Overfunding and underfunding, a main cause of the business cycle?

In 1946 the economist Arthur Burns defined a business cycle as a period of expansion occurring about the same time in many economic activities, followed by similar general recessions, contractions and revivals, which merge into the expansion phase of the next cycle. Cycles may take from one year to ten or twelve years. Milton Friedman argued that the concept of “cycle” was a misnomer as business declines are more of a monetary phenomenon. In this paper it will be argued that the increase and decrease in individual household debts in the U.S., especially of the long-term variety of home mortgages, was responsible for causing the latest cycle period. It will be argued that the cycle started in 1998 when overfunding became apparent. “Overfunding” occurs when mortgage funds are not only used to build new homes, but also to cause house prices to exceed the CPI indexed levels. In 2004 and 2006 68% of all new mortgage funding was used to cause such excess and only 32% of the funding was used for building new homes. The recession sets in when doubts arise about the ability of individual households to continue to service their long-term debts. Such doubts came into the open in 2007 when the liquidity for U.S. mortgage-backed securities dried up. The contraction was characterized by a turn around from a lending expansion period to a forceful reduction in outstanding debt through foreclosure proceedings and home repossessions. The period of “underfunding” started. The contraction resulted in substantial job losses, income losses for households and a switch to use incomes to reduce debt levels. The latter set off the reduced demand levels for other goods and services. The households most affected were the lower and middle-income families, whose livelihood depends on income earnings rather than on the use and benefits of savings. The tax revenues of the U.S. (Federal, State and Local) government were also seriously affected. The annual tax revenues dropped by $1.5 trillion in fiscal year 2009 as compared to fiscal year 2007; a drop of 29%. The Federal Reserve’s efforts to create a compensatory overfunding situation through Quantitative Easing: a $4.2 trillion exercise in buying up government and mortgage bonds, did not directly address the financial pressures on individual households. It helped the savers, who saw their financial assets increase in values, but not the borrowers who saw their jobs disappear and income levels drop. In a way the rich got richer, but the poor got much poorer. Inequality was enhanced. There is another way and this paper highlights the need to provide overfunding to individual households, once a recession sets in. Such method works directly, rather than indirectly, and shortens the contraction period. It also addresses the inequality issue