Melbourne Unitarian Peace Memorial Church

A talk given at the Melbourne Unitarian Church by Rob Watts, Professor of Social Policy in the School of Global Studies, Social Sciences Planning, RMIT University on 12th October 2008

INTRODUCTION

Almost precisely a year ago people in America, Australia and Europe began to hear disturbing stories about a crisis to do with housing mortgages: in July August 2007 several European banks failed as people, many of them on low incomes who had borrowed money to buy a house found themselves unable to keep up payments on their mortgage. We started talking about a sub prime mortgage crisis inn the US as Americans 'discovered' that some $1.3 trillion had been loaned out to were high risk borrowers and that 16% of the 7.5 million mortgages were delinquent or in foreclosure proceedings: by July 2008 over 25% of these mortgages were in trouble.

A year later we now are getting some sense of the scale of the crisis in credit which this is part of: in one of the biggest financial crises we have yet seen and we don't know how much more trouble lies ahead.

We now see a major crash in the US housing market, the failure globally of major, banks and other financial institutions; and worries about the very stabilility of the banking system itself as governments nationalize banks as has been done in Iceland over the last few days. Stock markets globally are melting down. We are no longer having the odd Black Monday or a Black Friday: As of October 2008 we are Having whole Black Weeks Black Weeks as Black Monday becomes Black Tuesday then Black Wednesday. Arid the effects are only slowly becoming clear superannuation funds tell retirees that their pension incomes are being cut this year by 20% and 30% the Australian dollar loses 32% of its value against the US dollar in just two months it seems that productive industries including secondary industry and various commodity. prices are heading into new levels of unemployment and falling prices which may mean we slide form recession into a full scale depression

Closer to home on we have had major banks writing off billions of dollars of bad debt: eg., National Australia Bank after claiming over the last year that is wasn't affected by bad debt problems first announced it was writing off a billion dollars in bad housing debt and then two week ago at the end of September said it was writing off another $1.2 Billion in bad debts it is caught up in via US CDO's and allows it is exposed to another $4 billion in other CDO's. CDO's are clearly one of the reasons for the cascading nature of the crisis CDO's or collateralised debt obligations a device invented first in 1987 by Drexel Burnham Lambert one of the big failures in the crisis of 1990. There appears to be some $2 trillion worth of these CDOs globally: investment banks sell them as packages of cash flows to investors and are set against assets which are in many cases simply packages of debt. It says a good deal that the financial markets refer to some of these CDO's as toxic waste. They are not subject to either regulation or market pricing

The smell of financial crisis is everywhere and that is why we are seeing unprecedented interventions by governments

We note eg., the extraordinary shifts in policy: the US government having pumped over $300 billion into the US housing mortgage market in July (as the two government run mortgage lenders with the funny names of Freddy Mac and Fannie Mae teetered on the brink of collapse). NB: Fanny Mae is the Federal National Mortgage Association (FNMA), a shareholder-owned corporation authorized to make loans, while Freddie Mac is the Federal Home Mortgage Corporation. Together they have either loaned or else guarantee approximately three out of four home mortgages in the USA worth half of the U.S.'s $12 trillion worth of mortgages. If Fanny Mae and Freddie Mac had fallen over we would all have known about it.

In effect the US government nationalised these two mortgage lenders. It has subsequently repeated the exercise has opted for an even larger rescue package (of $US700 billion) and voted reluctantly by the US Congress to stave off collapse of the entire US financial system. Elsewhere governments are engaging in behaviour unthinkable a year ago as they partially or entirely, nationalize banks and other financial institutions or introduce regulatory controls that looks a lot like a version of liberal socialism which Keynesian advisers prompted Western governments after 1945 to introduce.

How should we think about this crisis?

There are many ways of understanding it. There is no doubt that we are heading for a major global recession or depression as prices tumble, unemployment begins to return, and credit dries up. I do not know how well Australians will weather this crisis.

What I do know is that we have the chance to learn form this crisis but will only do so if we work out what has gone wrong.

I want to speak about this today to make it clear that what .is at stake is really. the way we have done economic things over the past few decades: by this I mean in particular our irrational use of credit/debt to feed economic growth and to enjoy an affluent lifestyle.

