Edward is working on writing a book that is based upon his Blogs. Here is draft 9b of the opening pages. Please send your criticisms and comments (so as to improve the script) to him at eingram@ingramsure.com
AND THE LANGUAGE PROBLEM
He also spent some time as a product development consultant with a major UK insurance company which was looking to gain knowledge of the mortgage market and other ways of offering mortgages. The marketing department was impressed but the directors did not enter the mortgage market.
The new mortgage model as it existed at that time still needed development as was announced in a letter written by Edward as head of the Housing from Income Committee and published by The Times on 11th April 1975; it has since then been re-invented in very similar (but unimproved) form and implemented some years ago in Turkey as a housing finance model for Civil Servants.[1]
The rest of the world was busy blowing property price bubbles and government bond bubbles, and saying it did not worry them, lenders were insured against such risks....that Edward's all-embracing equation for lending, showing how dangerous that might be, was out-dated...oh – and never mind the borrowers, we will be OK!
How wrong they were!
If the borrowers are not safe, neither are the lenders, nor is the economy.
AN APPEAL TO FINANCIAL INSTITUTIONS
The chapter gives powerful reasons why they should - the knowledge gained may be what is needed to protect their own businesses / financial institutions as well as their clients from rising interest rates, particularly in the near term, and overall, this may give them an edge over the competition on several fronts, including investment fronts.
The same knowledge can provide governments everywhere with policy options that they currently do not have. That is why it will pay any financial institution to be a part of the movement, helping to shape the future instead of lagging behind and being pulled along.
Incomes inflation creates demand inflation and that drives all other inflation. It drives the expected returns from property and equity investments but fixed interest bonds get left behind – why use them in that case? They fix the returns in money, not wealth. Doing that unbalances the ownership of wealth in the economy. Wealth ownership becomes unstable as does the wealth-cost of borrowing. Wealth gets re-distributed unpredictably.
So what have I done?
We do know this - if you [try to manage] the symptoms you will be kept very busy, but if you tackle the source of the problems the symptoms will mostly disappear. So we will see what difference it makes when the foundations are safe.
It will change our investments, savings, pensions, mortgages, bonds and our expectations of what can and cannot be achieved, starting as soon as our financial institutions and government agencies get their heads around what has been discovered and written.
New concepts rule. We will store wealth and we lend wealth, not just money. Until now everyone has thought in terms of money and prices. In future we will change the currency of our discussions and measurements, to wealth, and stored income (wealth). By doing so we will invest in, and borrow from, a much safer range of financial products and we will have a much safer financial world.
General knowledge about wealth and other concepts will get updated, and some important regulations and other new guidelines for future policy-makers to take things further forward are included in this book. An early series of pages on this was written on this Blog, starting on the home page.
Example 3 r% = 7% AEG% = 11% So I% = -4% p.a.
Such a contract can protect both parties. Both parties will know how much, or how fast a transfer of wealth, has been agreed upon and when it will be paid. There is no transfer of wealth up to AEG% p.a. of interest or of indexation, only the true interest rate payable above that is a transfer.
P% = C% + D% (fixed) + I% (fixed)
MATHEMATICALLY: P% and C% both rise slowly over time as the capital payment C% p.a. reduces the principal amount owed and the value of the money payments 'P' rises relative to the debt 'L' and so P% rises to 100% plus interest in the final year.
P% = P / L x 100%
What we want to avoid is any jerky changes of value, so in this equation which looks at how the value of P% is distributed, we want no jerky movements in P% or in C%. If both I% and D% are fixed there will be nothing to worry about. We will look at such ILS Defined Cost Mortgage later.
This draft has been overtaken by this draft book.
But the other pages on this website are the basic contents of the book. Best to read them in sequence as they were written.
A very popular topic today is the LOW INFLATION TRAP but also read the preceding pages.
Today my theme is that there is a simple explanation for all of the world's major imbalances: we have ignored Adam Smoth's pricing law.
Simple.
The book explains how we are doing that and what can be done about it.
COVER PAGES
But the other pages on this website are the basic contents of the book. Best to read them in sequence as they were written.
A very popular topic today is the LOW INFLATION TRAP but also read the preceding pages.
Today my theme is that there is a simple explanation for all of the world's major imbalances: we have ignored Adam Smoth's pricing law.
Simple.
The book explains how we are doing that and what can be done about it.
---------------------------
COVER PAGES
You cannot over-sensitize and mis-price $300 trillion worth of debt and by implication at least three quarters of the world’s wealth and investment assets, and do so in a constantly disruptive and unstable way, and NOT make a mess of the world's economies.
This is a draft of the first pages of a book about practical ways to re-think economics and get back on track without a crisis. It takes a new and scientific look at the way we do the pricing of debts and currencies and finds that neither of these is done in a way that is consistent with the basic principles of pricing. Prices are intended to balance the supply of goods and services with the demand for them. What is happening in practice amounts to very significant deviations from that path, deviations which can add and subtract $trillions to and from the wealth of the world, and it can happen very fast.
The solutions are both practical and remarkably simple. As one reader, Gilberto Emilio Hernandez Negron, wrote in a pictorial way:
It is a very simple and far reaching scientific discovery (at the e=mc2 level). The beauty of it is that it is not that hard to “fit” it in. It does not require changing banking, financing, trading, taxing [much], regulation [much] or international politics. It gives back to parties in a financial transaction a solid basis to negotiate upon.
It just gives back to the driver, the ability to really drive the [economic] car. You can still crash and have accidents but you can steer, brake, stop and accelerate assisted by good road signage, power steering, Traction Control, and anti-lock brakes.
---------------------------
The new science to be found between the covers of this book is based on the first principle that economists were taught...economics is about finding a balance between supply and demand; and that is what we are failing to achieve with our present economic structures in banking, borrowing, and currency management.
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OTHER COVER or INSIDE SCRIPTS THAT THE PUBLISHER MAY LIKE TO USE
COMMENTS ON THE BOOK
Timothy Hosking
Building Economist
I have read your work and don't seem to have further comments, other than it is incredible.
I watched BBC finance over the weekend and they were talking of the excess credit that has crept up from 15% per household income 40 years ago to 90% these days.... I kept thinking of an answer to the problem with your model.
Bilingual Loan Officer at First Mortgage Company...
Edward is a solution-oriented, out-of-the-box thinker. He is an optimist and approaches the most complicated macro-economic problems with a positive confidence, analysis and creativity. We need more economists like Edward Ingram.
Treasurer at Caribbean Financial Group
Macro-economic stability will allow each capitalistic "sin" to show for what they are... it can be applied starting tomorrow without provoking institutional, political, or social revolutions; a new "reset and restart" of modern capitalism for the next 100 years.
· Ted Mara
After reading what you sent, [draft book], I have to say that even as the "layman" I am when it comes to real economic discussions, what you have presented was enlightening, and logical. Your writing style is great - easy to read and understand. No question, you are on to something great! Damn the torpedoes, full speed ahead my friend! I am impressed!
Rachel L. Chueh, Ph.D.-Finance
Hi Edward, I am a member of The Prosperity Renaissance. The book you're working on is amazing! I'd like to add you to my professional network on LinkedIn.
· Micah Ogberhie
You're going places, and I hope to pop champagne with you when your discoveries come to general limelight.
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THE REAL PROBLEM
An economist writing in a discussion in LinkedIn wrote something that suggested a wide gap exists between the way that economists think and the way that Edward thinks – which is about the norm.
Edward replied almost exactly as follows – name changed:
Robert is that a swipe at me? I am asking because what I am saying is very much that economists are playing with the wrong economic model, (wrong pricing structures), creating all these theories based largely upon mathematical models of what we have now, finding correlations and past behaviour, and then trying to use that to manage the economic cycles.
