Wednesday, December 29, 2010

Inflation is Not "Recovery"

"Housing Recovery Stalls."  I love headlines like this, because in a few simple words are embedded virtualy every economic fallacy of the last hundred years or so.  (It also ties into my recent series of posts on the Federal Reserve.)  According to this article: "A new bout of declining home prices is threatening to hamper the U.S. recovery, just as consumers and the overall economy have been showing signs of healing."


What if the headline read "Food Recovery Stalls" or "Microwave Oven Recovery Stalls" and the article bemoaned the fact that food prices or microwave oven prices had decreased?  When prices go down, doesn't that make us richer?  Isn't that a cause for celebration since we can buy more food, ovens, and houses with the same amount of work? I'll repeat what I wrote in a previous post, "Houses are Not Investments":    


As Dr. Reisman has pointed out in Capitalism and in his recent post, houses should not be regarded as investments. (I'm referring to houses purchased to live in, not to rent to others.) Houses are depreciating consumer goods although the rate of depreciation is slower than many consumer goods. So why do people regard houses as investments and often see equity in their home as a primary savings vehicle? Quoting Dr. Reisman:
Only decades of inflation and credit expansion could make it possible for people to think of the houses they occupy as an investment. In reality, a house is a consumers’ good, just like an automobile or a refrigerator. The only difference is that it depreciates more slowly than they do. Only a long string of years in which inflation took place more rapidly than houses depreciated enabled their prices to rise every year and people to come to regard them as a source of financial gain. If not for inflation and the rise in prices that it produces, it would be very clear that housing is a wasting asset, a slowly wasting asset to be sure, but a wasting asset nonetheless.
In fact, housing price declines should be seen as the recovery.  Housing price declines reflect liquidations of a massive misallocation of capital that took place during the preceeding boom, viz., investment in the expansion of housing.  Only when this misallocated capital gets liquidated, can a true recovery take place.  To the extent the government props up housing prices through inflation of the money supply, subsidies to homeowners and the like, actual recovery will be delayed and we will once again divert critical capital to a superinflated supply of housing that no one actually needs or desires.   

2 comments:

madmax said...

Doug,

What is your opinion on the increasing number of doomsday scenarios out there right now? It seems that pretty much anyone familiar with Austrian economics is predicting hyper-inflation. Commodities are increasing and housing prices are falling. And, of course, the Demoncrats are "stimulating" and regulating everything in sight.

Is the end in sight? I must say that I feel more negative on the future than at any point that I have been alive.

Doug Reich said...

Madmax,

Part of the reason I'm doing this series on the Fed is to directly address these questions. I'm trying to build up to this so that readers not as familiar with economics can understand what is causing these problems and understand how vital the monetary system is not only to daily life but to the existence of civilzation itself.

We are on a path towards doomsday. Given the nature of our current monetary system, fiat currency and fractional reserve banking, the natural path after a boom is a bust, where cash is raised, misallocations of capital are liquidated (such as housing), and prices for goods and wages go down. Given the views of the current Fed regime, it appears they will do anything to stop that process from occuring, i.e., they will inflate the money supply to no end in order to stave off what they see as the real problem - "deflation."

What these Austrians fear is that Bernanke's fear of deflation will lead him to expand the Fed's balance sheet even further (create money). Already, he has created an inflationary powder keg, but an offsetting force has temporarily slowed down the effects of that money creation. The offsetting force is the natural path I just mentioned. That is, banks were not lending as much, consumers were paying down debt, businesses were going bankrupt, etc. In a fractional reserve system, this behavior actually destroys money. In other words, the private sector is deleveraging while the Fed is saying no, no, no, you must relever...

In this kind of a battle, the Fed can always win because it can print as much money as it wants.

The other issue adding to the fear that the Fed will continue to create money is the outstanding federal deficit and the upcoming spending plans which will require even more deficit spending. When a country gets to the point, where the interest on the debt is a significant percentage of the deficit, it is game over. It is like an individual who keeps taking out credit cards to pay off past credit cards. At some point, it has to end. The fear is that the Fed will "monetize" this debt, i.e., it will create money lifrom nothing to buy the debt to prevent interest rates from skyrocketing.

The anti-business policies only exacerbate the problem as the economy can't recover.

This whole process has played out many many times throughout history and it always leads to disaster. Like any addict, the politician will never stop until it is too late. This is a highly non-linear process and can happen quickly.

I think best hope is that this disaster leads to a new monetary system, perhaps, the spontaneous reemergence of gold as a currency as people turn away from the fiat currency. At least it is helping expose something that has gone on and on.

You have reason to worry.