While "financial conservatives" have been complaining about too much financial innovation, my complaint is that there's been too little. Why can't I use my house as an ATM, as long as I have sufficient remaining equity? Why can't I make positive, zero, or negative monthly payments on my mortgage, whenever I feel like it? The fixed amortisation mortgage may work for some people, but it doesn't work for everyone. Yet that's the only product I see advertised.
I own stocks in a margin account. This lets me borrow to buy stocks. Each month, the interest due on the money I borrowed to buy stocks gets subtracted from my net balance in the account. I don't have to send my stockbroker a monthly cheque to pay that interest. I can send a cheque if I want to, but I don't have to. I can even withdraw cash if I want to. My deposits or withdrawals can be anything I choose, as long as I stay below the margin limit.
Why can't I do the same with my home mortgage?
Buying a house with a mortgage is the same as buying stocks on margin. You borrow part of the money you need to buy the house or stock. And the house or stock is colateral for the loan. Why should a loan to buy a house require monthly payments of interest and principal, while a loan to buy stocks does not? In other words, why does a mortgage have an amortisation period, while my margin loan at the stockbroker can have whatever amortisation I want, including zero, infinite, or negative
Why can't I do the same thing with my credit card balance too? Why do I have to make a minimum monthly payment? Why can't I just let the interest accumulate, and pay it down when I wish, as long as I stay within my credit limit?
Why can't I just roll my mortgage (and my chequing account and credit card) into my margin account, so that my house gets listed as just another colateral asset along with my stocks, bonds, mutual funds, and of course my human capital.
Unlike some other financial innovations, I can see a clear fundamental need for this one. The typical mortgage, and line of credit, makes an implicit assumption about people's cash flow. The assumption is that there are large and infrequent negative cash flows, matched by small and frequent positive cash flows. You make a big infrequent purchase (a house, a car, etc.), then slowly pay off the loan with your regular monthly salary. So your cash position has a "saw-tooth" pattern, with big steep drops, then slow steady rises. What about people who have the exact opposite saw-tooth pattern, with slow steady declines, then big steep rises, if they get part of their income at longer than monthly frequencies? Or even people who just want to spend more than their income two months in succession?
Why isn't borrowing to buy a house more like borrowing to buy stocks? These aren't rhetorical questions; there presumably is some reason, but I don't know what it is. Here are some possible reasons:
1. Stocks are fungible, liquid, and frequently traded, and so can be marked to market daily. Houses aren't, so can't. If I held my house in my margin account with the stockbroker, it would have to be priced at book value. Perhaps that book value could be changed if the house were re-appraised, or perhaps it could be updated monthly using a Case-Shiller/Teranet index, or perhaps it could just be left at book value until I sold the house. But if this is a problem, why is it any more of problem than it is at present, with a standard 25 year amortised mortgage? If the lender offers the same rates on a mortgage for 75% of the value of the house as for 50% of the value of the house, why should they object if, after years of paying down the mortgage to 50%, I stop paying the monthly interest, start treating the house as an ATM, and let it rise again to 75%?
2. Stocks pay dividends that go directly into the margin account; houses pay rent, or the implicit rent if owner-occupied, but those rents don't go directly into my mortgage account. Maybe, but some stocks don't pay dividends. And even when they do, the dividends may be less than the interest payments.
3. Stocks pay dividends and capital gains, and we at least expect that those dividends and capital gains will exceed the interest payments on the loan needed to finance the stock (otherwise it wouldn't pay to hold the stock). So the natural "default option" of a margin account is for the net equity to rise over time. Houses sometimes yield a capital gain, but normally the rate of house price appreciation is less than the rate of interest on the mortgage (otherwise housing services would be free, and houses would be infinitely valuable). So the natural "default option" if you made no monthly mortgage payments would be for net equity to fall over time. Maybe, but my stockbroker does not limit my withdrawals, as long as I remain under the limit.