AND THE LANGUAGE PROBLEM
When economists read my essays they usually lose it because they are not reading what is written, but what they are used to seeing written. A part of the problem, explained to me by an economist, is that I write for ordinary people who in the past have been my clients. So whereas I should write 'investment and savings' for economists, I write borrowing and savings / investment because my clients invest in bonds and they borrow to buy houses.
I am not saying anything bad about their skills or intellect nor am I saying that Keynes or Krugman are not doing well in that area. It is just the wrong way of doing things. If your car was constantly surging ahead and falling behind you would take it back to the designer and ask what the hell he had designed. So why not do that for the economy?
Go back to first principles as I have done and get all the pricing mechanisms to work the way that they should do. THEN see how the economy performs and after that see if anything else is needed.
The frustrating thing with economists is that the skills needed to do that are not taught in economics. I have had to do it for you guys. In my book.
2. SKILLS OF THE WRITER
As an experienced practitioner the writer, Edward C D Ingram, is well placed to write this book. He draws upon his experience as CEO of both his own once famous UK Financial Advice and Management Company, Ingram Investment Services Ltd, which set new standards and introduced new financial products in the UK. Later, Edward was CEO of the Unit Trust Subsidiary of a Financial Holdings Company in Zimbabwe. He was given an office without furniture, and a budget. The resulting unit trusts became the leading brand and Edward’s presentations on television changed the mind-set of the nation which had barely heard of Unit Trusts till then.
He also spent some time as a product development consultant with a major UK insurance company which was looking to gain knowledge of the mortgage market and other ways of offering mortgages. The marketing department was impressed but the directors did not enter the mortgage market.
The new mortgage model as it existed at that time still needed development as was announced in a letter written by Edward as head of the Housing from Income Committee and published by The Times on 11th April 1975; it has since then been re-invented in very similar (but unimproved) form and implemented some years ago in Turkey as a housing finance model for Civil Servants.[1]
[1] Google search under “Kanak Patel, Turkey, Civil Servants, Wages-Linked Mortgage” for the latest references.
This is an ‘index-linked to wages’ mortgage pricing model for civil servants using an index of their wages as a template both for repayments and for the base / core interest rate.
IDEAS ALREADY ENDORSED
By 2004 Edward had presented his updated ideas - those contained in this book - to a top-level study group in Zimbabwe. They were unanimous, saying that the ideas should be published and tested. The composition of that group was the highest level that could be found in that country as explained in PART 2 of the SOME ENDORSEMENTS page of this Blog.
At subsequent university presentations the majority of lecturers in their several financial faculties including banking, business management, and actuarial science, wrote the same thing on their 30 or so feedback forms.
The problem was that Zimbabwe was not a place where any test of the new mortgage model could be carried out, and the poor reputation of the country as a whole blinded the world's major economists to the fact that those people are among the best educated people in Africa - by common consent.
The rest of the world was busy blowing property price bubbles and government bond bubbles, and saying it did not worry them, lenders were insured against such risks....that Edward's all-embracing equation for lending, showing how dangerous that might be, was out-dated...oh – and never mind the borrowers, we will be OK!
How wrong they were!
If the borrowers are not safe, neither are the lenders, nor is the economy.
BOOK CONTENTS - so far
Apart from looking (in later chapters) at exchange rate instability, this book deals with the latest versions of the new mortgage model and other innovative ways for governments and businesses to borrow and lend. They are powerful and very effective, at least in theory. Now it is time to try them.
AN APPEAL TO FINANCIAL INSTITUTIONS
Chapter 5 brings an appeal to financial institutions around the world to consider delegating some of their staff to a new study group, with a view to asking any government anywhere to clear the way forward for a test of the new mortgage model.
The chapter gives powerful reasons why they should - the knowledge gained may be what is needed to protect their own businesses / financial institutions as well as their clients from rising interest rates, particularly in the near term, and overall, this may give them an edge over the competition on several fronts, including investment fronts.
The same knowledge can provide governments everywhere with policy options that they currently do not have. That is why it will pay any financial institution to be a part of the movement, helping to shape the future instead of lagging behind and being pulled along.
As a result of comments and questions from readers I have made some changes which are now replacement or additional paragraphs in red font to help readers coming back for a second look.
This is work in progress. Anyone may email me and ask for a word copy and may make suggestions of ask for clarification.
MAIN BOOK
FOREWORD AND FOREWARNED
AN ABSTRACT
I found this article by Paul Krugman thanks to a discussion started by Anil Akbar about the state of macro-economic theory:
This must surely be of interest to everyone. It has several references that I will be following up on.
What it covers is the present state of the science of macro-economics which Professor Krugman claims is not as bad as it may appear – it is mostly the commentators that are blamed. That is all very well, but it does not mean that economies are designed to be financially stable. Mostly, modern economics is about managing the symptoms of financial instability instead of going to the source and correcting that.
What my work covers is a lead into a new era of financial stability through a redesign of the pricing structures for debts and currencies that form the foundations of an economy and which foundations, being unstable themselves, are creating most of the instability everywhere.
My theory is that when prices are free to do what prices are supposed to do, balancing supply with demand and protecting our wealth, we will get that elusive balance between supply and demand and secure wealth, automatically. That will keep economies in balance and on course almost automatically. It will also transform family and business lives, making everyone feel financially safer.
If this is backed by a steady drip of new money creation and we have sorted out the dynamic issues of fractional banking, it is hard to see where economies will find trouble. There will be undulations in the rate of spending certainly, but not any significant recessions, and no man-made crises other than from politics, natural disasters, and war.
If we have good control over the money supply, then the rate of interest will be set so as to balance the supply with the demand. Not the other way around. Interest rates are supposed to adjust to balance the supply with the demand, not to be adjusted. If there is not enough money there will be a signal – interest rates are too high, and then more money can be created and given to everyone in the form of temporary subsidies which will reduce prices uniformly as a percentage price cut of all goods and services. This will stimulate spending on those things that people want most, and are already buying.
If too much money is created there will be a response – low interest rates and easy access to money, raising wages and raising prices to match, so that the excess money is mopped up in an orderly fashion. Currently, because of the debt and other structures that are in place, structures that prevent a correct pricing response, that adjustment takes place in very dis-orderly fashion.
Most of the science that Paul Krugman is talking about will not be needed because until now the BASIC science of macro-economic design, needed to create an orderly response to such things, has not been written. The science of economics as it currently stands is the science of managing dis-order, not the science of eliminating disorder.
As just mentioned, a very interesting outcome of the new pricing structures for debt and for currencies is that in the event of an over-supply of money, leading to easy credit and rising incomes, the pricing response will apply equally to incomes, prices, and interest rates, and the result will simply be to mop up the surplus money supply without getting the economy, or spending, or wealth and savings distributions out of balance. Wealth stored in debt as savings and investments will not be lost or transferred from the owners to other parties. It should prove to be an almost painless adjustment.
So creating too little money may slow the economy, but creating too much will not do a great deal of damage. Asset prices will not race ahead very far, spending will not divert from some sectors into other sectors destroying jobs and confidence, and in fact the only noticeable change will be that the value of money has fallen taking the price of everything, including incomes and pensions, proportionately higher.
THE MIND BENDING PART
When any science takes a BIG step forward, it explains a lot of things that were previously not understood - they were seen to be happening but the reason why they were happening was not at all understood. So it is with this book. We all know what is happening but we are not clear about why it is happening.
At first, new science tends to meet resistance because all the text books have to be re-written, at least in part. The scientists around at the time can feel jolted and threatened. There are a lot of adjustments to be made. Gradually enthusiasm builds and more and more scientists are converted.
Then it becomes the mainstream stuff and the world moves forward.
TWO KINDS OF INFLATION
In this case, what is not painless, as always when the existing science is over-turned, is getting to grips with all of the mind bending challenges to what has previously been taken for granted about the meaning of inflation and wealth and how all the financial services are currently working. Almost everything is done on a money-back basis; and this distorts everything because the value of money is forever changing. It is not possible to write a contract to lend or to borrow that determines how much wealth is involved, only how much money is involved. As money rises or falls in value what happens to the wealth, how fast it moves and in what direction is all one big gamble.
