Perils of the debt-propelled economy-4 part-
By Henry C K Liu
Economics is a complex subject. Any subject, however complex, if looked at in the right way, will become even more complex. This fact baffles many experts who tend to avoid small errors meticulously while sweeping on to grand fallacy.
One of the shortcomings of economics is the inadequate attention paid to it as a behavioral science. The problem can be traced to the neoclassical concept of the economic man who is supposed to act rationally in his own interest which in a money economy is generally defined rather simplistically as financial gain. Economics is obviously more than finance, and economic well-being is not synonymous with financial gain. Modern economics of course deals with the problem of human behavior with some sophistication, albeit always through the back door, and always equating self-interest with rational individual response to pricing. A market economy is coordinated through the price system operating on the principle of marginal utility.
Economists construct indifference curves to show consumer preferences. In economics, the effect on consumption of a pure change in price is shown in an income-compensated demand curve (also known as a Hicksian demand curve after economist John Hicks - 1904-89). A Marshallian demand curve (after economist Alfred Marshall - 1842-1924) is based on the concept of marginal utility. Marginal utility is observed only through choices. Marginal utility in consumption is simply a problem of choosing the bundle of goods that maximizes a buyer's utility, subject to the income constraint - the requirement that the bundle the consumer chooses costs no more than the buyer's disposable income.
Yet the demand for goods is affected by human behavior. A good whose consumption increases when its price goes up is called a Giffen good, after Robert Giffen, a 19th-century English statistician, who noted that Irish peasants bought more potatoes when the price of potatoes rose. This contradicted the law of demand, one of the basic laws of economics. For the poor Irish peasants, potatoes, as the main staple, took up a huge share of their income. If the price of potatoes went up, the share of their income available to purchase other foods would shrink markedly, forcing them to consume more potatoes to make up the difference.
Giffen goods are also necessary for conspicuous consumption. When high-price items go up further in price regularly, such as art objects, more buyers will enter the market, bidding up prices even more. Tulip bulbs during the speculative bubble in Holland in the 17th century were overpriced Giffen goods. The stock market is full of Giffen goods. When a share price goes up, it attracts more buyers. Real estate is often a Giffen good, particularly in places like Hong Kong where the real-estate market is fundamentally controlled by the government through control of the supply of land.
When housing prices rise over long periods, more buyers enter the housing market. The increased demand created by anticipated price appreciation more than offsets the fall in demand caused by price increases. And price deflation in housing creates a downward spiral of shrinking demand, a phenomenon easily observed in recent years all over Asia, from Tokyo to Hong Kong to Singapore. Public health and commercial medicine have characteristics of Giffen goods. When the price of medicine rises, more people tend to get ill due to less preventive use of medicine, causing aggregate demand for medicine to rise.
An inferior good is a good that one buys less of when one's income rises, because one can afford a superior good by comparison, even if the inferior good may also rise in price. During periods of prosperity, when income rises generally faster than prices, inferior goods are separated from Giffen goods. During periods of recession, when income falls generally while prices remain the same or continue to rise, inferior goods and Giffen goods tend to merge. A Giffen good must be an inferior good, but most inferior goods are not Giffen goods.
Credit drives the economy, not debt. Debt is the mirror reflection of credit. Even the most accurate mirror does violence to the symmetry of its reflection. Why does a mirror turn an image right to left and not upside down as the lens of a camera does? The scientific answer is that a mirror image transforms front to back rather than left to right as commonly assumed. Yet we often accept this aberrant mirror distortion as uncolored truth and we unthinkingly consider the flawed reflection in the mirror as a perfect representation.
Similarly, we reflexively accept as exact fidelity the encrypted labels assigned to our thoughts by the distorting mirror of language. Such habitual faulty acceptance is consequential because it is through language that ideas are transmitted and around language that culture develops.
In the language of economics, credit and debt are related but not the same. In fact, credit and debt operate in reverse relations. Credit requires a positive net worth and debt does not. One can have good credit and no debt. Too much debt lowers credit rating. When one understands credit, one understands the main force behind the modern economy, which is driven by credit and stalled by debt. Behaviorally, debt distorts marginal utility calculations and rearranges disposable income. Thus debt turns more commodities into Giffen goods and creates what US Federal Reserve Board chairman Alan Greenspan calls "irrational exuberance", the economic man gone mad.
Human behavior is complex beyond the measurement of price. Price alone is not sufficient to influence market behavior. Karl Marx dealt with the concept of fetish as a factor in demand as expressed in price.
Education is a classic dilemma. Economics literature has never dealt satisfactorily with education, being unable to decide whether it is consumption or investment or both. It has done similarly with health care and environmental preservation. If these endeavors are consumption, the law of scarcity dictates that society cannot afford too much of them. If they are investment, then supply-side theory would conclude the more the better. If they are both consumption and investment, there should be a limitless upward spiraling supply/demand symbiosis. One could not possibly have an over-educated society or over-healthy population or an over-clean environment, if being more educated, more healthy and more clean is deemed economically productive and thus financially profitable.
It is obvious that debt changes human behavior. A little debt reinforces responsibility. The US social system of private property is built on the notion that homeowners with a life-long mortgage are better citizens than renters. People tend to take better care of their homes and plant roots in their communities if they "own" their homes, even though 90 percent of the purchase value is in debt that is not expected to be paid off until three decades later.
On the other hand, it is clear that excessive debt encourages irresponsibility. The borrower may develop an irresistible incentive to walk away from his debt if he perceives the debt to be beyond his ability to repay, or the cost of the debt to exceed its benefits. Even a central bank, which is the domestic lender of last resort, is wary of the problem of moral hazard, that commercial banks within its system would lend irresponsibly if they knew that their lending errors would be bailed out by the central bank.
The US bankruptcy regime is designed to give trapped debtors a fresh start from distressed debt to reestablish credit. Unlike European precedents, one cannot be jailed in the United States for failing to pay one's debt, unless criminal fraud is involved. In fact, there is a legal concept of lender liability, based on which a distressed debtor can sue the lender for damages for lending money irresponsibly that led the debtor into financial trouble.
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