Abstract Debt, equity and income: limits to the freedom of choice in an economy. Three concepts have been introduced in this paper, which help explain the economic developments in the U.S. and the U.K. over the last sixteen years; they are the “income gap”, the “equity gap” and the “productive assets versus non-productive assets”. The first concept is: “The income gap”. This gap can be defined as a shortfall in purchasing power to buy all goods and services which could have been produced if all available manpower would have been fully utilised. The second concept is: “The equity gap”. This gap can be defined as the loss in equity value and the loss in income out of equity for all individual households combined. The third concept is: “Productive assets versus non-productive assets”. Productive assets owned by individual households are savings which are used to create an income. All lending and other forms of savings’ transfers to the business sector create an income for the individual households, either through jobs or through profit levels. Mortgage debt incurred by individual households creates an income for others if it is used for expanding the volume of home building or for home improvements, but not if such debt is used to fund house prices to rise. The latter use of savings create non-productive assets, they do not create an income for other households. The same applies to government debt as the debt servicing costs have to come out of individual households’ incomes to pay other individual households: a zero-sum income game. In the U.S. over the period 2000-2006 average household incomes increased by 14.75% and mortgage debt by 105.1%. In the U.K. average annual earnings went up by 27.9% and household debt by more than 100% over the same period. In both countries house prices increased steeply leading to a rapid increase in non-productive assets and of course also to substantial mortgage default levels as income growth did not keep pace with the growth in mortgage debt. In 2008 the collapse occurred and in that year U.S. individual households lost $12.6 trillion in equity values and another $3.3 trillion in income lost over the equity invested: in total $15.9 trillion or 111.2% of GDP value in 2008. In the U.K. the loss was 90.3% of GDP. After 2008 both U.S. and U.K. individual households started to save more and reduce their borrowing levels. They were also confronted by income growth below inflation levels, increased unemployment which led to a slower combined income growth, lower labour force participation rates again leading to slower income growth and increased tax levels and higher government debt levels; the latter producing more non-productive assets. Also house prices dropped as did new housing starts. In this paper a series of possible measures have been spelled out which could redress the loss in purchasing power, reduce the chance of excessive mortgage lending reappearing, reduce the risks on interest only and variable rate mortgages, change the way in which banks foresee their risks patterns and finally keep a better balance between productive and non-productive assets in an economy. Individually individual households have very few economic options; collectively they can address all current economic problems and turn events to their benefit.
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