TJP

Money Crunch: Where did the Money Go?

By Byron A. Ellis, April 09, 2008

We’ve heard about sub prime mortgages, a liability against borrowers with poor credit histories, and how they have caused economic turmoil. But, is the sub prime mortgage the real problem or just a red herring?

According to the Chairman of the Fed, Ben Bernanke, in a May 17, 2007 speech, there are about 7-1/2 million sub prime first-lien mortgages or about 14 percent of all first-lien mortgages. Thus, the implication is that a mere 14 percent of first-lien mortgages, and not all in default, are causing the so-called money crunch.

A mortgage is a financial liability issued by the homeowner in the form of a primary security. Financial intermediaries, such as banks, using funds from savings-surplus units purchase these primary securities and resell then in secondary markets. Homebuyers use the funds from the primary security to purchase their homes. Thus, the money moves from savings-surplus units to home sellers. 

If a builder sold the home, the funds would be used to cover the cost of building the home. If another homeowner sold the home, the funds might be used to purchase another home or to pay off the existing mortgage. So, up until this point the money from the mortgage is still in the economy and, presumable, due to the multiplier effect, its circulation expands the gross domestic product (GDP).

Now, lets assume that the issuer of the primary security defaults. Does the money disappear? Of course, the money does not disappear; it is still in the economy. So, how can a small percentage of mortgage loans (sub primes) cause an economic crisis?

Now, lets look at the economy from a macro perspective, we know that the in the private sector the excess of savings over investment (S - I) is equal to the budget deficit (G + R – T) plus the trade deficit (NX) or

                                                S - I = (G + R –T) + NX

Furthermore, if the private sector is in balance, savings (S) equal investment (I) or S –I = 0, then when the government incurs a deficit (surplus), there is an equal external deficit (surplus) or

                                                T – (G + R) = NX

The government since 2002 has been incurring a deficit (see graph below) and hence an equal external deficit. Therefore the money is going out of the country and causing the money crunch. And, increases of the supply of money by the Fed are unlikely to improve capital formation, particulrly if the government is unresponsive to market conditions, such as rising energy prices.

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