Commentary on the Book:

"The New Road to Serfdom"
by Michael Hudson

Edward J. Dodson

[Commentary on the article, "The New Road to Serfdom," by Michael Hudson, published by Harpers, May, 2006. This paper was prepared in August, 2007. See the original article for the graphs and charts referenced below]

Michael Hudson is Distinguished Professor of Economics at the University of Missouri, Kansas City and the author of many books, including "Super Imperialism: The Origin and Fundamentals of U.S. World Dominance." Nigel Holmes was the graphics director of Time magazine for sixteen years and is the author of Wordless Diagrams.

Even men who were engaged in organizing debt-serf cultivation and debt-serf industrialism in the American cotton districts, in the old rubber plantations, and in the factories of India, China, and South Italy, appeared as generous supporters of and subscribers to the sacred cause of individual liberty. - H. G. Wells, The Shape of Things to Come - (1936)

Never before have so many Americans gone so deeply into debt so willingly. Housing prices have swollen to the point that we've taken to calling a mortgage -- by far the largest debt most of us will ever incur -- an "investment." Sure, the thinking goes, $100,000 borrowed today will cost more than $200,000 to pay back over the next thirty years, but land, which they are not making any more of, will appreciate even faster. In the odd logic of the real estate bubble, debt has come to equal wealth.

Ed Dodson comments: To clarify this point, what has swollen is not housing prices, per se, but the price of land parcels beneath housing. In response, builders either construct very large housing units (i.e., what are commonly referred to today as "McMansions" or attempt to secure from local governments authority to construct more units per acre to offset the huge up front investment in the location).

And not only wealth but freedom -- an even stranger paradox. After all, debt throughout most of history has been little more than a slight variation on slavery. Debtors were medieval peons or Indians bonded to Spanish plantations or the sharecropping children of slaves in the postbellum South. Few Americans today would volunteer for such an arrangement, and therefore would-be lords and barons have been forced to develop more sophisticated enticements.

The solution they found is brilliant, and although it is complex, it can be reduced to a single word -- rent. Not the rent that apartment dwellers pay the landlord but economic rent, which is the profit one earns simply by owning something. Economic rent can take the form of licensing fees for the radio spectrum, interest on a savings account, dividends from a stock, or the capital gain from selling a home or vacant lot. The distinguishing characteristic of economic rent is that earning it requires no effort whatsoever. Indeed, the regular rent tenants pay landlords becomes economic rent only after subtracting whatever amount the landlord actually spent to keep the place standing.

Ed Dodson comments: While economists, as a group, might define "economic rent" as above, a moral distinction is warranted between "earned" and "unearned" income flows. Passive income flows generated by investment of savings accumulated from incomes derived by producing goods or providing services to others accrues to the owner because of a decision to transfer purchasing power to another party. This income is, therefore, earned, and ought to be excluded from the definition of "economic rent."

Most members of the rentier class are very rich. One might like to join that class. And so our paradox (seemingly) is resolved. With the real estate boom, the great mass of Americans can take on colossal debt today and realize colossal capital gains - and the concomitant rentier life of leisure - tomorrow. If you have the wherewithal to fill out a mortgage application, then you need never work again. What could be more inviting - or, for that matter, more egalitarian?

That's the pitch, anyway. The reality is that, although home ownership may be a wise choice for many people, this particular real estate bubble has been carefully engineered to lure home buyers into circumstances detrimental to their own best interests. The bait is easy money. The trap is a modern equivalent to peonage, a lifetime spent working to pay off debt on an asset of rapidly dwindling value.

Ed Dodson comments: To a degree, the high rate of homeownership in the United States, Australia and some other countries, has moderated the concentration of wealth and income, although those who derive most of all of their income from economic rent have experienced a level of wealth almost beyond comprehension. With all material desires more than satisfied, this rentier class has committed its financial reserves to the full range of investment opportunities. Acquiring real assets, such as buildings of all types and raw land are important parts of this mix, as are shares of stock and bonds. A considerable portion of this fund finds its way to the secondary mortgage market.

The assertion that the current "real estate bubble has been carefully engineered" assigns more power to participating agents than is warranted by a close analysis of the market dynamics at play. While land markets are inherently dysfunctional, and that this dysfunction is caused by the failure to publicly collect location rental values, is not widely understood. Upon this flawed economic foundation, the markets for labor and capital goods and credit operate in a manner that makes difficult the accumulation of wealth for a significant portion of the population in nearly every country.

