Price Levels

Everyone’s attention seems to be focused on whether we’ll see deflation or inflation in the US economy (and in the global economy) as we move forward.

On the deflation side, we have the moribund housing market, falling or stagnant consumer spending, along with falling incomes and rising unemployment, and on the inflation side we have truly massive money creation led by the Fed, followed by the Treasury, and finally by the Federal government in the form of federal stimulus packages, all on borrowed money.

Which of these two forces will prove to be more powerful?

I live in San Francisco, one of the more expensive urban centers in the country. In my neighborhood, I see flyers posted that say “One Hour Massage, $40”. It caught my attention because I think that price is half to a third the price you would have paid two years ago. Basic economics: if goods and services won’t sell at a given price, then the price will fall.

The bond market may provide us with a clue, as bond investors are highly concerned about inflation. The yield on the bellwether 10-yr US Treasury bond has been dropping rapidly. Since mid August, the yield has fallen from 3.8% to close below 3.2%. This may mean that bond investors are taking a stand on deflation, but it may also mean that investors see the rally in the stock market ending soon, and they’re getting back into Treasuries for a safe haven. The surge in gold prices to close above $1,000 for six days seems to lend support to the safe haven thesis, but it also could support the inflation thesis.

Oil and copper are also important signals to the strength of the global economy. Both seem indecisive after strong gains this year. The same can be said for the CRB commodities index, which is up 25% from its low this year, recorded back in March.

Given all this indecision, we may see a bifurcation, with certain commodities and services rising while others fall. We await, with bated breath, the next round of economic developments. The latest labor market data indicate that the US economy shed 263,000 jobs last month, for a total of about 7.2 million jobs lost so far during this recession. That is a truly stunning number, made all the more serious when one considers that the economy must create 150,000 jobs or so each month in order to simply keep pace with population growth.

What Caused the Housing Crash?

“Problems started at the household level, with poorly-designed mortgage products”, claims Elizabeth Warren, professor of law and member of the newly-formed Financial Products Safety Commission. According to this view, the US housing bubble, where prices of homes increased 125% from 2000 to 2006, was the result of shoddy products sold to an unsuspecting public. Like the general claim of ‘predatory lending’ such a view assumes that people need a government agency to protect them from making bad decisions.
The fall in home prices, which began in 2006 and continues, has so far wiped out perhaps $10 trillion in value. If only there had been some government agency providing oversight, all of this may have been averted, Warren suggests. But there was. It’s called the Federal Reserve. But the Fed did nothing to avert the housing bubble—in fact, former Fed Chair Alan Greenspan made public statements urging people to buy homes with adjustable rate mortgages. What a spectacle: the nation’s foremost economist urging people to commit financial hari-kari.
Sure, there were ‘toxic mortgages’, to use a recently-coined term which seems to have caught on. Mortgage brokers aggressively sold them to people. People were encouraged to lie about their income and assets and they did so eagerly, to get their piece of the American dream: their own home. Fraud and deception proliferate in an atmosphere of denial. Home prices will always go up; you’ll be able to re-finance later at low rates, an army of mortgage brokers said.
But to say the current crisis is the result of bad mortgages is to employ a circular logic. Why did these mortgage products spread and gain dominance? Why did they displace the traditional banker’s strategy of lending conservatively to qualified borrowers? The reason is that the creation of toxic mortgages is the result of the same force that produced the rapid growth in hedge funds, credit-default swaps and other financial derivatives, and massive increases in trading volumes: money creation. Money created out of thin air always creates inflation. But when the price being inflated is a home, it seems to cause a special kind of madness that does not result from the inflation of other prices, like food, gasoline, or medical care.
Money creation is itself the product of two forces: the fractional reserve banking system, and the desire of the government to run large, continuing deficits, which are partly financed by slowly depreciating the currency through inflation. The change in bank policy which made toxic mortgages possible was a relatively new practice of moving money into new categories (such as repos, Eurodollars, collateralized debt obligations, and others) which allowed banks to circumvent the Fed’s required reserve ratio (which ranges from 10% for larger banks to 3% for smaller ones). As the result of this shell game, the actual reserve ratio in US banks fell to an incredible 0.74% at its trough—that’s $0.74 for each $100 deposited (this ratio has since risen, as banks are now in panic mode).
The Fed, which, after all keeps the statistics on bank deposits and lending, certainly must have known, but opted to look the other way. The rewards to financial ‘innovation’ of this kind were great, and the riskier banks bought those who employed more traditional strategies. Mortgage lending became so profitable that banks specialized in it, eschewing deposits altogether, instead obtaining funding by selling the mortgages as securities and making more loans, always more loans.
Given that the housing bubble was caused by money creation, it would be simply silly to think that some commission assigned to prevent bad mortgage products will have an impact. The solution to future asset bubbles is clear: abolish fractional reserve banking.