4. Many people choose fixed interest mortgages, but flexible repayment would only work with variable interest mortgages. Maybe, but I can't find a variable interest mortgage with fully flexible repayment, where that means I am allowed to make zero or even negative repayments whenever I choose. And even if I did have a fixed interest mortgage, I could also have a variable interest account on the side, which could be in positive or negative balance.
5. Perhaps the monthly mortgage payments are just part of an optimal "forced saving" plan. Because of weakness of will, or time-inconsistent preferences, or just difficulty of keeping track of our financial position, people need to commit themselves to a fixed schedule of repayments. Maybe, perhaps some people are like that, and would choose a mortgage that forced them onto a regular and strict financial diet. But not everyone wants to join the financial equivalent of weight-watchers. And why don't stockbrokers offer margin accounts with the same feature?
OK, some people who used their houses as an ATM ended up in negative equity, and that was one thing that helped caused the financial crisis. But the problem is not using their houses as an ATM; the problem was too little equity. Having a 90% loan to value ratio is risky, no matter how you got there.
Perhaps if we limited leverage on a mortgage to 3:1, as most personal margin accounts do, we could safely run them the same way. Since most first-home mortgages are more like 19:1, there's a substantial difference in risk. Fixed amortization is a way of reducing that risk, by forcing people to build more equity. While on the whole, keeping people at 3:1 would be substantially lower risk on a society-wide level, it would cause a lot of short term turmoil as house prices would have to come crashing down in order for there to be any substantial number of buyers.
There actually are some mortgage products, such as the Manulife One, that do combine the features of a chequing account and a mortgage, where the mortgage is just a negative balance on the chequing account. As I understand it, you can withdraw up to the limit at any time. They do, however, mainly market it as a way to save money, by applying your monthly revolving cash to reducing your debt (and by extension, interest).
Posted by: Neil | June 15, 2009 at 04:07 PM
Aren't you describing a home equity line of credit? I have one of those, and it lets me do exactly what you describe. I think they even gave me a chequebook to write cheques against it. I can "borrow" up to 70% of the original price of my house (although I'm sure the limit is negotiable).
Also, a few years ago, someone (Manulife?) advertised a "one" account that worked this way. Ah, I see that Neil wrote about it above.
Posted by: Phil | June 15, 2009 at 04:12 PM
Phil: the home equity line of credit comes close, but you still need to make a monthly minimum payment. Now, there is a way round it, I know, but I don't think they exactly approve of your doing this. (You need to make a $100 monthly payment, so you withdraw $100 from the HELOC, deposit it in your chequing account, then use that $100 in your chequing account to pay the minimum on your HELOC.) If you have two credit cards you can also use the "kiting" method.
If they think it's OK to kite like this, why don't they just eliminate the monthly payment?
Neil: agreed. A positive finite amortisation period does mean that equity builds up faster. But why can one person get a (say) 90% mortgage for one year at 5% interest, while they won't let an otherwise identical person with an 85% mortgage pay no interest for one year?
And I would think it's a lot safer to let people ATM at will up to 50% than to give anyone a 75% mortgage with no ATM privileges ever.
Posted by: Nick Rowe | June 15, 2009 at 04:54 PM
Payments allow lenders to detect when they might have a problem and address it before it gets out of hand, otherwise they are simply speculating. The borrower could consume the housing by letting it deteriorate as well as by borrowing against it and could well do both given the necessity and opportunity. A declining balance against a declining asset limits possible losses. As has been seen, most are not sophisticated enough to handle this, and the ones that are more commonly use fixed and adjustable rates to time the market, locking in low rates and floating high ones. More than anything, I think this has to do with the needs of lenders to turn sums into consistent reliable streams as what is most convenient for the borrower is also the least to the lender. There is always that alternative to tying up equity called renting.
Posted by: Lord | June 15, 2009 at 07:01 PM
When things were getting crazy I wondered why no one offered a zero down, zero payment, 50 year mortgage. I could buy a great beach house and let them collect it from my estate. No need to afford anything.
Posted by: Lord | June 15, 2009 at 07:03 PM
Right, I *do* have a mininum payment with a due date. I hadn't realized that!
