MATHS 3 - Defining AEG / GDP

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HOW SHOULD THE SELECTED INDEX BE DEFINED?

At first thought one would just use whatever national statistics that are available and that is what has been done when back-testing the ILS model on past data.

In practice there are conflicting interests at work. And we live in a world of free choice out of preference, wherever possible.

This means that the lenders may be free to define their own index or they may decide to agree to a standard index which could be created by a committee of experts including statisticians.

On the one had there is the point of view of the investors. They want their wealth to grow as fast as possible but they are also reasonable people and will accept an average rate of growth of incomes for their own group as a way of preserving that wealth.

LATER - delete this: "Remember, we are defining wealth as the preservation of the share of GDP that has been earned or given to a person as wealth."

I was trying to simplify the concept and implicitly assumed that aggregate income is GDP. The illustrations in Chapter 4 of the draft book show that a more useful measure of wealth for many purposes might be National Average Earnings / Incomes, NAE. (I am not sure of the difference between earnings and incomes except perhaps earnings would include profits as a form of income to an entity rather than to a person. The aim is to define something that is not destroyed (wealth) by virtue of a debt contract, but which is passed from one party to the other by virtue of the true interest paid; that is, net of inflation of aggregate income / earnings). This is how I tried to do that:

If we look at some illustrations we soon find that if a lender is lending at the same rate as AEG% p.a. and if that AEG is representative of the group to which the lender belongs, then lending 'n' years' income will result in 'n' years' income being repaid.

But if the interest rate is lower then it may come about that 'n-1' years' income gets repaid. This means that the borrower spends 'n' years' income and then repays 'n-1' years' income and can then spend 1 years' income in addition to the 'n' years' income already spent.

What this is telling us is that when we come to measuring wealth and preserving wealth we are not trying to keep pace with prices, but with incomes. So the rate of return will include the real rate of economic growth, at least in broad terms.

To be able to lend and get that rate of return, tax free (hopefully) is an undistorted way of lending and preserving wealth at no wealth cost to the borrower.

From the borrower's viewpoint it may be different. As a young person income is low and with experience and promotion income rises faster than the index. So borrowing and repaying wealth will be cheap. 

Later, income may be rising less quickly than average so borrowing and repaying wealth will be more costly. Luckily, by then most of the mortgage may have been repaid and later on the person may become a lender as they buy into wealth bonds or savings accounts.

But there is another issue to consider:

There are significant statistics which show that in America there are two separate economies and two separate groups. The median income has barely risen in decades, but the top earners are doing exceedingly well.

What to do?

Lenders can create an index for each group, maybe. They may also consider sampling their own borrower's incomes and coming up with another index, not necessarily for use, but to feed to an independent party assigned to the task of providing an index which reconciles the interests of both lenders / investors / savers and borrowers.

Social pressures and simple pragmatism may tell lenders to have two indices - one for the wealthy and one for the median population.

As an investor in the top 1% they may want to lend and get a return based upon the index which links to their group. Then the economists will say that few people would borrow at that rate and those who are in that income group will find ways to borrow at the lower rate linked to the median group.

Economists may also say that the two indices cannot go separate ways for ever.

Then there is the question of defining the GDP index. I was told by one economist that he stopped reading the moment he read of such an index link. His objection was that the data is distorted and manipulated.

Well that means that an index of aggregate incomes needs to be created. Who would use the index? Governments might. They may want the index to move in a way that was at least correlated with gross tax revenues. After all they are the largest borrowers in most economies. So they will want the wealth that they borrow to be measured in a GDP index which reflects their revenues.

Since I am writing for all nations and all economies I do not propose to give specific answers to all of these questions.

We will just have to see what develops. 

What we do know is that there has to be an index-link and there has to be a measure of true interest I% and a measure of D% p.a. in order to create a safe and economically sound debt structure.

What is economically sound? A debt structure for housing finance which keeps house prices and borrowing costs somewhat in line with aggregate demand = aggregate incomes over the medium to long term.

Risk management dictates that lenders must keep D% under control and to achieve that then the safe entry cost P% has to be relatively stable.

If P% is relatively stable then there will be a correlation between what can be borrowed and the aggregate level of incomes / spending / demand in the economy.

The economy will no longer generate bubbles and crashes and horrendous arrears and spiralling down recessions. At least not from this source.