Thursday, March 29, 2007

Credit and Consumption Theory

Related to the worries over the subprime sector is some criticism over whether subprime loans (credit) should be extended in the first place. One way to defend credit lending is to extend the theory of consumption that we learned last night. Think of consumers as rational maximizer's of their utility. Since they are rational they will want to maximize their consumption over their entire life. That is, it is unlikely that they will consume all their income in one period but rather attempt to spread it out over their lifetime. One way to do this is to save. If you earn $100 dollars you spend $80 and then save $20 a paycheck. You then use your savings for future consumption.

Another way to smooth your consumption out is to purchase large items on credit. That is, instead of saving you purchase on credit and pay it off slowly but surely. Perhaps some people have done this for the Flat Panel TV purchases (via a credit card or a 0% credit offer. I know I have with my latest laptop). But I would venture to guess that any of you who own a house have a mortgage. You purchased the home on credit and then pay off a portion of it each month, with interest.

Sub prime lending is an extension of this type of theory, except that it targets low income borrowers. So while there may be some people complaining that supporters of sub prime lending are voo-doo economists, we can answer them by showing how these type of financial innovations actually allow consumers to smooth out their consumption or use their lifetime income to make a purchase now. Granted, their are problems with this type of development, but in the end it will work out.

Update: The New York Times has a good article on subprime lending here.

The money quote (which I was trying to explain above):

These economists followed thousands of people over their lives and examined the evidence for whether mortgage markets have become more efficient over time. Lost in the current discussion about borrowers’ income levels in the subprime market is the fact that someone with a low income now but who stands to earn much more in the future would, in a perfect market, be able to borrow from a bank to buy a house. That is how economists view the efficiency of a capital market: people’s decisions unrestricted by the amount of money they have right now.

And this study shows that measured this way, the mortgage market has become more perfect, not more irresponsible. People tend to make good decisions about their own economic prospects. As Professor Rosen said in an interview, “Our findings suggest that people make sensible housing decisions in that the size of house they buy today relates to their future income, not just their current income and that the innovations in mortgages over 30 years gave many people the opportunity to own a home that they would not have otherwise had, just because they didn’t have enough assets in the bank at the moment they needed the house.”

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