So the question is: why do the banks insist on regular (token) repayments, even from borrowers they deem fully creditworthy?
I don't know, but my best guess is a variation of what Lord said. I'd guess that conscientiousness in payment is a way the bank verifies that you're still a good risk. If you're willing and able to make the payments -- or willing and able to do the kiting required -- that correlates with taking the debt seriously and being less likely to default.
My guess would be that borrowers who don't care enough to make the monthly payment are worse borrowing risks than those who don't, even when all other indicators are identical and positive, and the repayment requirement is a cheap way for the bank to pick up that signal.
But, as I said, I'm guessing.
Posted by: Phil | June 15, 2009 at 07:41 PM
Phil, Lord: that has a ring of plausibility to it. When they get the token monthly payment on the credit card bill, at least they know you're still alive, and in town, and paying attention. But on a secured debt, like a mortgage, why should they care (as long as the house can still cover the mortgage). Or even just ask you to send them a postcard!
Lord: let's see, a 50 year zero payment mortgage, at say 5%, would rise about 10-fold in value by the end. So they would only give you about 10% of the value of the cottage. But why not?
Posted by: Nick Rowe | June 15, 2009 at 08:15 PM
Could it be that the bank is lending to you expecting that you'll repay them out of the flow of wages you earn. They need to make sure they tap the flow to get repaid, otherwise they risk finding the bucket isn't full when they wanted it to be.
Posted by: Patrick | June 15, 2009 at 09:04 PM
I'd bet that if you had a legitimate reason to not want to make monthly payments, and the debt was well-secured, the bank would waive that requirement.
Posted by: Phil | June 15, 2009 at 09:15 PM
"Buying a house with a mortgage is the same as buying stocks on margin."
Heh, file under 'things only an economist could write'! You might as well argue that wheelbarrows are the same as cars because they are both wheeled vehicles that moves things around :)
Your first guess is basically the right one, although it is not just keeping track of the value of the collateral that is easier for margin accounts, *realizing* the collateral is far easier - would you rather sell some stocks or kick a family out of their house and then try to resell it!
"If the lender offers the same rates on a mortgage for 75% of the value of the house as for 50% of the value of the house"
But they don't, pricing and availability of funds are often affected by the loan to value ratio.
You have to keep in mind that there is a difference in risk between someone who borrows, say 75% of a house's value and then pays it off in regular increments over the next 25 years and someone who borrows 75% of a house's value and never pays it down at all. The second case is far riskier since the average loan to value is much higher and there is a much greater risk of the borrower getting 'underwater' and costing the bank money. In addition, based on the current state of the culture, certain behaviour patterns (like not paying down your mortgage) may be a sign of a customer who is irresponsible with their use of credit.
There is also a difference in risk between 'installment' credit which is paid down over time on a regular schedule and 'revolving' credit which allows the borrower to re-draw credit as they choose. In the former case, a bank can do a single approval and then basically forget about it unless payments start to be missed. In the latter case, the borrower requires constant monitoring since (among other reasons) the bank can save money by cutting them off before they run their balance up to the limit.
"Because of weakness of will, or time-inconsistent preferences, or just difficulty of keeping track of our financial position, people need to commit themselves to a fixed schedule of repayments. Maybe, perhaps some people are like that"
Actually, as sure as the sun rises in the East, many, many people are like that. I'd argue that it's likely a majority of the population that would get into trouble with debt without some support either from social norms or regulations that prevent irresponsible use of credit (as we seem intent on proving, with disastrous results) - during the brief period when 40 year amortizations were available they made up the majority of mortgages issued in Vancouver, even though they are extremely unwise for the borrower (and for the banks, but what do they care when the government is taking on the credit risk).
Historically, debt was considered something to avoid and almost all debt was installment in nature since people only borrowed when they had to, and then tried to pay it off as soon as they could. Only in the last few decades has the use of revolving credit become a widespread phenomenon, with the use of revolving credit against your home only really happening in the last decade (and already with one global meltdown partially to its credit).