There are in fact two very distinct definitions of inflation, one is incomes based and the other is prices based. Both have their own distinct and vitally important applications. We know about prices inflation but who has studied incomes inflation in close up detail?
Incomes inflation creates demand inflation and that drives all other inflation. It drives the expected returns from property and equity investments but fixed interest bonds get left behind – why use them in that case? They fix the returns in money, not wealth. Doing that unbalances the ownership of wealth in the economy. Wealth ownership becomes unstable as does the wealth-cost of borrowing. Wealth gets re-distributed unpredictably.
ORDINARY FOLK
In contrast, ordinary people are not generally disturbed by the ideas. The new financial products that are needed to balance the economy and to protect their budgets and their wealth from such things are relatively easy for them to accept and adopt. The new financial products and services will bring a great deal of confidence and financial security with them, which is what people want.
They want to know that their borrowings are affordable and that the cost to their wealth (cost-to-income as a percentage p.a., going forward) is, like rentals and other prices, going to be under some kind of control, and that their savings and pensions will be well protected from inflation and other hazards – unless they themselves choose to put them at risk.
INSTITUTIONAL MIND BENDS
The same mind bending problems arise for some of the product providers like bankers. They, in particular, appear not to have accepted that if you have control over arrears rates you get control over the interest rate. If you get control over the interest rate you can price interest rates correctly and then you will not get any cash flow imbalances – supply and demand for funds will come into balance. There will not be the traumatic fear of losing control of the cash balances and then having insufficient incoming cash or other funds with which to finance the loans.
Lenders appear to be traumatised by a long and continuous history of crises which were brought about mostly by NOT being able to do that. Until now, lenders could only choose between either, a loss of control over arrears and collateral security as they raised interest rates, or a loss of control over interest rates and deposits as they fought to keep arrears under control. Either way they were, and currently are, unstable and at risk.
SOMETHING NEW
The new mathematics of lending and the repayments thereof, contains one extra variable: the rate at which payments can rise. Rising payments might be purely in response to rising incomes / aggregate demand for example. That would be a simple and natural response to incomes inflation, but it is a response that currently cannot happen.
What the equations show is that mortgage lenders cannot safely lend a great deal more when interest rates are low. This is because the mortgage repayments will experience both high and low rates of interest on their journey through the interest rate cycle. This also means that, given clearance to use the new knowledge in practice, lenders cannot lend a lot less when interest rates are either temporarily high or high because of inflation, because they do not need to lend a lot less for these reasons, and competition will keep that in order.
SIDE EFFECT ON PROPERTY VALUES
The good news coming out of this is that property prices will not be able to bubble and burst because lenders will not be able to lend more or lend much less over a cycle. Only rising incomes will increase what they can lent and at a similar rate. Lenders will only be able to lend an amount that rises as incomes generally rise, keeping the relationship between property values and national average incomes in a steady relationship.
Collateral security will be safer, so lower deposits will be fine, and because the arrears risk is now managed and collateral value is safe, lender’s reserve ratios will be able to fall. If there are almost no arrears and there is no lack of collateral security, where is the risk?
WARNINGS TO READERS
I give a clear warning to readers that the above outline is more suited to a conclusion after all the evidence is in; and a further warning to economists who often stop reading before they have read the evidence. Why do they do that? They are looking for an excuse because it is new and really hard work at the mental adjustment level. It contradicts a great deal of what they have been taught about how an economy works because economies will no longer work in the same troublesome way, and people’s behaviour will become more predictable.
The new science to be found between the covers of this book, is based on the first principle that economists were taught – economics is about finding a balance between supply and demand; and that is what we are failing to achieve with our present economic structures in banking, borrowing, and currency management.
WAYS TO HELP
FOR BANKERS
For bankers there is an interactive spreadsheet for forecasting their profits, with variables that can be entered covering current and new taxation models, interest rates, redemption rates, and mandatory reserve ratios.
Also for bankers there are spreadsheets to test the risk levels based upon the arrears rates likely to be encountered in the event of interest rates and income growth rates getting out of line. There are options to test various business strategies and a suggested formula for setting the initial level of monthly repayments is given, using the recent history of interest rates and incomes growth rates to measure their standard deviation and mean.
Ten sets of bar charts are generated for each pair of spreadsheets – one of the pair is for the traditional mortgage model using level payments, and the one is for the new mortgage model, enabling comparisons to be made on a year by year basis.
These spreadsheets were used in compiling the illustrations provided in this book, including the tabulations and the bar charts relating to the cost-to-income for borrowers on a year by year basis.
There is a brief chapter on how to find the median rate of interest, using the insights found in this book. So far it has passed the predictive tests done with it. The hyper-link just given will take a reader to the relevant blog page where the current wording can be found.
FOR POLICY MAKERS
For policy makers there are chapters with suggestions about an agenda to follow to ensure that the theory is well understood by a committee of enquiry. That committee could also become the steering committee that oversees the implementation. Those chapters draw on the writer’s long time experience in the financial services industry at many levels. Currently that agenda can be found on the main Blog http://macro-economic-design.blogspot.com as a series of 10 pages the final one being an outline of how the whole project might be implemented if there is a rush to do so. Another page describes many new financial products. The ILS Mortgage page directs readers to another Blog but that is also covered in this book in Chapter 5.
FOR ECONOMISTS
For economists, I can only encourage you to keep on reading. Here is a copy of a script that I wrote on that subject in a discussion group at LinkedIn in which the participants complain that the ‘science of macro-economics’ has been taken over by mathematicians. Present day economists are said to try to make forecasts based upon past events and trends that consistently fail because circumstances change and so does human behaviour. The complainants claim that their views are consistently ignored. To this I responded as follows:
Of course you are ignored. People have to try to sort it out no matter what.
But let me say something:
[In recent times] economists have ignored the fundamentals of the subject.
As for [management], the science of electronic controls systems has proved very capable of helping machinery to do as it is supposed to do.
So what have I done?
I have gone to the basics to show that the foundations upon which economies are built do not have to be unstable. The proof will be in the testing of my new debt structures, and a new currency pricing regime when we have that sorted out.
We do know this - if you [try to manage] the symptoms you will be kept very busy, but if you tackle the source of the problems the symptoms will mostly disappear. So we will see what difference it makes when the foundations are safe.
Then I go to the science of control systems to look at how to manage the money supply because if the prices are right I propose that the economy will be self-balancing, only needing the right amount of money to keep it going. Well that is a good start anyway. Once all this has been done, we will be able to see what other problems there may be to look at.
CHAPTER ONE
FAMOUS ECONOMISTS WERE RIGHT
But the science was missed
As far as my reading about the major economists of the past is concerned, people like Adam Smith, Heyek and Von Mises and their Austrian School, and even J M Keynes, and Milton Friedman, have all had this thought: huge natural disasters and war apart, there should be a way of maintaining a sustainable growth rate with near full employment in any economy.
Indeed, if the pricing of everything is right then there should be a balance between the supply of everything and the demand for everything. Given that most people want to buy more and so stimulate the demand, that provides more income for others and more jobs, there should be a constant tendency for any well managed economy to move towards full employment.
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If you were driving a car and no matter what you did the car was alternately racing ahead and falling behind the speed that you were aiming at, you would take it back to the workshop or return it to the manufacturer for some detailed attention.
If the wheels were round but they were not mounted even near to the centre you would have a very uncomfortable journey and you would not want to ride in such a car.
Yet when the economy behaves in much the same ways, we are not even looking at the design to see why the wheels are not correctly centred causing property price and other price bubbles, which is basically the reason why the economy then rushes ahead and later falls behind the rate of growth that we are aiming to achieve. The alternating herd instinct of greed and fear amplify the cycles and make them hard to manage.
