Traditional Economic Theory Essay Example

created large capital gains for households which formed a strong wealth effect for consumer expenditure and helped reduce the national savings rate. The median annual growth rate of actual consumer expenditure was a sturdy 3. 2% ever since 2003, with consumer durable expenditure such as furniture, appliances and autos escalating 5.

7% per annum. (Hampel) While individual consumption spending makes up more than 71 percent of the total economy, mounting house prices were a foremost catalyst for overall economic growth.Over the last two years, the mounting house prices were also a contributing factor to the nearly negative U. S.

household savings rate. If nationwide home prices fall by 5% in 2008, a negative wealth effect will decrease consumption spending, increase the national savings rate and reduce economic activity. (Hampel) Traditional economic theory portrays the consumer choice process as one where consumers act “rationally. ” This outlook assumes that consumers have recognized choices, face a transparent set of prices for each good or service, and have a fixed amount of income or other existing belongings to accomplish these goods or services.

It also assumes that consumers are capable to precisely rank the “utility” of the various options, given the prices and available resources, and make selections that are in their best interest over time. (McCoy) This study assumes that consumers have the ability to estimate the worth of making large upfront fees in order to get lower monthly payments; the prudence to anticipate their capability to meet future credit obligations of varying levels; and the awareness of likely trends in house prices, mortgage interest rates, and other economic variables that affect the appropriateness of different mortgage products.Each

of these assumptions, at paramount, depicts a perfect analysis of how most consumers make preferences. In several cases simple concepts of rational consumer preference present some insights as to how consumers react to income shifts or changes in the prices of some goods.

However frequently the assumption of rationality can present a unclear view about how consumers act and a confusing source for generating efficient policy approaches that can aid consumers evade falling prey to exploitation in the mortgage market.Minsky moment According to Hyman Minsky, periods of economic and financial stability lead to a lowering of investors’ risk hatred and a process of releveraging. Investors start to borrow excessively and push up asset prices excessively high. In this process of releveraging there are three types of investors/borrowers. First, sound or “hedge borrowers” who can meet both interest and principal payments out of their own cash flow.

Second, “speculative borrowers” who can only service interest payments out of their cash flows.(Dblwyo) These speculative borrowers need liquid capital markets that allow them to refinance and roll over their debts as they would not otherwise be able to service the principal of their debts. Finally, there are “Ponzi borrowers” cannot service neither interest or principal payments. They are called “Ponzi borrowers” as they need persistently increasing prices of the assets they invested in to keep on refinancing their debt obligations.The other important aspect of the Minsky Credit Cycle model is the loosening of credit standards both among supervisors and regulators and among the financial institutions/lenders who, during the credit boom/bubble, find ways to avoid prudential rules and supervisions. (Roubini) Minsky’s thoughts and representation fit satisfactorily the last two

US credit booms and asset bubbles that finished up in a collapse: the S&L-based real estate boom and bust in the late 1980s; and the tech bubble and bust in the late 1990s.

But the experiences of the last few years suggest another Minsky Credit Cycle that has probably now reached its peak. First, it was the US households and households in some other countries that releveraged extremely: rising consumption, falling and negative savings, increased in debt burdens and over borrowing, especially in housing but also in other categories of consumer credit, an increase in leverage that was supported by rising asset prices.We know now that many sub-prime borrowers, near-prime borrowers and many condo-flippers were exactly the Minsky “Ponzi borrowers”: think of all the “negative amortization mortgages” and no down-payment and no verification of income and assets and interest rate only loans and teaser rates. About 50 percent of all mortgage originations in 2005-2006 had such characteristics. Also, many other households were Minsky “speculative borrowers” who expected to be able to refinance their mortgages and debts rather than paying a significant part of their principal.(Roubini) The Minsky idea of loosening of credit/lending standards among mortgage lenders – and the phenomenon of supervisors/regulators falling asleep at the wheel while the irresponsible credit bubble occurs – is also now evident in the latest mortgage credit cycle.

A supervisory ideology that tried to minimize any prudential supervision and regulation and totally reckless lending practices by mortgage lenders led to a massive housing and mortgage bubble that has now gone bust. (Roubini)