"OK, some people who used their houses as an ATM ended up in negative equity, and that was one thing that helped caused the financial crisis. But the problem is not using their houses as an ATM; the problem was too little equity. Having a 90% loan to value ratio is risky, no matter how you got there."
So the problem wasn't people reducing their equity - the problem was too little equity? :) Again, you need to separate the initial loan to value from the loan to value over the life of the loan - one of the many mistakes lenders in the U.S. made in the run-up to the crisis was to lose track of this distinction.
As for minimum payments, I wouldn't be surprised if this was controlled by legislation in Canada, but at any rate, if there was no minimum payment, how could you charge people fees for not making it? Plus, as Phil and Lord note, its usually wise to make sure the customer can at least pay a tiny amount towards their debt. It's better not to be the last to know if somebody is going to default, regardless of the collateral. Say you run a bank, do you want to be the one bank that offers no minimum payment cards/lines of credit - and get all the customers who can't or won't make a minimum payment? Good luck with that!
"why don't stockbrokers offer margin accounts with the same feature?"
Because banks already offer loans for investment purposes? There is no need for a loan to be linked to the broker in the same way as a margin account is, again because of the difference between a revolving account that requires constant oversight and an installment product which is approved and then forgotten.
Posted by: Declan | June 15, 2009 at 09:16 PM
Instead of making mortgages as easy as margin accounts, maybe margin accounts should be as difficult as mortgages? Maybe we shouldn't even have consumer credit...
Posted by: pointbite | June 15, 2009 at 09:44 PM
Declan:
"Your first guess is basically the right one, although it is not just keeping track of the value of the collateral that is easier for margin accounts, *realizing* the collateral is far easier - would you rather sell some stocks or kick a family out of their house and then try to resell it!"
But then why does my bank allow me a much higher loan to value ratio on my house than my stockbroker allows me on my stocks?
"But they don't, pricing and availability of funds are often affected by the loan to value ratio."
Is that true, once you are below a 75% LTV ratio? And even if it were true, why not just raise the interest rate in the same proportion when I use my house as an ATM?
"You have to keep in mind that there is a difference in risk between someone who borrows, say 75% of a house's value and then pays it off in regular increments over the next 25 years and someone who borrows 75% of a house's value and never pays it down at all."
Yes, but in the first year the risk is the same. And I might switch mortgage companies in the second year (if I have a one year fixed rate).
"So the problem wasn't people reducing their equity - the problem was too little equity? :) "
Yes. What should matter is the risk now. Which depends on equity now. Not what equity was in the past.
"As for minimum payments, I wouldn't be surprised if this was controlled by legislation in Canada,..." you might be right. I hadn't thought of that one.
"... but at any rate, if there was no minimum payment, how could you charge people fees for not making it?" Just add it to what I owe? What's the problem?
" Say you run a bank, do you want to be the one bank that offers no minimum payment cards/lines of credit - and get all the customers who can't or won't make a minimum payment? Good luck with that!"
Sure. That way I can pick the customers with the best credit ratings, and make them pay higher interest rates, because I am giving them more flexibility.
Actually, banks generally do just this: they offer overdraft facilities to their best customers. But the interest rate is higher than on a mortgage, because there's no colateral.
pointbite: why is zero debt optimal? What makes intertemporal trade inefficient while trading apples and bananas today is good?
Posted by: Nick Rowe | June 15, 2009 at 10:36 PM
Patrick: but what if the flow of income is irregular?
Phil: I never tried it on a mortgage. I tried it once on a credit card, didn't get an immediate "yes", even though I was only about 10% of my credit limit, and gave up.
Posted by: Nick Rowe | June 15, 2009 at 10:42 PM
Ha ha, sarcasm, I love it!
Posted by: asp | June 15, 2009 at 11:58 PM
The mortgage I have is a blended product from a major bank. You start with 20% down, and start making payments. The equity portion of the payments go to make room in a HELOC. You can draw on the HELOC as you see fit -- essentially you can keep the mortgage at 20% (of the initial purchase price) perpetually by drawing down equity created by making payments. No need to make a monthly payment on the HELOC, as you are making payments on the mortgage and it is all treated as one account.