Now as Clive Hamilton argued in his book called Affluenza, Australians are now sinking beneath a tidal wave of debt as borrow money from banks or use our credit cards to spend more than we earn. If Hamilton is right:

Banks and financial institutions [have] engaged in the marketing of debt have made billions by redefining the way Australians understand and use debt - a process that has resulted in radical changes to the way Australians spend save and live. Debt is an essential element in the cycle of affluenza (Hamilton 2005: 72)

In July 2008 eg., it was announced that Australian bad debts had increased by $7 billion over the last three months; that each credit card owner now owed an average of $3,115; that we had increased our credit card debt from $39 billion to $43 billion in January-February 2008 and that we were now at record levels of servicing our debt with an average of 14% of our disposable income going on repaying interest repayment

Incredible as it seems there is evidence is that between one in four and one in five households now spend 35% or more of their income on debt and that one in seven household are now spending more than 50% of their income on servicing debt.

This is curious and important for all sorts of reasons. One reason why it is important is because of the light it sheds on a long-standing economic idea, namely that we are rational creatures who would never do anything as stupid as get into debt.

Without going on about it; one of the most basic ideas found in mainstream or neo-classical economics is the idea that we humans are rational creatures and that when we pursue our individual self-interest rationally then whatever this involves and whatever kinds of activities we are talking about, this is the `economic' at work.

Welcome to the core idea or claim made by economists that we are homo economicus or 'economic man' an idea sometimes expressed by using the term Rational Economic Man or REM.

This idea is a very powerful and influential idea.

It has been used to explain all sorts. of things like the course of modern history, the shape of modern, societies, the kinds of political processes at work in democracies and has played a role in changing the way governments do things.

It uses an old and very flattering idea we humans have develop to talk about ourselves: after all are we not homo sapiens where the idea of sapiens is that we are thoughtful or reasoning creatures.

In principle there isn't anything that isn't economic in nature as people like Gary Becker the 1991 Nobel Prize winner argues in his lecture.

We are rational
economics is rational
economic activity is rational
These are big ideas this claim that we are rational creatures, and that
when we behave economically we manifest our rationality and we are behaving rationally when we pursue our self-interest.

In effect economists operate with an identity proposition

(a) The rational pursuit of individual self interest = economics

(b) Economics = refers to whatever activities involve the rational pursuit of individual self interest:

This big idea is expressed by the first economists in the late eighteenth century and really takes off in the last decades of the nineteenth century when economists begin to embrace a natural scientific framework (eg Jevons adapts Newton's calculus (used in physics) to begin to make mathematical models of human behaviour: by the 1970s and 1980s economists like Becker are really pushing the idea as hard and as far as it can go backed up with all the authority possessed by mathematics and by one of the oldest big quite complex ideas around, namely the idea that that we humans are rational creatures.

So what does it mean to say that something is `rational' or `reasonable' or that something is `irrational' or `unreasonable'?

So let me turn directly to the idea of reason/rational -as economists use it. I hope I don't have to say that I think that the way economists use this idea may be very narrow and even stupid ... but that is really another point.

HOMO ECONOMICUS OR RATIONAL ECONOMIC MAN (REM)

When economists claim that we are `rational economic men' or that we behave as `homo economicus' they are using and mean to specify a limited and quite narrow idea.

It is an idea essentially developed in the second half of the nineteenth century. It gets an outing at the hands of one of the most influential philosophers and economists of the 19t' century in John Stuart Mill. It was Mill who insisted that economics is about humans rationally promoting an increase in their economic well being as measured or defined by increasing income or wealth

...[Economics] does not treat the whole of man's nature as modified by the social state, nor of the whole conduct of man in society. It is concerned with him solely as a being who desires to possess wealth, and who is capable of judging the comparative efficacy of means for obtaining that end

... an economic man is a: being who inevitably does that by which he may obtain the greatest amount of necessaries, conveniences, and luxuries, with the smallest quantity of labour and physical self-denial with which they can be obtained."

The great Italian economist Pareto (1906) first used the idea of Homo economicus while by 1930 Lionel Robbins set loose a fully developed theory of rational economic choice base don the, assumption that markets are made up of individuals who act' rationally to promote their self-interest so as to enhance their wealth or well being.

Today this assumption about our capacity to act and judge rationally is the basis for the majority of economic models. This amounts to the claim/cum/ assumption that all human beings are rational and will always attempt to maximize their utility - whether it be from monetary or non-monetary gains The idea of Rational Economic Man treats our "rationality" in as our capacity to calculate what will make us happy or increase our well being using the least amount of pain or effort to do so.