As it turns out, achieving homeownership has proven over time to be one of the few means of wealth building for those who derive most or all of their income from working for a living. Savings from income for many households is becoming almost impossible for very good reasons: (1) employment and income instability associated with downsizing, outsourcing and movement of goods production to lower cost regions of the world; (2) constantly rising costs of medical care; (3) increasing state and local taxation, particularly property and sales taxes; (4) constantly rising utility and transportation costs; (5) rising insurance premiums; and (6) constantly rising costs of higher education for children. More recently, senior homeowners have been forced to take on second mortgage debt or reverse mortgages in order to meet these and other expenses.

Are some people victimized by the financial services industry's marketing strategies and high cost loan structures? Of course. Despite a concerted effort by banks and non-profit partners to develop financial literacy programs, thousands of mostly elderly and poor households have been victimized by contractors, finance companies and mortgage brokers by predatory lending practices. Regulation and prosecution of these predators has been sporadic and ineffective at closing down these individuals. However, most home purchases are financed by what is called "conventional" financing to households that meet standard credit criteria. The performance of these mortgage loans, even when made to first-time homebuyers able to make minimum down payments, is good. The three main reasons for borrower default are: (a) loss of employment; (b) long-term serious illness; or (c) divorce.

Most everyone involved in the real estate bubble thus far has made at least a few dollars. But that is about to change. The bubble will burst, and when it does, the people who thought they would be living the easy life of a landlord will soon find that what they really signed up for was the hard servitude of debt serfdom.

Ed Dodson comments: There is a real difference between housing and other consumer goods that must be considered. While many people are influenced in their housing choice by the promise of gains (i.e., capitalized economic rent), only a relatively small percentage of such purchasers - absent prolonged unemployment or the other circumstances noted above - will default on the mortgage loan for their primary residence when housing (i.e., land) prices fall, even when the market value of their property falls below the purchase price. Our interest rate environment has been low enough for long enough that most borrowers who have adjustable rate mortgage (ARM) terms are not now experiencing huge jumps in their annual rate of interest. Many ARMs have both annual and life time caps in interest rate adjustments. Some provide at stated periods the option to convert to a fixed rate of interest without the necessity to have their property reappraised. There is some number of households that leveraged themselves higher than was prudent, taking out interest-only mortgage loans with minimal cash contributed - in order to purchase properties with high selling prices. Such individuals have tended to view housing not as shelter but as a short-term investment. When these borrowers default, the greatest part of any loss experienced is absorbed under some risk sharing agreement between the mortgage lender, the investor in the mortgage loan, and any private mortgage insurer that agrees to cover the top (usually 20%) of the mortgage amount. We should have little sympathy for any of the participants in these transactions. Nor should we have any sympathy for those who acquire or finance income-producing real estate without a thorough analysis of current and future cash flows.

1. The new road to serfdom begins with a loan. Since 2003, mortgages have made up more than half of the total bank loans in America-more than $300 billion in 2005 alone. Without that growing demand, banks would have seen almost no net loan growth in recent years.

Ed Dodson comments: It is also the case that consumers generally benefit more by obtaining credit that is specifically collateralized than by unsecured credit, such as credit cards or installment loans. Secured credit for most households is lower in cost and offers tax benefits (because mortgage interest is a deduction under the Federal Income Tax rules).

GRAPH 1: Mortgages account for most of the net growth in debt since 2000 - billions

2. Why is the demand for mortgage debt so high? There are several reasons, but all of them have to do with the fact that banks encourage people to think of mortgage debt in terms of how much they can afford to pay in a given month-how far they can stretch their paychecks-rather than in terms of the total amount of the loan. A given monthly payment can carry radically different amounts of debt, depending on the rate of interest and how long those payments last. The purchasing power of a $1,000 monthly payment, for instance, nearly triples as the debt lingers and the interest rate declines.