Posted by: loomis | June 16, 2009 at 12:39 AM
"But then why does my bank allow me a much higher loan to value ratio on my house than my stockbroker allows me on my stocks?"
Margin requirements for stocks are set by the government (as are margin requirements for mortgages, you are just allowed more leverage on a house because the government wants to 'encourage' home ownership more than they want to encourage stock speculation). Also, the one advantage that a mortgage has (from a risk perspective) is that housing prices are less volatile than stock prices.
"Is that true, once you are below a 75% LTV ratio? And even if it were true, why not just raise the interest rate in the same proportion when I use my house as an ATM?"
That's how it works, your HELOC (Home Equity Line of Credit) typically has a higher rate than your mortgage (although not always, if you get a product like loomis has, for example). But its not worth the administrative hassle to be constantly changing the rate all the time.
"And I might switch mortgage companies in the second year (if I have a one year fixed rate)."
You might, but you're more likely to stay with the same bank... There are switching costs (the effort involved, not a fee, per se)
"Sure. That way I can pick the customers with the best credit ratings, and make them pay higher interest rates, because I am giving them more flexibility."
Hmm, you weren't running risk management for Washington Mutual were you? I can see why you might think that would work if you hadn't seen similar things tried, but trust me, adverse selection will kill you (the people who don't want to make minimum payments tend not to have the best credit ratings) if you get too far away from the pack (not to say you might not be able to make it work in this case , but its extremely risky to offer a product that your competition doesn't that will attract the highest risk customers - its like a life insurer offering insurance to old people with no medical exam - you can do it, but you have to be very careful and it may not be worth your effort.
Your post and comments are actually, in my opinion, quite a good example of why financial innovation in lending has caused such ruin (sadly the bankrupt banks just went ahead and made various changes of the type you proposed without getting feedback on a blog first!) - a desire for innovation and no respect either for tradition or real understanding of why the rules were there in the first place before taking them away.
---
I'm sure that pointbite can speak for him or herself, but intertemporal trade is inefficient because people discount hyperbolically, and overweight the present vs. the future. Half of human morality relates to trying to overcome this fundamental weakness in our character (patience IS a virtue), and we're better off when laws and culture and helping us fight this weakness, not pushing the drugs on us at every opportunity.
As David Hume said, "There is no quality in human nature which causes more fatal errors in our conduct, than that which leads us to prefer whatever is present to the distant and remote"
Posted by: Declan | June 16, 2009 at 01:54 AM
Nick: interest.
Posted by: pointbite | June 16, 2009 at 01:14 PM
pointbite (and Declan): Think about a world with no intertemporal trade: I would have to build my house brick by brick, over about 20 years, because I could neither borrow to build it, or lend my savings to others; I would have to store cans of beans and everything else I might need for my retirement, because I could not lend my savings to others; firms could not get financing, but would have to be sole proprietorships, or partnerships. S=I would have to hold at each time for every individual.
pointbite: yes, "interest". So what? It makes no more sense to assume that $1 today should trade for $1 next year than to assume that one apple today should trade for one banana today.
Declan: houses are either more risky or less risky as colateral than stocks. You can't have it both ways. And whichever they are, you can set the margin (or loan to value ratio) at a level to adjust for risk.
And why don't your other arguments for forced savings, like administrative costs, apply equally to margin accounts for stocks?
Plus, if everything were all rolled into one big account, it would be much easier for the lender to keep track of my total financial position, and credit-worthiness.
I take your point about there being traditional "rules" that we use as guides to stay out of trouble. But sometimes these traditional rules just don't work. For example, if there were a higher inflation target, nominal interest rates would be higher, and mortgages would be more "front-end loaded". So the traditional rules of thumb, about what percentage of your income should go to the mortgage, would become very misleading. It's the job of economists like me to try to make sense of these traditional rules, to try to find out their underlying rationale, if any, and to see if that rationale makes more or less sense when the world changes.