That is to be very clear rationality is applied to one task and one task only: That is, the rational economic individual seeks to attain very specific and predetermined goals which increase wealth, income or happiness to the greatest extent at the least possible cost or with the least possible effort.

Note that this kind of "rationality" does not say that the individual’s actual goals are "rational" in some larger ethical, social, or human sense, only that he tries to attain them at minimal cost.

Now the simple test is this: How well does this assumption apply to or describe what actually happens. This is where any number of tests might be applied or cases looked at.

THE TEST CASE: DEBT/CREDIT

One that come to mind straight away is the case of gambling.

Gambling in Australia is worth billions of dollars and chews up at least 6-7% of Gross Domestic Product and the fact that so many people do it -me included cos I have a weekly flutter on Tattslotto- suggests the power of fantasy and magical thinking. Anyone who goes into Crown casino planning to win is a fool.

No less interesting is the case of our use of credit or our ability to get into debt and stay there.

Some 20 years ago I decided to buy a house. I bought a house in Coburg for a bit over $110.000.00. Last year l paid off the money I had borrowed plus the interest on that money. For the record I ended up paying off a tad over $800,000.00. You can work out how far ahead I am when I mention that I have
had the house on the market for six months and haven't had an offer past $540,000.00.

My oldest son has just bought his first house for $350,000.00 out in Hurstbridge He knows he will be paying back $1.3 million I hope I am still here in 30 years time to see whether his house proves to be an asset or not.

So: How rational (and using the rather restricted notion of rationality that economists use) are these decisions?

You might decide that there are individual cases but that these do not as they say prove any point: it might be suggested that there may be cases where individuals make bad choices but no further conclusion can or should be drawn about the general tendencies of people.

For the test to be pertinent we need
evidence about large number of people engaging in irrational behaviour
we need evidence of behaviour where people either know better or should know better

On the issue of scale we can see straight away that going into debt in a big way has become increasingly widespread.

One table catches the scale of the use of debt and suggests that people across
all of the income levels are relying on debt

Secondly we need to recall that the chief idea about economic rationality is the proposition that, people will rationally choose those actions which increase their well being income, wealth or whatever for the least amount of effort

Going into debt especially in the ways we do it is clearly deeply irrational when set against this definition:

Firstly you don't actually add to your wealth or income but rather you subtract from it.

That is you end up further behind than when you started.

As Hamilton notes using the interest rates as they were in 2004 if you racked up a credit card debt of $5000.00 during 2004 you will need to reduce your consumption expenditure by approximately $11,000.00 in 2005 simply if you want to get back to where you were before you borrowed or spent $5,000:00 you didn't actually have;

If you keep spending $5,000.00 more than you earn you will soon be in trouble... You simply cannot keep on spending $5,0000.00 more than you earn each year even though this is what lots of people do

Secondly you have to repay the money your borrowed ie., by reducing your weekly expenditure by approximately $100.00 a week

Then you have t o repay the interest and with interest rates of about 18% that means that you need to cut expenditure on other things by more than $20.00 a week.

Imagining that by getting into debt is putting you ahead is a bit like believing that by going to sales to spend money on cheap goods that you will save money especially if as Hamilton points
out you max out your credit card to save money by-buying stuff at post Christmas sales !!

Then there is the evidence that people actually choose not to know what the interest rates are or even whether they have the capacity to repay the debt burden they have cranked up. Very few Australians seem to have read the fine print on their credit card to know the true extent of interest charged on the amount of credit they have borrowed

Then there are the problems of living with anxiety, stress and the threat increasingly real of having to declare yourself bankrupt to deal with excessive debt burden. This is not pleasant and is very far form any idea of adding to your pleasure or sense of well being. The number of households said to be facing what the ABS calls financial distress snow exceeds 900,000 households out of a total of 7.9 million households.

In effect as Steven Keen points out after interest repayments households are now worse off than they were in 2002 Increased interest payments have wiped out any small wage increases since then. Indeed over the past 40 years private debt has just gone though the ceiling in 1964 private debt amounted to around 26% of GDP :now it is a staggering 156% Of Australian CDP.

CONCLUSION

By any reasonable test of the neo-classical economist's idea that we are rational, our use of credit-debt whether as consumers or as lenders is not all that rational. The actual behaviours of key financial institutions and many governments especially in the US and perhaps as well as locally, looks more like a mix of criminal fraud and criminal negligence. As to the future I can only say `watch this space'.