The answer is right there in front of our eyes, we are looking it: we know it is happening, we know that some of our accounting rules say that money has a constant value whereas we know that this is not true.
We are seeing how this forces lenders to demand the payment of all of the interest as if money does not ever change in value and we see how lenders lend too much when interest rates are unsustainably low and they lend too little when they are unsustainably high. We know that a large part of the interest rate is there to compensate for the rate of devaluation of money, but lenders treat that part of the interest as if it was not a different function. They demand that interest be called income and treated as income, as does the taxation of all interest as income. This failure to recognise that interest is not all income affects the economy, but we are not seeing what can be done about it. Accountancy, and traditional ways of doing things, reign supreme.
Attempts have been made to counter this by index-linking debts and repayments to prices. Not only is that too simplistic, but it is also wrong. Prices respond to aggregate demand. Mortgages are paid out of incomes, not prices, and interest rates respond to aggregate demand for which a reasonable proxy to use is aggregate or average incomes / spending / borrowing demand – all of them being inter-related.
In other words, before we look at anything else, we should look at the way we are pricing debts and also currencies. If anything is not correctly priced the supply and the demand cannot balance. This is why property prices inflate and deflate faster than any other prices such as rentals: the wheels of the car are not correctly centred to offset incomes inflation in the costing / pricing of mortgage payments. Compare that to rentals – they tend to rise as incomes rise. They do not rise ten times faster and then ten times slower, even falling rapidly. They conform to what we might expect – they respond to aggregate demand / incomes plus or minus other local market forces in their area.
And currencies are unstable because the price of the currency is being asked to perform two separate functions, and so to have more than one value. One relates to the balance of trade, the other to hot and not so hot capital flows.
Government bonds are over-sensitive to interest rate changes because they make the same mistake of make believe – all of the interest is income. And fixed money is fixed wealth. Well that is not true.
And so in the midst of this mayhem, the economic ‘generals’ that we have are not able to manage the economy efficiently. In fact what is there to manage? Only the mayhem, or is there more?
Certainly, no car driver could keep such a vehicle under good control without strenuous efforts and a bit of luck.
You cannot mis-price and over-sensitize the value of $300 trillion worth savings and debt – around three quarters of all wealth world-wide and in almost every country, and do so in a constantly disruptive and unstable way and mis-price currencies so that they too are unstable, and NOT make a mess of everyone’s financial plans and security, (other than in the case of those that make profits from chaos), and in the process, not make a mess of the world's economies.
You cannot do that and expect people to feel safe in business, or to make firm and reliable business and savings and financial plans for family homes and for retirement, in such conditions.
As the mis-pricing of debt creates and encourages over-borrowing, the economic car accelerates and makes everyone hasten to buy into assets like property and equities, and then it slows creating panic as the bubbles burst. The positive feedback [2] created by the herd instinct of greed followed by panic and fear, re-enforces the cycle.
[2] A number of economic commentators not versed in control systems theory are confusing the word ‘negative’ with the word ‘bad’. Negative feedback is actually good in most cases, restraining a response or guiding the system towards a target. Positive feedback is bad unless it is used in a carefully managed way for say power assisted steering, because it re-enforces (positively) the direction already taken; in economics positive feedback creates an upwards or a downwards spiral out of an initial disturbance by re-enforcing the direction taken.
SOCIALLY
And the cycle re-distributes wealth in a way that looks to be causing social unrest because it has gone way too far. Although this is only one contributing factor that takes wealth from the poorer sections of the community, it is a big factor. And it is socially ruinous – it destroys families and businesses.
Feeling safe and having confidence in one’s finances and the economic conditions, being able to hold onto the wealth that one has earned and saved, is currently impossible. Expert advice can help but it is not reliable. And those that can afford that advice often take gambles / make or sell investments in ways which take wealth from those that cannot afford the same kind of expert advice. They dump falling assets on buyers that are ignorant and they buy undervalued assets from them later on.
Having confidence in one’s finances and savings is a pre-condition for a socially comfortable world and for creating stable and ongoing economic growth.
So it is time to re-organise and accept that the accountants got it wrong.
We need to allow the price of debt, of debt servicing, of interest rates, and the value of savings, to counter the falling value of money and thus to be correctly priced at least on that score and so to keep economies in some kind of self-preserving balance without the need for large interventions.
Of course, there are plenty of other influences on prices, but for the main part they are market forces, not plain distortions, as in this case. It is important to know the difference.
HOW THE WORLD WILL CHANGE
Solutions to things which we thought had no answers
When these reforms have been put in place, everyone will be affected: House Buyers, Businesses, Government Borrowing, Lenders, all Financial Institutions, Rating Agencies, Regulators, and Politicians.
It will change our investments, savings, pensions, mortgages, bonds and our expectations of what can and cannot be achieved, starting as soon as our financial institutions and government agencies get their heads around what has been discovered and written.
New concepts rule. We will store wealth and we lend wealth, not just money. Until now everyone has thought in terms of money and prices. In future we will change the currency of our discussions and measurements, to wealth, and stored income (wealth). By doing so we will invest in, and borrow from, a much safer range of financial products and we will have a much safer financial world.
General knowledge about wealth and other concepts will get updated, and some important regulations and other new guidelines for future policy-makers to take things further forward are included in this book. An early series of pages on this was written on this Blog, starting on the home page.
The following is an extract taken from another Blog that I wrote:
THE NEW WORLD
HOW IT WILL FEEL
Basically, when the suggested restructuring of debts, taxes, accounting, and regulations have been completed everything will be dynamically safer and more assured. Thus:
- Your savings and investments will be safer,
- Your pension and your contributions needed will be more assured,
- Your mortgage will not run away with your money and destroy your family,
- Average property prices will not skyrocket or crash,
- Your employment will be safer,
- If you want to start a business or to boost the one you have, the facilities for financing that will be better and safer, AND
- The economic outlook will be more assured. If people's budgets are under their control and people's properties, savings, and pensions are safe, it will take a great deal to make them panic the economy into a recessionary downwards spiral.
- It is estimated that making these changes will add more than 1% p.a. to real economic growth, based on shallower business cycles and better managed savings and borrowing, also leading to ongoing increased confidence generating more investment.
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CHAPTER TWO
The main concepts and a new equation
Before I get into all of the mathematics, and the detailed economics, I want to explain all of the concepts because some of them are new, especially the idea that money devalues as fast as average incomes increase, yet that is the key to understanding the dynamics of lending and of macro-economics. Making a start in getting to know the basic concepts and understanding them is what this chapter is all about.
I stumbled upon an equation and a formula for resolving the price instability of debt that is as important for economics as e=mc2 is important to the physical sciences. It was found during an investigation into mortgage finance. The related economic formula for success in creating a stable financial sector for an economy is based upon allowing all prices to adjust for Average Earnings Growth, AEG% p.a. this being a proxy for the ever changing level of aggregate demand in the economy as well as for finding out what level of payments borrowers can afford. It serves both purposes.
NOTE: The precise definition of AEG, or average earnings / incomes, to be used will depend upon the exact application, but for now, I will ignore such refinements, assume that it reflects aggregate demand or average borrowers’ incomes depending on the context, and get on with the general scripts.
AEG is also important to our understanding of the dynamics of economies because many investments have a relationship between their price and the level of aggregate demand / average incomes of the people within the economy. Rising income tends to drive their prices higher.
But significantly, that part of the rise in price does not increase the share of GDP that the investment represents, because GDP is the total of all incomes (at least by some definitions), so a rise of that kind does not increase the owner’s share of the national wealth at all. It just preserves it. As readers progress they will see more and more how wealth is represented by the share of national income that the stored wealth represents. After all, if you cannot spend it, it cannot be wealth.
When it comes to selling an investment to a willing buyer, so as to release that spendable income, where does that spendable income come from? It comes from the buyer who loses the same amount of spendable income and power to spend it. It becomes stored income at market value – not reliable.