I don't yet have a convincing rationale for the "minimum monthly payment on credit cards and mortgages" rule of thumb. But you guys are maybe moving towards it.
Posted by: Nick Rowe | June 16, 2009 at 01:50 PM
"It makes no more sense to assume that $1 today should trade for $1 next year than to assume that one apple today should trade for one banana today."
I may have missed something but that statement really doesn't make any sense to me. The purpose of dollars and fruits are completely different, if that wasn't the case dollars wouldn't exist. It's absolutely reasonable to expect my dollars to maintain their value, that's part of what makes them useful as money, if I didn't expect $1 to equal something close to $1 next year I wouldn't use it as a store of value. Nobody has similar expectations for fruit, and I don't see the relevance of the relationship between apples and bananas, maybe 1 apple will cost 100 bananas, maybe 0.5 bananas, who cares? I don't get paid in apples, I can't deposit bananas in my bank account or demand someone accept any fruit as payment. I don't even need to buy fruits if I feel someone is trying to cheat me. Dollars have a government imposed monopoly on legal tender. No comparisons here... I must have missed your point.
But to answer your question, interest matters because people don't know how to use debt. Other than emergencies (in which case most people could probably borrow from family or friends anyway) I can't think of a single reason the average person should carry even a single dollar on a credit card balance. It's very rare that someone will have income that increases faster than credit card interest, so by definition borrowing to consume today is equivalent to reducing your future capacity to consume. I see this concept as fundamental to our problems, we are progressively making ourselves poorer by spending beyond sustainable levels. (And when a sustained crunch comes, maybe it already has, the solution isn't printing money!)
With regards to houses, if people couldn't borrow to buy the most immediate impact would be a fall in prices. Probably to a level many people could afford to pay in cash, maybe just a few times more than what today constitutes a down payment. Is that really so bad? That gives all of us a tremendous increase in purchasing power. Banks would lose, but I don't really care about banks. House prices should be governed by the cost of construction and availability of land, not leveraged speculation. It's funny how everyone blames leverage for fueling recent stock market volatility, then applauds a drop in mortgage rates just a few months later without recognizing the irony...
I just don't like debt. It can be used wisely, but that isn't the common experience. Most people are in debt most of their lives, caught in a cycle of societal pressure and expectations -- oh you've entered stage X of your life, time to borrow for this. Oh you've entered stage Y of your life, time to borrow for that. I'm reading a book about the psychology of influence, one of the strongest "weapons of influence" is social approval, when everyone does something it must be right, therefore I will do it too, even without thinking. Especially when people are confused about the details, confusion enhances the perception that other people must know something you don't. I'm not a fan of real estate as an investment, and I can't tell you how many times people have told me, based exclusively on my rejection of that concept, "everyone says real estate is the best investment, do you think you're the smartest person in the world? You know something the whole world doesn't know?" People are outsourcing their brains.
Is there a chart of cumulative interest payments over an entire life?
Posted by: pointbite | June 16, 2009 at 08:16 PM
"Think about a world with no intertemporal trade"
To clarify, I have no real problem with corporate/business debt, just personal debt. I'm not arguing for some fantasy world that never has or could exist, I'm arguing for the status quo for the majority of the last 1000 years, from which we have strongly departed in the last couple of generations....
"houses are either more risky or less risky as colateral than stocks."
As I said, the difference is caused by government fiat for political reasons. Aside from that, you're trying to oversimplify things again. The riskiness of stocks is more sensitive to the margin level due to the higher volatility of the collateral. Additionally, the temporal distribution of collateral value shocks is very different for stocks than it is for mortgages.
"if everything were all rolled into one big account, it would be much easier for the lender to keep track of my total financial position, and credit-worthiness"
Not really, lenders already keep track of your overall credit-worthiness across multiple products held at multiple institutions. If anything, having it all in one account would provide less data to look at and make it harded to assess risk.
