A Simple Mathematical Model Of The Underlying Economics

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The current crisis is catalyzing an array of responses, including searching for causes, reworking regulations, scapegoating and a massive capital injection. Without a clear understanding of the cause, the remedies may do more harm than good, innocents may be scapegoated, and valuable progress in financial tools may be lost. Worse, it will happen again. From a simple mathematical model of the underlying economics, I first predicted this crisis in July of 2004. Economic dynamic relating very low interest rates to the structure of the demand curve in the housing market made this outcome foreseeable, indeed inevitable. The current crisis had a mathematical cause. There isn’t space here for full explanations; see…show more content…
The two central facts are these: for reasons we’ll discuss, buyers buy a monthly payment, not a house price, and buyers buy as much house as they can afford. This brings us to the heart of the matter: mortgages that require no down payment, and only interest payments, alter the structure of the demand curve for real estate, in a way that is harmless enough when interest rates are high, but which drives a bubble at low interest rates. Specifically, they make housing prices inversely proportional to the interest rate. If interest rates are cut in half, house prices double. When those rates double, house prices are slashed in half. When interest rates are large, they are not likely to double or halve, but when interest rates are small, a small adjustment can be a big percentage change, and the danger of big swings in housing prices is appreciable, even inevitable. With no down payment, no amortization and closing costs folded into the loan, the only issue in affording a house is the monthly payment, which is the house price multiplied by the interest rate. If interest rates are cut in half, the house you can buy with a given monthly payment costs twice as much. But the same number of people with the same income distribution is competing for a fixed stock of housing. The house price is bid up until the new monthly payment at the new interest rate matches the old monthly payment at the old interest rate. The house price varies inversely
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