Both the equation and the concept of adjusting all values for changes in aggregate demand, uses the proxy of adjusting for AEG% p.a. because it is something that we can at least define and measure. In terms of demand, and thus pricing, AEG drives everything.
My equation is the general equation for debt repayments. It divides the monthly payments P% p.a. into their three basic elements such that:
P% p.a. = C% p.a. + D% p.a. + I% p.a. –
All percentages are a percentage of the current debt / loan / mortgage.
For example, P% = P / L x 100% where ‘P’ is the money paid per annum, and ‘L’ is the loan, debt, or mortgage.
Amazingly it is just simple addition. The value of the payments P% p.a. has three separate parts which are just added together, where -
C% p.a. is the rate of Capital Repayment.
D% p. is the Rate of Payments Depreciation D% p.a. which is like inflation that usually eases the burden of payments as incomes rise. D% p.a. is the lag in the rate at which money payments rise compared with average incomes / AEG % p.a. It prevents payments fatigue.
I% p.a. is the Rate of Wealth Transfer. In fact, I% is a part of the interest rate, but netted down for incomes inflation, by AEG% p.a. It is NOT netted down for prices inflation.
I will give examples later that show how wealth is transferred between the borrower and the lender / investor by this value I% p.a. The higher the value of I% the more of an average borrower’s total income / wealth gets captured by the interest rate, and vice versa – it can, and often does, go the other direction if I% is negative. That is, if the nominal interest rate is lower than AEG% p.a.
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This equation, this splitting up of the monthly / annual payments into these three basic elements, gives the lender choices about how best to divide the currently affordable level of payments P% p.a. among those three elements. The lender can choose how to split this up – how much to give to D% and how much to give to C% bearing in mind that I% is subject to market forces unless by some arrangement made with the investors / depositors, the value of I% is fixed.
The aim is to keep D% positive to reduce cost-to-income (wealth cost) of the payments to be made every year, by setting P% at a high enough level initially, to create the space needed to do that if I% is not fixed, which can only happen if the mortgages are funded by fixed I% rate bonds with maturity dates set to match the liabilities of the lender, at least on average / approximately.
Normally, in many nations, interest rates used for mortgages are fully variable so as to balance supply of money with the demand for money and so to prevent any kind of ‘run on the bank.’ But to prevent that run on the bank, the rate of return to depositors / investors, has to be high enough at all times.
If investors are interested in how else they can invest their money, as for example in properties or equities that have some link to AEG% p.a., then they will be looking at the marginal rate of interest above AEG% p.a. that they can earn from deposits or bonds that are used by lenders to mortgages etc.
Or they should be making that comparison.
In short, everything, including the interest rate used in the equation, and the return earned on other forms of investment, is or can be, adjusted for inflation of incomes and the rise in aggregate demand that flows from this.
NOTE: If all incomes rise and no additional supply is added then money falls in value and wealth and debts and costs all need to adjust. If some prices do not rise quite as fast, then everyone benefits. In other words there is a place for prices inflation – if prices inflation is less than incomes inflation then on average everyone is better off. If prices rise less quickly than incomes – that is the same thing. Just different words. Both AVERAGE price rises and AVERAGE income rises are forms of inflation. But apart from issues of efficiency, competition, and supply, all prices are driven by aggregate demand / incomes inflation.
The result should be a mortgage whose cost varies somewhat like a rental does (because everything should increase in cost as average incomes increase aggregate spending / demand), but for individual borrowers, (not the aggregate of all borrowers), easing in cost-to-income over time, by D% p.a.
A mortgage will cost more than rental at first because borrowers are prepared to pay more at first; but they then need some relief and that is what payments depreciation gives to them. The result is that a mortgage will usually cost less than rental after some years. That is for individuals. How about aggregate spending in the sector as a whole?
The national average / aggregate amount spent on all mortgages will rise at a similar rate to the national average spend on everything else, including rentals, but the rate of arrears from mortgages will reduce significantly because the raises in cost for individuals will be affordable. This means that the proportion of national income spent on mortgage finance will not change as a result of changes in AEG% p.a. (incomes inflation), and so spending patterns will not change at the national level whilst at the individual level, if lenders are managing the D% variable properly, borrowers will be safe.
PAYMENTS FATIGUE
If payments were to start as high as 30% of income, as they usually do, which is much higher than for a rental, and if the payments then increased as fast as rentals do, say as fast as AEG% p.a., then people would soon get what is known as payments fatigue. They would start dropping out, much as they do when renting a property that they cannot really afford. But there would be no crash, no sudden tsunami of arrears and defaults as happens now when variable rate mortgages experience an interest rate increase sending repayment costs up ten or more times faster than everything else is increasing.
The lenders’ task is to find a way of keeping D% positive so that even this payments fatigue problem does not happen and say, 95% of all borrowers will not suffer that.
The actual equation, already given above, is so simple that when I first saw it I had that Eureka moment – which actually lasted several days, or weeks, or maybe I still have it now, years later. Here it is again:
P% = C% + D% + I% - all expressed as a ‘% of the debt’ and payable p.a.
The equation requires that the payments should always be afforded by say 95% of borrowers and that the payments should not jump around, so that those that could not keep pace with any necessary increases would not be shocked by a sudden increase in their payments: instead, they would be eased out as the cost to their own budgets increases only if the payments gradually became too much, or as other costs creep up, such as school fees etc, just as happens with people paying rentals. So just like with rentals and based upon this new mortgage model that problem of affordability would usually happen only if the person’s income gradually and consistently fell far behind the average, or if other family costs kept on rising fast. A mortgage would be safer than a rental in this way.
Earlier I mentioned that I% is a key ingredient in the equation used for risk management of these debts:
P% = C% + D% + I%
I% is defined as the marginal rate of interest above AEG% p.a. It determines how fast wealth is transferred from the borrower to the lender. If I% is very high then the lender is getting a better rate of return than can be obtained elsewhere from risky investments. If very low, then the demand for mortgages will become too great and the interest rate will need to rise.
The value of I%, is the difference between the nominal interest rate r% and AEG%.
If I% rises and the lender does not want to alter the current value of C% or of P%, because C% is repaying the debt and P% has to be steady to prevent ‘payments shock’ and arrears, for the borrowers, then there is only D% that can be varied.
In that case, P% has to start high enough to allow I% to vary and I% must not increase by more than D% if D% is to remain positive.
In short, for this to work, I% has to be limited to a narrow range over an interest rate cycle. I have selected D% = 4% p.a. as a typical starting point and have found that while I% can vary a lot, its mean value cannot vary a lot, probably not more than around 1% either side of its long term average value over an interest rate cycle.
So some in-depth studies had to be made to see how that may work out in practice. In fact, all interest rates can depart far from their middle ground, but the deviation can only be temporary and so the problem can be managed fairly easily as readers will see later.
Remember, this I% value applies to all mortgages and so they all have this problem. The difference lies in how high they set P% at the start, and how they then manage or fail to manage D%.
BASE CASE
The base case for the new mortgage model would be when AEG% = 0% p.a. How would everything work without incomes inflation?
In this case average incomes are not rising. In this case it simply makes sense to start the payments high and let them fall over time because, even when average incomes are not rising, some incomes are falling; and no one wants to pay as much as they are prepared to pay in the first year for a full 25 years in order to get a home. They would get a severe case of ‘Payments Fatigue’. And as they get older they find other costs are rising, like the cost of a family, or a pension contribution.
In general terms, mortgages tend to cost more than rentals and rentals tend to keep pace with AEG% p.a.
The reason for this keeping pace by rentals is that as incomes rise people have more income to spend on rental and they compete to rent the best properties. Typically, a person may spend 30% of disposable income in the first year on a mortgage but only 21% of income on renting a similar house. If you are paying a mortgage you would not want the cost to look something like this:
FIG 2.1 - Cost of a mortgage if there is no relief from inflation or similar.
