A recent comment by Scott Sumner caught my eye:
Reading Russ’s paper makes me realize just how much our system is biased toward debt. And by the way, it isn’t just moral hazard; our tax system is also biased toward debt and against equity. People talk about Americans borrowing too much, but given all these distortions it’s surprising that we don’t have even more debt. Why didn’t I take out some mortgages and buy Florida condos? I’d like to think it was civic virtue, but I suppose it was just laziness.
This brought me back to a long-forgotten economics blogosphere argument from three years ago, before the ‘bubble burst’:
On December 8, 2007, Patri Friedman (grandson of Milton, son of David) responded to an Arnold Kling post on leverage stating:
Why do people assume that high LTV and low payments mean buyers are leveraged? I have a high LTV, and an interest-only loan, and I pay the minimum, because I would rather have my money in the stock market. If I ever had equity in a home, I would tap it and buy index funds. So anyone who assumes that my low equity and payments mean I am overspending is wrong.
To my mind, anyone with equity in their house is crazy. They are the ones being financially imprudent. Why wouldn’t you get a loan at 6%, with tax benefits that make it effectively 4%, and put it in the stock market and earn 10%-12%?
Some guy nobody has ever heard of agreed with Friedman and added:
I have to give the points to Patri on this one, for two reasons:
Reason 1: “My guess is that paying high mortgage rates in order to own stock is relatively inefficient.” Unless the after-tax interest payments as a percentage reach the same level as the after-tax payoff from index funds, how is this less efficient than making larger mortgage payments?
Reason 2: I think this: “you will have less wealth than if you took out a lower-cost mortgage and got your high-leverage stock portfolio by using derivatives” is a bit of a false dichotomy. Why not do both?
Kling very well might be right – but without posting any numbers, I can’t see how.
Note that Friedman’s argument does not work as well in a country such as Canada, where mortgage interest is not tax deductible.
To which Kling responded:
But the point is important that the typical investor should act as if the efficient markets hypothesis is true. One of the most widespread biases in finance is hubris. I could not believe it when [some other guy] sided with Patri Friedman’s argument to use mortgage leverage to buy stocks. In an efficient market, that is just plain incorrect.
Like practically everyone else not named Nouriel Roubini, I didn’t see the real-estate bubble bursting when it did. I probably should have, given that I believed it was absolutely insane for anyone in the U.S. in the post-mid 90s pay off their mortgage, given what massive advantages there were to holding debt rather than repaying it.
I wonder how much Canada’s smaller-than-most recession was due to the fact that, unlike the U.S., most Canadian provinces lacked mortage interest deductability.
Given that there haven’t been significant regulatory changes in the U.S. in this area, one wonders if the U.S. is doomed to repeat itself once monetary policy finally loosens.
Worthwhile Canadian Initiative 
There is a book circulating called “The Smith Manoeuvre” which in essence counsels making an equity withdrawal and investing in the market. Loans used for investment are tax deducible in Canada*.
Leverage magnifies both the upside and downside of any investment (per Leverage 1A03) and I could never bring myself to embrace such a tactic.
I am concerned about what happened to clients who did implement this book’s advice because the book was popular in retail financial advisor circles here in Canada.
*This method is a bit complicated and therefore I make no warranty on the CRA’s final view of the deductibility of loans following Smith’s advice.
I hadn’t heard of that book before – I’ll have to check it out. Thanks for the tip!
I’m not doing anything that exotic. My mortgage is on a variable rate line of credit which is currently under 3% interest. Given that I haven’t maxed out either my and my wife’s TFSA or our RRSP room, putting money in those seems like a much more sensible play than paying off a loan that is costing me next-to-nothing. I have to think that a lot of others have come to the same conclusion I have, even though I have to admit I do feel a little uneasy not paying off debt when I have the chance. Given that feeling of unease, perhaps behavioural economics explains why not everyone is using such a strategy, even though on paper it seems rational.
by the way, mortgage loans on investment properties in the US are not tax deductable — except that the interest can be taken as a business cost. (that’s true of all businesses, not just real estate.) so i just don’t see how the home interest deduction affected speculators that much.
I wondered if bankruptcy exemptions for principal residence could also provide a reason to keep equity in your home, but the answer is largely no for Canada (http://www.bankruptcy-canada.ca/what-i-keep-or-lose-in-bankruptcy-in-canada/bankruptcy-exemptions-in-canada.htm).
“Like practically everyone else not named Nouriel Roubini, I didn’t see the real-estate bubble bursting when it did. I probably should have, …”
You should try some other web sites although I’m not sure everyone got their timing exactly right.
From:
Click to access MPRA_paper_15892.pdf
titled: “\No One Saw This Coming”:
Understanding Financial Crisis Through
Accounting Models
Michael Hudson, US
Eric Janszen, US , itulip.com
Stephen Keen, Australia , debtdeflation.com
Dean Baker, US
Peter Schiff , US
Robert Shiller , US
There are others on the list, and I think it was been expanded.
I would include Mish , US
I’d be careful with Dean Baker (liberal , gov’t debt) and Schiff and Mish (austrian , basically no debt)
“I wonder how much Canada’s smaller-than-most recession was due to the fact that, unlike the U.S., most Canadian provinces lacked mortage interest deductability.”
Using national income accounting like from Bill Mitchell, I’m going to go with the trade deficit was not big enough, specifically the one with china.
“I have to think that a lot of others have come to the same conclusion I have, even though I have to admit I do feel a little uneasy not paying off debt when I have the chance.”
What assumptions are you making about your future real hourly wage and future hours working?
“Given that there haven’t been significant regulatory changes in the U.S. in this area, one wonders if the U.S. is doomed to repeat itself once monetary policy finally loosens.”
Is there more than taxes involved in an asset bubble?
Isn’t it almost impossible for the last asset bubble to be the next asset bubble?