"It's the job of economists like me to try to make sense of these traditional rules, to try to find out their underlying rationale, if any, and to see if that rationale makes more or less sense when the world changes"
Certainly, I agree, just as it is the job of blog commenters to keep you honest :) Don't get me wrong, I wasn't criticizing you for your post or your comments, what I was saying is that my problem is with the regulators and risk managers who allowed the sort of thinking your post exemplifies to become not just blog post speculation but real world reality without sufficient 'reality checking' first.
Posted by: Declan | June 16, 2009 at 08:44 PM
Nick: If income is unpredictable, then a bank probably isn't going to take the risk . If income occurs at non-standard intervals, then in my experience the bank will just say "not our problem; manage your cash flow". To use a crude piping metaphor: they expect you to build reservoirs so that you can match your income flow to meet the outgoing flow of interest payments (maybe a bucket brigade is a better metaphor than a pipe... i dunno)
Come to think of it, the bulk of managing day to day finances of a household or small business is all about managing mismatched incoming and outgoing cash flows by ensuring you have sufficient reserves on hand, plus something to absorb unexpected outflows. I suspect this relates to the demand for money stuff you where talking about in previous posts.
Posted by: Patrick | June 16, 2009 at 08:55 PM
Declan: we are on the same page, especially your last paragraph.
Except, that bit about the last 1,000 years! I wish I was a better historian, but would we really want to go back to how household loans used to be managed even 50 years ago? Like mortgages.
Can some other commenter chime in who knows how things have changed over the centuries?
pointbiite:
Why do A and B trade apples and bananas? Unless A and B are identical, they will almost certainly be able to gain by trading apples and bananas. A prefers apples, B bananas, will do it. A has lots of apples and few bananas, and B vice versa, will do it. Any differences between A and B in either relative preferences or productive capacities will lead them to trade. The relative price of apples to bananas will equal one only by sheer chance.
We can think about loans, and interest, in exactly the same way. Instead of apples and bananas though, the two goods are fruit this year, and fruit next year. Suppose A has lots of fruit this year and little fruit next year, and B vice versa. Or A prefers fruit this year to next, and B vice versa. If A and B differ in preferences or productive capacities in regards to present vs future fruit, they will trade fruit this year for fruit next year. In other words, A will lend B fruit, or vice versa. And the relative price of fruit this year to fruit next year will equal one only by sheer chance (i.e. the rate of interest will be zero only by sheer chance).
The only complication is we do trade with money, we don't barter or borrow or lend fruit.
What I'm saying is that the reasons behind borrowing and lending (i.e. debt) are exactly the same as the reasons behind all trade. "Finance" is just trade across time.
Posted by: Nick Rowe | June 16, 2009 at 09:24 PM
Nick, I hate to spend half my time here arguing about analogies... but when I'm trading fruit A for B, or B for A, either way I still have fruit. I still have an asset. When I trade future consumption for current consumption I'm acquiring a liability, one that grows over time. Imagine the fruit has a virus that will infect you and your family. And if the whole country engages in the same trade at the same time, well, we get the current economic mess.
Posted by: pointbite | June 16, 2009 at 09:59 PM
"This Time is Different: A Panoramic View of Eight Centuries of Financial Crises"
http://www.publicpolicy.umd.edu/news/This_Time_Is_Different_04_16_2008%20REISSUE.pdf
Posted by: pointbite | June 16, 2009 at 10:48 PM
Nick, Great post and comments. I had never thought of this issue. I don't have much to add; my initial thought was the self-control issue. Off topic, but most people I meet in America, even highly educated people, get tax refunds due to overpayment of income taxes, Sometimes I will even hear people boast about the refund they got in the faculty dining room. I try not to say anything, but to me it's as if they had "I'm a moron" tattooed on their forehead. So I guess it doesn't surprise me that people would force themselves to pay off mortgages in a timely manner. At least they save on interest payments by doing so, which can't be said for the interest-free loans they give Uncle Sam. Does this nonsense also occur in Canada?
Posted by: Scott Sumner | June 17, 2009 at 07:54 PM