That would cost 7.5 years’ income in total. If there is a reasonable level of payments depreciation, D% p.a., and average incomes were not rising, the outcome would look something like this sketch:
FIG 2.2 – Mortgage costs v rental costs
AND if incomes were rising, instead of standing still with AEG% p.a. NOT = 0% p.a. we would want the same sketch to apply: the same shape, the same ‘% of income’. Everything should adjust for a changed level of AEG% p.a. Everything should adjust for incomes inflation and the falling value of money.
We would still want to see that same downwards slope starting at 30% of income, that same rate of payments depreciation ending the cost at around 11% of income. In other words, we need to adjust everything for a changing rate of AEG% p.a. which is a proxy for the falling value of money that we can measure.
This is in fact, broadly, how the new ILS (Ingram Lending and Savings) model for mortgages that I am proposing works. The question to ask is “does the interest rate move to adjust to a changing rate of AEG% p.a. so that I% remains the same?” Nothing in a free market does exactly that but we will examine the market forces that may help it to happen.
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Normally, with traditional mortgages, that downwards slope is created by having a fixed or fairly steady rate of interest whilst average incomes rise at around 4% p.a. say.
But the problem comes when incomes are not rising at that kind of rate, or when interest rates are not steady; incomes can even be falling.
Either one of the two variables, AEG% or the nominal interest rate r%, can create a problem as they vary. The reason is mostly because I% - the rate of transfer of wealth - is the difference between these two variables.
I% = r% - AEG% - all p.a.
THOSE OFF-CENTRE WHEELS
As far as the pricing of mortgage payments is concerned, this is where the accountants move the wheel of the economic car off centre. Whereas, in response to aggregate demand rising, rentals and other prices rise steadily and somewhat proportionately, mortgage payments rise and fall ten times (or more) faster than any other prices in the economy. Whilst the road ahead is gently rising and dipping the wheels of debt costs are off centre and take everything relating to mortgage costs up and down much too fast.
Variable rate mortgages re-price monthly payments for both new and current payments in this way. Fixed interest mortgage adjust costs ten or more times too fast for new mortgages when interest rates change, and being fixed in money terms, they are a burden if incomes are not rising fast.
If average incomes start falling but interest rates are already low, or if interest rates are fixed the result can be something like this:
FIG 2.3 – The cost-to-income rises if incomes are falling and nominal interest rates are fixed.
In other words, in one way or another, by NOT responding proportionately to the changing value of money, by proxy changing in response to changes in the rate of say AEG% p.a., everything can go haywire.
What the accountants do is to say that money never changes in value and therefore all interest added is a transfer of wealth, which is in defiance of everything we all know about money. The result is that as AEG% p.a. rotates up and down (rises and falls) the wheels on the economic car (the lending industry’s costs / pricing) that drive mortgage costs and property values rise and fall faster compared to everything else.
‘VIEWING’ THE TOTAL COST
Here is a useful observation. If you consider the above sketches showing the ‘% of income’ taken in mortgage payments every year, you could divide it into vertical columns of income, one for each year. By adding up all of these columns you would find that total cost-to-income of all of those years of payments. It is the same whether the columns are mounted vertically one on top of the other, or laid side by side as shown in the sketches. The total cost is the shaded area.
Given 25 years to pay, what decides how big that shaded area is, are two things: The total size of the debt (income multiple), and I% p.a., the marginal rate of interest above AEG% p.a.
Because it is I% p.a. that adds to the shaded area, as we will see in some convincing illustrations later, for any kind of mortgage model to work, there has to be some relationship between AEG% p.a. and nominal interest rates for Mortgage / Housing Finance in order to limit the size of the area, and the total cost of borrowing. It is this difference between the nominal rate of interest r% and the rate of AEG% p.a. that adds to the shaded area and the cost to wealth / income of the borrower.
I% = r% - AEG%
In fact, there is a relationship between nominal interest rates r% and AEG, and that is another reason why AEG plays a key role in an economy. AEG is not just a proxy for the growth rate of aggregate demand. It is also a key feature of the mathematics of safe lending and borrowing.
CHAPTER THREE
An introduction to net (true) interest, I%
So far we have learned that there is an equation which can be used to guide lenders on how to manage arrears and Payments Deprecation. But a key part of the equation is the true rate of interest, I% p.a., defined as the marginal rate above AEG% or the net rate after adjusting for AEG% p.a.
If readers would now prefer to go and see how the equation is derived they may turn to that chapter or read from my Blog here:
This will later become a part of this book. It has links to another Blog with a page on Siegel’s Constant, which indicates an upper limit for the marginal (true) rate of interest as competition for funds from equities would be overcome, and there is a lower limit because the demand for cheap loans at low interest rates could not be met.
Here is an outline of how that relationship between AEG% and interest rates r% p.a. works:
When the marginal rate of interest I% = 0% we can write:
r% p.a. = AEG% p.a.
Noticing that the debt then rises at the same pace as incomes are rising is a key observation. The interest added of r% of the sum borrowed is the same percentage as the income increase AEG% p.a. for an average borrower.
A year’s (average) income borrowed will still be a year’s (average) income borrowed a year later if no payments are made, and the same thing applies year after year beyond that. The race between rising debt and rising income will never be won. It is a dead heat. The ‘debt: income’ ratio will never change. By the time 100% interest has been added, doubling the size of the debt, average incomes will also have doubled, because every year r% added to the debt = AEG% added to incomes.
Remember, we have been saying that AEG% p.a. is a proxy for the growth in aggregate demand, and as that rises, the price of everything, including debt and wealth invested in debt, should rise or be ‘willing and able to rise’ at the same pace if no other market forces get in the way.
THE CONDITION FOR MAINTAINING FULL EMPLOYMENT
In a well-balanced economy, when the value of AEG% p.a. changes for no specific reason, or maybe because an economy is in recovery mode (maybe after QE) and incomes are rising, then all prices have to respond proportionately, rising by the same or similar percentage if the world’s spending is to stay proportionate on everything, keeping the supply of everything in balance and the jobs protected, and if the balance between supply and demand is to remain the same. And if savings are to keep their value they also need to respond to AEG% p.a. with a proportionate increase / interest rate. Only if all of that can happen can the same people be employed delivering the same goods and services to everyone else. If wealth changes people spend more or they spend less, and if some costs rise faster than others some jobs will be lost. Either way, spending patterns will change. The situation is unstable.
An example may help readers to remember this:
In the 1980s the price of oil fell sharply to $11 per barrel. Economists using those mathematical models so hated by some readers, thought that there would be an immediate economic boost. My office had a constant stream of investment sales reps telling me so. They saw this as an opportunity for me to get more clients invested.
Unfortunately it did not happen. As I explained to them, if the oil producers cut back on spending what will happen then? The chances are that jobs will be lost and the surplus profits that you are talking about will take time to convert into other jobs.
And six months later mainstream economists found out that this is what happened. That is why there was a slowdown.
It does not matter how or why spending patterns change, the effect is the same. Jobs get lost first and new jobs arise later.
In the case where the accountants have the upper hand and the effect of raising interest rates forces a significant part of national spending (on debts of all kinds) to be increased or decreased in the borrowing and related sectors, the outcome is the same. The change is not productive because it is largely an adjustment to the falling value of money. It is not even the same thing as ‘creative destruction’. It hits new and upcoming and viable enterprises at their most vulnerable time and that is destructive. It destroys jobs only to re-instate the same jobs later and mostly in the construction and related sectors.
If a productive change is needed, like a slowing or speeding of total spending to match aggregate demand with aggregate supply, then all sectors should be affected equally, or as equally as practical. In an optimal economy, the slowdown would not destroy jobs, but would slow the rate of increase in demand so as to match the levels of supply and demand, thus keeping prices inflation in check.