Ed Dodson comments: The stalwart players in the financial services industry have not orchestrated the enormous expansion in consumer debt (including mortgage debt); but, they have facilitated it. As land prices have increased across the U.S., the two GSEs (Government Sponsored Enterprises), Fannie Mae and Freddie Mac, have undertaken a continuous re-examination of their eligibility criteria and underwriting guidelines in an effort to keep access open to potential homebuyers faced with higher and higher housing prices. As more performance data on mortgage loans has been gathered and analyzed, they were able to use credit scores as a predictor of borrower performance. Windows of expanded affordability were briefly opened, only to be closed again by rising land prices. Again, the challenge to the GSEs was to find ways to allow households whose incomes were not keeping pace to still acquire housing. The solutions including lower and no down payment terms, adjustable rate mortgages that generally offered lower start rates than would be required for a 30-year fixed rate mortgage. And, every year the GSEs increased their maximum loan amount to accommodate rising land prices. Had the GSEs (and FHA, and the Federal Home Loan Banks) held firm on their underwriting standards and maximum loan amounts, the market would not necessarily have slowed; the jumbo market would have entered more aggressively with higher costing mortgage loans, accelerating the aggregate stresses created by the overheated and dysfunctional land markets.

GRAPH 2: A $1,000 monthly payment can carry different levels of debt

3. As it happens, banks are increasingly unhurried about repayment. Nearly half the people buying their first homes last year were allowed to do so with no money down, and many of them took out so-called interest-only loans, for which payment of the actual debt-amortization-was delayed by several years. A few even took on "negative amortization" loans, which dispense entirely with payments on the principal and require only partial payment of the interest itself. (The extra interest owed is simply added to the total debt, which can grow indefinitely.) The Federal Reserve, meanwhile, has been pushing interest rates down for more than two decades.

Ed Dodson comments: Again, I believe this is best explained as an accommodation to what was happening in the land markets, rather than any strategy to ring out huge short-term profits from homebuyers and homeowners. It is worth observing that mortgage loan originators and brokers are paid only when loans close; and, individually, they have no financial responsibility for loans that default (other than losing investors if their track record gets too bad). Investors do keep lists of people who have been found to be involved in fraud or misrepresentation and will not purchase mortgages if these individuals are involved in the transactions.

GRAPH 3: A $1,000 monthly payment can carry different levels of debt

4. The IRS has helped create demand for debt as well by allowing tax breaks - the well-known home-mortgage deduction, for instance - that can transform a loan into an attractive tax shelter. Indeed, commercial real estate investors hide most of their economic rent in "depreciation" write-offs for their buildings, even as those buildings gain market value. The pretense is that buildings wear out or become obsolete just like any other industrial investment. The reality is that buildings can be depreciated again and again, even as the property's market value increases.

Ed Dodson comments: Real estate appraisers are, as a result of depreciation considerations, to overvalue buildings and undervalue land, which cannot be depreciated.

GRAPH 4: corporations hide their real estate profits behind depreciation

5, Local and state governments have done their share too, by shifting the tax burden from property to labor and consumption, in the form of income and sales taxes. Since 1929, the proportion of tax burden has almost completely reversed itself.

GRAPH 5: the tax burden has shifted from property to labor and consumption

6. In recent years, though, the biggest incentive to home ownership has not been owning a home per se, or even avoiding taxes, but rather the eternal hope of getting ahead. If the price of a $200,000 house shoots up 15 percent in a given year, the owner will realize a $30,000 capital gain. Many such owners are spending tomorrow's capital gain today by taking out home-equity loans. For families whose real wages are stagnant or falling, borrowing against higher property prices seems almost like taking money from a bank account that has earned dividends. In a study last year, Alan Greenspan and James Kennedy found that new home-equity loans added $200 billion to the U.S. economy in 2004 alone.

Ed Dodson here: In a period of high interest rates, such as occurred in the U.S. from around 1981-86, land prices were kept somewhat in check. The nation was in a recessionary downturn as well. Thus, for those households who could afford to purchase a property during that period, they were able to refinance one or more times after 1986. This allowed millions of homeowners to reduce their monthly mortgage payments, or significantly reduce the term of the loan (e.g., from 30 to 15 years). Many were able to use the increased disable income to pay off other types of consumer debt.

GRAPH 6: real estate prices have far outpaced national income

7. It is also worth noting that capital gains-economic rent "earned" without any actual labor or industrial investment-are increasingly untaxed.

