TJP

The Inability to Properly Identify Root Cause

Byron A. Ellis – December 17, 2008

The argument that sub prime lending to potential homeowners caused the economic crisis is superfluous and disingenuous. Lending, by itself cannot cause an economic crisis, except if borrowers are unable to repay the loans and other potential buyers are unable to purchase assets in default.

Therefore, the lack of demand for housing is not due to sub prime lending. Demand is a function of income and prices. Hence, given the appropriate income and falling housing prices, there should be a heightened demand for housing.

If housing prices and consumers’ real incomes were stable, or if they increased or decreased proportionately, housing demand would remain unchanged. However, if real income allocated to housing diminished and housing prices were unchanged or increasing, the demand for housing would fall. Conversely, if real income allocated to housing increased and housing prices were unchanged or falling, the demand for housing would increase.

It is clear, therefore, that if real income of consumers were increasing the demand for foreclosed housing would be high and excessive housing inventory accumulation would not exist.

Thus, the real housing problem is not sub prime lending, but rather that consumers’ real income allocated to housing was reallocated to higher transportation costs. That is, given an unchanged total income, consumers had to compensate for higher crude oil prices by reallocating budgetary outlays, with a greater share of outlays going to energy and food.

Say, for  exposition purpose, the consumer budget is $1,000 per month and prior to the spike in crude oil prices, the consumer allocated on a monthly basis $400 for housing, $200 for food, $200 for transportation, $100 for education, $50 for clothing, $25 for entertainment and $25 for savings. If transportation cost increases by 200 percent to $400 and food to $250, the consumer has to reallocate outlays, since income is now less than outlays:

            $1,000 < $400 + $400 + $250 + $100 + $50 + $25 + $25 = $1,250

It is possible that some consumers reallocated outlays from housing, entertainment and savings to transportation and food. Thus, although overall income remained the same, the allocation of income among goods and services changed.

It is this reallocation, resulting from the spike in crude oil prices that precipitated mortgage defaults, and diminished demand for goods and services.

Therefore, the root cause of the economic crisis is not sub prime lending or even spikes in oil prices due to speculative manipulation of the crude oil futures, but rather the destabilization of the Middle East, a source of crude oil supply.

Congress and the new Administration should understand that violence (wars) often have unintended consequences, which are difficult to predict ex anti. Additionally, that it is prudent to seek the clearest understanding of the root causes of problems; solutions are worthless if they do not address root of the problem.

And, it is this inability to focus on the root causes of the current economic crisis that has led to the application of wrong solutions.

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