TAXATION IMPLICATIONS
AEG% p.a. is the adjustment factor for all prices and all wealth. Any profit up to AEG% p.a. should be tax free. Any increase in any value that is the same as AEG% p.a. should be tax free. In that way the wealth that people have, their share of GDP, the national; wealth / spending power, will not be taken away by taxation at a rate that depends upon the rate of AEG% p.a.
If AEG% p.a. interest is taxed, then this just makes it harder for lenders to retain and to grow the deposits that they need to meet rising demand for loans. As incomes rise at AEG% p.a. so more can be lent, the demand sources from this aspect rise at AEG% p.a. So deposits need to rise at AEG% p.a. to keep everything in balance. If interest of AEG% p.a. is taxed, this means that lenders may need to raise interest rates to compensate – to replace the lost savings that are needed to keep pace.
CHAPTER FOUR
Market forces and true interest rates
If the interest rate r% is higher than AEG% then it will take an average borrower more years of income to repay the debt than the years of income that was borrowed. And if the interest rate was less than AEG% then it would take fewer years of income to repay the years of income that had been borrowed.
Interest equal to AEG% p.a. just makes the debt rise as fast as average incomes. It does not add an income cost to the debt. The ‘debt: income’ ratio is not affected.
TRUE INTEREST
The marginal rate of interest above AEG% p.a., called the true interest rate, I%. It is the net rate after adjusting for AEG% p.a. and is a key feature of any economy.
This is the rate at which the cost-to-income of an average borrower is being increased as readers will see happening in the examples given below.
If AEG% p.a. = 0% - that is if incomes were not rising, the accountants would be right – all of the interest would transfer wealth from the borrower to the lender.
What we now have to do, if AEG% is not zero, is to make an adjustment for that. If all prices get pushed up by a higher AEG% p.a., then interest rates must also get pushed up if the same balances are to be maintained. If we make no adjustment at all then the usual balance between lenders and borrowers, between the supply of funds and the demand for funds will be destroyed or at least disturbed. Of course we will want to see if that adjustment will be made naturally by market forces if the accounting systems in current use are altered to remove the inbuilt distortions. But first we will look at the maths:
MISSING WORD - MISSING SCIENCE
In the dictionary there is no name for this marginal interest rate feature, this marginal rate of interest above AEG% p.a. I% p.a.
The absence of such a word shows that macro-economists have not been doing their science, at last not from first principles. They have been looking elsewhere. They have been ignorant learners trying to drive an impossibly unstable and unmanageable economic car and adding device after device in an attempt to cope with the symptoms. All of that is confusing and expensive. If you are sick the doctor can treat your symptoms or you can treat the origin of the sickness. Which is best? Maybe a mixture of both, but surely you would want the sickness to end!
The science of macro-economic design has not been done. It means that this is largely news to the economic generals that we have and they are fighting the wrong battles. They are adding complex and expensive solutions and still they do not seem to understand exactly what they should be trying to achieve, nor how to achieve it.
So as readers now know, I gave this marginal interest rate a name: True Interest, I% p.a. In other words, interest rates have two parts, one of which is incomes-inflation adjustment and the other is a wealth transfer:
r% = AEG% + I%
or if you prefer:
I% = r% - AEG% ----- (i)
Here are three examples of a mortgage being repaid to illustrate the point. The difference between r% and AEG% is I% as is shown in the fourth column in each example, as the rate of TRUE interest.
Example 1. r% = AEG% - so I% = 0%
HOW TO READ: Read across the shaded columns one at a time to see the balance at the start of every year, initially 100,000 (any currency), the interest added at year end, 7,000, the payment made after the interest has been added, 8,581, at year end, and the balance remaining at the end of the year, 98,419. This then moves down a row to the start of the next year. Repeat every year till the debt has been repaid.
The interest rate r% = 7% but incomes are rising just as fast, (AEG = 7% p.a.) so the mortgage interest adds no wealth to the debt – it rises at the same pace as average incomes at 7% p.a. That is to say, there is no net cost-to-income as shown in the bottom row at right. The amount borrowed of 3.50 years’ income (first column bottom row) is the same as the amount of income repaid – third column from right, another 3.50 years’ income for borrowers.
What is going on here?
Firstly we should expect this result because the debt rises as fast as incomes are rising, the debt increases by 7% every time interest is added and income rises by 7% just as often – both happen every year. This is not true for individuals whose income increases vary but it is right for an average measure against average borrowers’ incomes. At least we are getting an insight and a base from which to measure deviations.
HOW TO CALCULATE
The cost-to-income of each year’s payment is given as a percentage of income in the right hand column. These percentages are added up to give the total cost-to-income expressed in years of income, which comes to 350% or 3.50 years’ income as shown at the base of the third column from right.
The money cost of the nominal rate of interest, which is often what is quoted by accountants and others today, is much higher at 114% of the sum borrowed. This looks very expensive. The explanation is that money has fallen in value every year. The actual cost to wealth / average incomes, is zero as shown.
If you are checking these calculations, please note that the table pays the annual cost at the end of the year at the same time that interest is added. This is why the table shows 26 year’s income. By year’s end income has risen by 7%. To do the calculation for the 25th year we need to show the income prevailing in the 26th year. Please note that the first year, 3.50 first year income is lent at the start of year 1. This is the loan size of 100 000 divided by the first year’s income level, 28,604 p.a., so we still need to show that first year’s income at the top of the incomes column.
If incomes were not rising, the cost-to-income would have been 30% every year. This is a typical percentage used by lenders for the first year. They usually take 30% of net free income after tax and maybe after making other deductions for credit card payments etc. Lenders using the current mortgage models decide what they think it is safe to lend, but they never get it right because AEG% p.a. and r% never stay still. Even if r% is fixed, AEG% cannot be fixed.
Even fixed interest rate mortgages can fail if incomes are not rising. They become too costly and usually their interest rate is higher from outset. Later we will see this can happen to governments that borrow using fixed interest rates. Those fixed interest government bonds can be very expensive indeed without even giving any guarantee as to their worth to the investor / lender.
Example 2 r% = 7% again but now AEG% = 4% p.a. so I% = 3%
Here AEG% p.a. has fallen from 7% to 4% while the interest rate r% remains at 7%.
Although the interest rate r% is still the same at 7% and the amount lent has not changed, the cost-to-income has risen. Whereas in example 1, the net cost-to-income was zero, with 3.50 years’ income being needed to repay a mortgage of 3.50 years’ income, now the net cost-to-income has increased by 34.1% (of the income / wealth that was borrowed), meaning that an extra 1.19 years’ income has been taken in payments. Actually that 1.19 year’s income has been transferred to the lender for distribution between savings interest and other costs / profit.
The money cost has not changed. It is still 114.5% more than was borrowed because the interest rate has not changed and the payments have not changed. This way of costing the mortgage tells you nothing of value. It assumes that money has a constant value.
As shown in the left hand column, Payments Depreciation has changed from 7% p.a. to 4% p.a. because it is equal to the rate at which average incomes are rising.
The definition of D% is:
D% = AEG% - e%, .............. (ii)
Where e% p.a. is the percentage rate of increase in the money payments ‘P’ p.a. which in this example is zero: being the traditional Level Payments (annuity) Mortgage, the money payments are fixed level at 8,581 p.a.
D% FOR TRADITIONAL MORTGAGES
From equation (i), by definition:
D% = AEG% - 0% for all traditional level payments mortgages because e% p.a. = 0% p.a.
Thus:
D% p.a. = AEG% p.a.
D% p.a. = AEG% p.a.
It is the rate at which incomes are rising as long as the level of the payments is constant.
At least that is true whilst incomes are rising, producing D% = AEG%, and until the interest rate changes; an interest rate change forces a new calculation and a new level of payments. There is no control over D% p.a. before the interest rate changes, (AEG% is not controlled by lenders), and there is a total loss of control when interest rates change.