Ed Dodson comments: One way to address this problem is to change the structure of the Federal and state individual income tax systems. We might combine progressivity with simplification by creating what I refer to as a "graduated flat tax." Under this structure, all individual incomes up to some amount (e.g., the national median) would be exempt from taxation. Then, above this amount, ranges of income would be subject to increasingly higher rates of taxation. There would be no other deductions for exemptions, and the ranges and rates would be adjusted as required to balance the Federal or state government budgets.

GRAPH 7: capital gains are taxed at a lower rate than ever - top rate

8. All of these factors have combined to lure record numbers of buyers into the real estate market, and home prices are climbing accordingly. The median price of a home has more than doubled in the last decade, from $109,000 in 1995 to a peak of more than $206,000 in 2005. That growth far out-paces the consumer price index, and yet housing affordability-the measure of those month-to-month housing costs-has remained about the same.

Ed Dodson comments: Just to make a point, the price of newly-constructed homes is almost always considerably higher than that of existing housing. The reason for this is that developers will generally not break ground unless they are fairly certain they can sell the finished home for at least four times the cost of land acquisition and development. This also means that new home construction is almost exclusively directed at the high end of every market. Affordable housing is, in these markets, possible only when attached housing is permitted and "inclusionary zoning" requires developers to construct housing units deed restricted to sell at prices affordable to households with incomes no greater than 80-100% of area median.

GRAPH 8: housing prices have far outpaced consumer prices, even as monthly payments remain affordable

9. That sounds like good news. But those rising prices also mean that more people owe more money to banks than at any other time in history. And that's not just in terms of dollars-$11.8 trillion in outstanding mortgages-but also as a proportion of the national economy. This debt is now on track to surpass the size of America's entire gross domestic product by the end of the decade.

Ed Dodson comments: Worse yet, reliance on GDP as a measurement of the health of any nation's economy is unwarranted. Much of what goes into the calculation of GDP is spending on goods and services that reduce the well-being of a nation's population.

GRAPH 9: mortgage debt is rising as a proportion of gdp

10. Even that huge debt might not seem so bad, what with those huge capital gains beckoning from out there in the future. But the boom, alas, cannot last forever. And when the growth ceases, the market will collapse. Understanding why, though, requires a quick detour into economic theory. We often think of "the economy" as no more than a closed loop between producers and consumers. Employers hire workers, the workers create goods and services, the employers pay them, and the workers use that money to buy the goods and services they created.

GRAPH 10: the production/consumption economy

11. As we have seen, though, the government also plays a significant role in the economy. Tax hikes drain cash from the circular flow of payments between producers and consumers, slowing down overheated economies. Deficit spending pumps more income into that flow, helping pull stalled economies out of recession. This is the classical policy model associated with John Maynard Keynes.

Ed Dodson comments: More accurately, I would say, is that what drains cash from the circular flow are taxes on "earned" income flows and material assets.

GRAPH 11: the keynesian economy,/i>

12. A third actor also influences the nation's fortune. Economists call it the FIRE sector, short for finance, insurance, and real estate. These industries are so symbiotic that the Commerce Department reports their earnings as a composite. (Banks require mortgage holders to insure their properties even as the banks reach out to absorb insurance companies. Meanwhile, real estate companies are organizing themselves as stock companies in the form of real estate investment trusts, or REITs - which in turn are underwritten by investment bankers.) The main product of these industries is credit. The FIRE sector pumps credit into the economy even as it withdraws interest and other charges.

Ed Dodson comments: This "FIRE" sector of the economy provides important services that facilitate the production of goods and commerce. Michael's conclusion, as I understand it to be, is that the net impact of the FIRE sector is negative. Obviously, a thorough analysis of the laws that grant corporate charters to such businesses needs to be performed. The objectives of law and regulation by government ought to be to foster both efficient and fair markets.

GRAPH 12: the FIRE economy

13. The FIRE sector has two significant advantages over the production/consumption and government sectors. The first is that interest wealth grows exponentially. That means that as interest compounds over time, the debt doubles and then doubles again. The eighteenth-century philosopher Richard Price identified this miracle of compound interest and observed, somewhat ruefully, that had he been able to go back to the day Jesus was born and save a single penny-at 5 percent interest, compounded annually-he would have earned himself a solid gold sphere 150 million times bigger than Earth.

