huge amounts of disposible income.  All around me I saw people who owned homes keep their mortgage term the same and reduce payments as interest rates declined.  Their disposible income was massively increased. 

But, what was happening to those who were entering the market is that prices were going up to fit the maximum people could afford at lower rates.  So, like any new home owner, they were struggling to make ends meet.  Evidence is that for the past 10 years incomes have been declining relative to costs in the US, so each year for the past 10 years America has had more and more first time home owners with less and less ability to increase their disposible income.

At this stage of the game reducing interest rates will do very, very little to free up disposible income for the masses.  Unlike when the credit bubble was first launched 20 years ago, many people already "own" their debt at reasonably low rates.  I remember about 15 years ago my older cousin saying that when her mortgage renewed her payment went down about $300/month.  She had three small children at the time and it enable the family to keep their lifestyle even though wages were not keeping up with the cost of living.

Contrast that to someone who bought a home say 10 years ago.  In Vancouver our affordability of housing price to median income was probably around 4 or 5.  Housing was already hardly affordable and interest rates were down some.  Wages have not kept up with the cost of living.  That promise of my youth that buying a home is only hard for the first couple years was a complete lie.  Many that entered the housing market here in from 1992 to 2002 have hardly gotten a handle on debt.  Many have seen net debt remain fairly constant as other forms of debt increase as mortgage decreases.  They've absolutely struggled every single year they've been homeowners.

The US has been following what I've seen here in Vancouver, but in a time frame about 5 to 8 years behind it.  Home affordability has grossly declined for many that have entered the housing market and young people will not be able to "rescue" the economy by increasing consumer spending.  They are borrowed up to their limit at an already lower rate.  There are no tricks left to increase their disposible income.  Additionally, costs have been increasing faster than wages.  For many people wages are not going up to make managing the debt easier.

These are the things that have made consumer spending work and have increased disposible income.  They don't exist anymore.   Lowering interest rates will not free up disposible income.  Essentially, lowering interest rates have transfer the cost of all economic growth to younger people and there is no where for them to lighten their load.

So, why was my ursury post was too nice?  The truth is that many young people who have bought homes believing that it will improve their economic future have become indentured slaves to debt that they will never escape, and they will not be participating in consumer spending to save the economy regardless of what interest rates do.  Suggesting there is any comparison to having those two hard years is grossly ignorant.  There is no way for this to eventually work out for younger people.  They have the debt, wages are flat and they already own their debt at reasonably low rates.

4 Comments – Post Your Own

#1) On November 30, 2007 at 11:52 AM, cabuilderboy (83.70) wrote:

If the value of sub-prime borrower’s home is now worth 20% less, on an original 100% LTV loan, what good are you really doing that de-facto renter by allowing them to keep an “underwater” house? While your argument is very credible, a free market correction somewhat solves your problem. The first time buyer is now looking at prices they have not seen in years. I offered homes at a money losing price, a couple of weeks back, just to close out a couple of entry-level communities, and people came running with FICO scores in hand. An unencumbered correction may not solve your problem, but is certainly helps. Regionally speaking, you would be hard pressed to find someone in CA who has owned a home for 8 to 10 years, who has not seen significant equity appreciation, which has improved thier financial position.

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#2) On November 30, 2007 at 6:17 PM, dwot (28.86) wrote:

cabuilderboy, if the current prices are still a maximum that people can afford to qualify at current interest rates they will not be easily able to get out of debt or manage the existing debt.  Here in Vancouver our home prices were not affordable at the beginning of this last bull run in housing. 

Since 2000 we've had school districts shrinking and the number one reason families give for leaving has been affordability.  Families were giving up on Vancouver when we were at the lowest relative price here in about 20 years.  Families were quitting Vancouver because of their inability to provide any of lifestyle due to the bull run that led of the high cost of living we've had here since the early 90s.

We could go back to prices we haven't seen in years and the prices would look very good compared to what they had been, but they would still have serious affordability issues.

While I would agree that here, like CA, has significant equity appreciation for anyone who has been in the market for 8 to 10 years, even 5 years, I would not necessarily say their fiancial position has improved.  I see too many that don't have a cent to spend, and too many that no longer seem to make ends meet because wages have been flat yet food, energy, utilities are probably all up at least 50% in that time and some have easily doubled.  They have increased paper wealth, which is perhap a definition of financial position, but too many are no longer making ends meet and they are simply trading long term debt for short debt as the mortgage declines and other forms of debt increases.

And, as we are currently seeing, that part of the fiancial position can just disappear as easily as it appeared.

I personally haven't seen this kind of spending,,  but I tend to think it is far from the norm, at least it is far from the norm here.

They are simulating the economy. 

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#3) On November 30, 2007 at 8:34 PM, abitare (29.55) wrote:


Outstanding insight as always.

I went flying last week. Looking at all the new subburbs and McMasions, that have been builting in the last couple of years. While many houses were beautiful, I just felt likemany of the people inside were SLAVES to their debt and home.

The amazing thing is: THEY ARE STILL BUILDING more McMasions, town homes and condos! It used to be only Doctors and lawyers could afford such gaint houses now I guess everyone can? I cannot imagine how this is going to end well. 

Will there be a panic? What will cause the slow down? Declining / collapsing dollar, rising commodies, higher interest rates, credit tightening, or over supply of houses.

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#4) On November 30, 2007 at 11:35 PM, dwot (28.86) wrote:

abitarecatania, 5 years after I moved into my second home, which was a stretch for us financially, many of the people in my age group still didn't have furniture in their front room.  I just don't remember seeing that kind of thing when I was growing up...

I was just thinking how much younger people get blasted for having to have everything now, but I think I've seen a lot of waiting...

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