So lenders currently have no control over AEG% p.a. or over D% p.a. And the nominal interest rate is not within their control either as far as market averages are concerned.
UNDERSTANDING WEALTH TRANSFER AND FINANCIAL WEALTH
Example 3 r% = 7% AEG% = 11% So I% = -4% p.a.
There was a transfer of wealth in example 2 – the lender captured a greater amount of income than was lent because the marginal interest rate above AEG% p.a. (the true interest rate I%) was positive at 3%.
Here, in example 3, with the true interest rate being negative, the transfer goes in the other direction – away from the lender and to the borrower.
As shown, almost a whole year’s income has shifted away from the lender in this example. 3.50 years’ income was lent and just over 2.50 years’ income got repaid.
The borrower is lent 3.50 year’s income, which he/she spends at the start while money has good value, and repays only 2.53 year’s income in depreciating money. Effectively, the borrower has had 4.5 years’ income to spend, 3.50 years income initially, and then a spare years’ income after the debt has been repaid. The lender ends up with 2.5 years’ income to spend. The lender has passed a year’s income to the borrower – a year’s spendable income.
We can use that measure of spendable income as a measure of wealth – how much spendable income has been saved for lending and how much remains to be spent after interest has been added and repayments have been made whilst incomes have risen.
All savings and investments can be measured in years of spendable income.
If savings or investments cannot be spent, is it wealth? Maybe not. If you have shares or property, gold or diamonds, you can only spend it as income if there is a buyer with income or saved income to buy the good / the investment from you. All financial transactions can be expressed as an exchange of spendable income, or wealth.
When you reach retirement age and want to sell your shares or property you must hope that there are enough younger people with enough savings or income to buy your investment at a price that provides you with enough lifetime income that you can retire on. And you must hope that someone, a government or other borrower, will offer you an annuity or pension that is invested in a wealth preserving investment (a loan / bond) that is index-linked to AEG% or a similar index. The indexation costs the borrower nothing, no wealth, no spendable income, so why not index-link so as to preserve the wealth that has been borrowed?
Such a contract can protect both parties. Both parties will know how much, or how fast a transfer of wealth, has been agreed upon and when it will be paid. There is no transfer of wealth up to AEG% p.a. of interest or of indexation, only the true interest rate payable above that is a transfer.
If we look at this marginal interest rate’s relationship with the rate of transfer of wealth on a single year basis, we get this:
Example 4 A single year’s wealth transfer
Here, 3% true interest was added and the debt was repaid after one year.
The cost-to-income was 3%, of the year’s income borrowed, the same 3% true rate, I%.
So if you borrow three year’s income at 3% true interest it will add 3 x 3% = 9% of one year’s income to your debt adding 9% to your total cost-to-income for having borrowed three years’ income.
This is why, when average incomes are falling taking nominal interest rates down below the norm / median rate, (which, for mortgages, is typically 6% - 7% for an advanced economy whose average incomes are growing at 4% p.a.), the cost-to-income of repaying the mortgage can become unsustainable. The lender using traditional methods will have lent too many years’ income – and remember, interest rates always revert to mean. They rise again.
The problem of high true interest and excessively large mortgages is a problem currently faced by some lenders in Europe, not because interest rates may rise if they are offering a fixed interest rate loan, but because AEG has fallen or become negative. This takes I% to an extremely high level and falling incomes converts D% to a negative number at the same time. Remember, D% = AEG% p.a. for level / fixed payments loans / mortgages.
Imagine a lender offering you 5 years’ income because interest rates are around 3% and then incomes start falling by 3% p.a. (a lot more in some cases). Now I% = 6% so wealth is being added to the debt at a rate of 5 x 6% p.a. = 30% of a year’s borrower-income, per annum. That is the same as the borrowers would have been are paying in total in the first year – payable in true interest costs only. No wealth capital repaid.
This is why it is risky for a lender to lend too much – they do not usually have control over either AEG% p.a. or over the true rate of interest.
A NICE SOLUTION
But there is a way to get control over the true interest rate – by finding an investor that wants a fixed true interest rate and a borrower that also wants a fixed true rate. That could be you, as a lender or a saver, when you are ready to retire. Put these two individuals together and you can offer a defined cost mortgage with defined (fixed) D% and a defined (fixed) I% and a pre-defined cost per annum:
P% = C% + D% (fixed) + I% (fixed)
MATHEMATICALLY: P% and C% both rise slowly over time as the capital payment C% p.a. reduces the principal amount owed and the value of the money payments 'P' rises relative to the debt 'L' and so P% rises to 100% plus interest in the final year.
P% = P / L x 100%
What we want to avoid is any jerky changes of value, so in this equation which looks at how the value of P% is distributed, we want no jerky movements in P% or in C%. If both I% and D% are fixed there will be nothing to worry about. We will look at such ILS Defined Cost Mortgage later.
GOVERNMENT DEBT
When governments use a fixed interest bond to borrow money they have no idea what the cost-to-revenue (national wealth) will be and the investors have no idea of the value, how much wealth, or what part of GDP or tax revenues, will be captured by repayments on their bond investment.
The result for fixed interest mortgages is very variable costs and property bubbles and crashes, with severe damage suffered by all concerned including lenders.
The result for government borrowing in 1980, was as follows for USA government borrowing / treasuries / bonds:
FIG 4.1 - Volatility and cost of government borrowing using fixed interest bonds
Source: Morgan Stanley Research c/o Money Game Chart of the day.
The blue line shows the return on investments in USA treasuries made at market prices from year to year from 1980 to 2010. The expected / perceived /open market value of these bonds was constantly changing resulting in the price changes shown. In the second year, an investor that owned all of the bonds might have made 27% true profit (true = in wealth terms): in theory, for every GDP invested, a profit of 27% of GDP could have been made.
What did all this cost USA tax payers? Check out the straight line which is the trend-line. It appears that it cost USA tax payers about 9% p.a. true interest / wealth transfer rate falling gradually towards zero thirty years later. That is a rate of transfer of 9% of GDP p.a. per GDP borrowed. Like a 9% tax on all of GDP that was borrowed by the USA government at the time.
Why could they not have offered an AEG-linked Bond with a 1% true interest rate coupon?
The result of using fixed interest rates for both mortgages and bonds was instability for the economy, and a complete lack of certainty about the value of savings, pension funds, bonds, property, and the cost-to-income / revenues of borrowing for governments, for people and for businesses. And lenders were made vulnerable.
For variable rates th instability problems should be less because lenders can ion theory adjust their rates to retain the deposits that they need and to balance the supply with the demand. But they are unable to do that because they are using the wrong mortgage model.
All this is because accountants, lenders, and regulators, are ignoring the necessary adjustments for AEG% p.a. Debts are not correctly priced.
The science of macro-economic design and dynamics is yet to be done. But at least, this book makes a start on the design.
SUMMARY
So far we have noted that economies are unstable and that the wealth invested in mortgages and the cost of repaying mortgages is unstable and unpredictable. The same goes for government finances using fixed interest bonds.
Since debts are an investment that is made by savers or investors in bonds, this instability has a destabilising influence on the whole economy. No one knows what an investment in debt is worth and no one knows what wealth it will cost a borrower to borrow. The best that can be said is how much money is involved if fixed interest is used. But no one knows what that money might be worth. It depends upon when it is paid and the rate of AEG% p.a. over the period – how much money has fallen in value.
Money falls in value when the level of demand rises as a result of average incomes rising. Some prices may not rise in price as much as others, but all prices will rise by AEG% more than they would have risen otherwise. So money falls in value as average incomes rise.
The result of financial instability is an unstable economy, huge social damage, damage to businesses and lenders, uncertainty about how the economic generals will respond, uncertainty about what will happen going forward on many fronts, and a slower rate of growth. Theoretically, as well as in practice, sustainable growth rates cannot be sustained.
Financial stability is a pre-condition for sustainable economic growth.
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