Ed Dodson comments: The underlying issue, in my view, is whether sufficient competition exists in the FIRE sector to achieve the above objective of efficient and fair markets. A bank or insurance company attempts to set its charges for loans or insurance coverage in order to cover its costs of doing business and an assessment of the risks. For a bank the primary risk is default risk (but also is exposed to interest rate and inflation risks). For an insurance company the primary risk is exposure to a greater number of claims than anticipated (e.g., when a broad disaster occurs affected a large number of insureds). Mortgage lenders require a homeowner to carry fire insurance but are not primary beneficiaries; the purpose of the policy is to assure the collateral will be rebuilt in the event of a fire.

It is also worth stating that the FIRE sector is not the only set of beneficiaries of compound interest. Every individual and every business "invests" financial reserves in interest-bearing funds, if they have sufficient cash after covering basic expenses. A serious societal problem exists in the United States because a large and growing segment of the population cannot or does not have sufficient reserves invested for emergencies or toward retirement.

GRAPH 13: the miracle of compound interest

14. The FIRE sector's other advantage is that interest payments can quickly be recycled into more debt. The more interest paid, the more banks lend. And those new loans in turn can further drive up demand for real estate-thereby allowing homeowners to take out even more loans in anticipation of future capital gains. Some call this perpetual-motion machine a "post-industrial economy," but it might more accurately be called a rentier economy. The dream is that the FIRE sector will expand to embrace the fortune of every American-that we need not work or produce anything, or, for that matter, invest in new technology or infrastructure for the nation. We certainly need not pay taxes. We need only participate in the boom itself. The miracle of compound interest will allow every one of us to be a rentier, feasting on interest, dividends, and capital gains.

Ed Dodson comments: I share Michael's deep concern with the growing concentration of income and wealth into the hands of rentiers. There are a greater number of individuals in possession of large personal fortunes than ever before in history. Yet, as a percentage of the world's population, the concentration is also greater and the distance between those at the top and the bottom is rapidly expanding. The most important observation to make is that the stresses under which the global economy now operates because of rentier privilege will certainly exacerbate the effects of the next (i.e., the coming) economic downturn. Producers are running out of places where they can go to protect profit margins. As Adam Smith observed centuries ago, the healthiest of national economies are those where full employment is matched by high wages.

GRAPH 14: the rentier economy

15. In reality, alas, we can't all be rentiers. Just as, in Voltaire's phrase, the rich require an abundant supply of the poor, so too does the rentier class require an abundant supply of debtors. There is no other way. In fact, the vast majority of Americans have seen their share of the rental pie decrease over the last two decades, even as the real estate pie as a whole has expanded. Everyone got a little richer, but rich people got much, much richer.

Ed Dodson comments: All too true.

GRAPH 15: rich people are getting a bigger share of overall economic rent

16. We will be hard-pressed to maintain even this semi-blissful state. Like any living organism, real economies don't grow exponentially, or even in a straight line. They taper off into an S-curve, the victim of their own successes. When business is good, the demand for labor, raw materials, and credit increases, which leads to large jumps in wages, prices, and interest rates, which in turn act to depress the economy. That is where the miracle of compound interest founders. Although many people did save money at interest two thousand years ago, nobody has yet obtained even a single Earth-volume of gold. The reason is that when a business cycle turns down, debtors cannot pay, and so their debts are wiped out in a wave of bankruptcy along with all the savings invested in these bad loans.

Ed Dodson comments: There is a delicate balance between the "benefits" of inflation to debtors and the "threats" of inflation to employment and income stability. If individual incomes are increasing faster than the real rate of inflation (which, for most individuals, they are not), debts are being repaid with currency that has less purchasing power than when credit was advanced. I do not mean to diminish the seriousness of the forecast alluded to by Michael. Personal and business bankruptcies in the U.S. are at historic highs (although, again, this is a numerical statistic that some economists have downplayed because the actual percentages of the population or the number of businesses operating have not escalated).

GRAPH 16: the miracle of compound interest will inevitably confront the s-curve of reality

17. Japan learned this lesson in the Nineties. As the price of land went up, banks lent more money than people could afford to pay interest on. Eventually, no one could afford to buy any more land, demand fell off, and prices dropped accordingly. But the debt remained in place. People owed billions of yen on homes worth half that-homes they could not sell. Many commercial owners simply went into foreclosure, leaving the banks not only with "non-performing loans" that were in fact dead losses but also with houses no one wanted-or could afford-to buy. And that lack of incoming interest also meant that banks had no more reserves to lend, which furthered the downward spiral. Britain's similarly debt-burdened economy inspired a dry witticism: "Sorry you lost your job. I hope you made a killing on your house."

