Economics 15/01/2010: Negative equity & entrepreneurship

There is an interesting piece of research relating to the issue of negative equity that sheds some light on potentially disastrous effects on the economy from our current crisis in house prices.

First, a quick synopsis of the paper (available here):

“In the absence of any correlation between wealth and entrepreneurial talent, initial net wealth should have an explanatory power in the decision to become an entrepreneur only for households that are financially constrained; its importance should decrease with wealth.”

In other words, if you believe that higher starting wealth does not make for a better entrepreneur further, then only households that have no capacity to borrow – no assets to borrow against – or that have insufficient income to take on the risk of becoming an entrepreneur should be constrained in their pursuit of entrepreneurship by wealth considerations. This means that as household wealth increases, the constraint of wealth on ability to take up entrepreneurship falls.

The paper tests this theoretical predictions for the Italy, showing that: “…household's initial wealth is indeed important in the decision to become an entrepreneur and its effect is lower for the richest households.” (Point 1)

“Furthermore, the effect of net wealth is stronger when legal enforcement of the loan contract is weaker...” Which, of course means that as the regulators, government, or lenders fail to enforce lending contracts, such lax enforcement increases the role that initial wealth plays in constraining entrepreneurship, making it harder for assets-poorer households to pursue business opportunities. (Point 2)

“Finally, conditional on becoming entrepreneurs, initial household wealth does not significantly affect the size of the business.” So that once a person becomes entrepreneur, the levels of their initial asset holdings do not act to determine the rate of their success in business. (Point 3)

“In summary, it seems that imperfections in capital markets can induce people to accumulate assets in order to facilitate the decision to become entrepreneurs.”

And so now, to interpreting these results for Ireland.

Majority of our households rely on house equity to act as their main life-cycle asset. As house equity is being destroyed by the negative equity, two things happen to household financial position:

1. Net wealth declines directly with increase in negative equity; and
2. Net future wealth declines directly with the gap between rental value of the property and the mortgage cost (in effect, people in negative equity are paying more for their property than it is worth, thus reducing disposable income available for other savings and investments.
   

So on the net, the twin effects of negative equity in Ireland have so far (during this crisis) meant that as property prices declined by ca 40-50% already, while rents have fallen over 15%, Irish households worst affected by the negative equity (home buyers in 2006-2007) have seen combined effect of falling wealth to the tune of 49-58%.

That is a serious chunk of wealth being destroyed, implying some adverse effects on future entrepreneurship rates. Since the rates of success in entrepreneurship do not suffer from initial wealth effects, we can assume that entrepreneurs lost due to negative equity are of average type. Which means some serious losses to the economy over the years to come.

But wait, there is more: Point 1 clearly suggests that the adverse impact of negative equity will be felt more by those would be entrepreneurs who come from lower wealth-holding groups of Irish population. No, not exactly the poor (although them as well), but from:

• Traditionally assets-poor younger households – so Ireland is now foregoing higher future rates of entrepreneurship from younger generations (also, incidentally, most adversely impacted by rising unemployment);
• Traditionally mortgages-heavy families – so Ireland is now potentially cutting into its business potential when it comes to families, thus adversely impacting future population growth rates as well;
• Lower middle class would-be-entrepreneurs – so that Irish society is now running a greater risk of reducing social class mobility, as entrepreneurship is often the only ticket out of lower middle class;
• And yes – the poor would-be-entrepreneurs: people who like many of our best business leaders today came from the poorer family backgrounds.
  

Points 2 & 3 go straight to NAMA. As NAMA in effect simply means a bailout clause for bankers, it undermines enforceability of lending contracts – for bankers directly, for developers indirectly via NAMA holiday clauses, and for households also indirectly via political manipulation of lending going on behind the scenes. Which means that overall, Ireland is moving, thanks to NAMA, toward a society where entrepreneurship will be even more polarized into the domain of the better-off. Yet another obstruction on that social mobility ladder that business ownership entails.

So here you go, to all those (like some of our economics commentators) who say that negative equity only matters when people want to move, I’d say – read real evidence, folks.