GRAPH 17: in japan, real estate prices fell as quickly as they rose

18. We have already reached our own peak. As of last fall, even Alan Greenspan had detected "signs of froth" in the housing market. Home prices had "risen to unsustainable levels" in some places, he said, and would have exceeded the reach of many Americans long ago if not for "the dramatic increase in the prevalence of interest-only loans" and "other, more exotic forms of adjustable-rate mortgages" that "enable marginally qualified, highly leveraged borrowers to purchase homes at inflated prices." If the trend continues, homeowners and banks alike "could be exposed to significant losses." Interest rates, meanwhile, have begun to creep up.

GRAPH 18: interest rates are on the rise

19. So: America holds record mortgage debt in a declining housing market. Even that at first might seem okay-we can just weather the storm in our nice new houses. And in fact things will be okay for homeowners who bought long ago and have seen the price of their homes double and then double again. But for more recent homebuyers, who bought at the top and who now face decades of payments on houses that soon will be worth less than they paid for them, serious trouble is brewing. And they are not an insignificant bunch.

Ed Dodson comments: The demographic shifts in the U.S. add a further problem. The largest segment of homeowners are now those approaching retirement age. When retired, most will experience a considerable drop in annual income. Even though their mortgage debt may be fully repaid or now quite low, other costs of owning a home (particularly property taxes and utilities) continue to rise. The desire or need to downsize will create more competition for housing that has historically been available for other segments of the population. On the positive side, if the supply of larger, existing homes available for resale increases, this should bring down home prices without creating widespread defaults and foreclosures. This is a market segment that most easily can absorb the fall in housing (i.e., land) prices.

GRAPH 19: the annual sale of existing homes has more than doubled since 1989 - millions of homes

20. The problem for recent homebuyers is not just that prices are falling; it's that prices are falling even as the buyers' total mortgage remains the same or even increases. Eventually the price of the house will fall below what homeowners owe, a state that economists call negative equity. Homeowners with negative equity are trapped. They can't sell-the declining market price won't cover what they owe the bank-but they still have to make those (often growing) monthly payments. Their only "choice" is to cut back spending in other areas or lose the house-and everything they paid for it-in foreclosure.

Ed Dodson comments: The weakest part of the market, in my view, is for second homes, many of which over the last decade have been purchased purely for speculative gain, ignoring current and potential cash flows generated from leasing the properties. A recent survey of second-home owners reveals that six out of ten owners hold two or more properties in addition to their primary residence. Second home prices in the most overheated markets have fallen back to around 2004 price levels; however, the overall market continues to experience an increase in the median price paid (up 7.4% in 2006). Just how many people got into housing at so-called "teaser" rates now increasing to annual rates they cannot carry is yet to be made clear. Homeowners with negative equity only rarely execute a deed in lieu of foreclosure in order to protect their credit rating; if they cannot make payments, they try to negotiate a debt restructuring with their lender; if that fails, they most often wait for foreclosure to occur and the eviction notice to be enforced.

GRAPH 20: negative equity traps debtors

Free markets are based on choice. But more and more homeowners are discovering that what they got for their money is fewer and fewer choices. A real estate boom that began with the promise of "economic freedom" almost certainly will end with a growing number of workers locked in to a lifetime of debt service that absorbs every spare penny. Indeed, a study by The Conference Board found that the proportion of households with any discretionary income whatsoever had already declined between 1997 and 2002, from 53 percent to 52 percent. Rising interest rates, rising fuel costs, and declining wages will only tighten the squeeze on debtors.

But homeowners are not the only ones who will pay. The overall economy likely will shrink as well. That $200 billion that flowed into the "real" economy in 2004 is already spent, with no future capital gains in the works to fuel more such easy money. Rising debt-service payments will further divert income from new consumer spending. Taken together, these factors will further shrink the "real" economy, drive down those already declining real wages, and push our debt-ridden economy into Japan-style stagnation or worse. Then only the debt itself will remain, a bitter monument to our love of easy freedom.