Dialogue on Housing Deflation - from ArizonaRealEstateNotebook.com

Cbass // Apr 27, 2008 at 7:12 pm

Brian,

So you mean to tell me that prices for goods and services can not increase while our economy stops growing or goes into a recession just becuase there is supply?

en.wikipedia.org/wiki/Stagflation

“Demand-pull stagflation theory explores the idea that stagflation can result exclusively from monetary shocks without any concurrent supply shocks or negative shifts in economic output potential. Demand-pull theory describes a scenario where stagflation can occur following a period of monetary policy implementations that cause inflation. This theory was first proposed in 1999 by Eduardo Loyo of Havard University’s John F. Kennedy School of Government.”

Just an example of some smart dude who agrees my thoughts are possible.

Brian McMorris // Apr 28, 2008 at 9:19 pm

CBass, I don’t think you and I are very far apart on this. I concede the idea of some level of stagflation at a time like this. Today we have “demand shocks” rather than supply shocks. That demand comes from the BRIC nations and is outside our Fed’s control.

I don’t know that residency at Harvard makes this guy smarter than you or me. But yes, anything is possible. But there is no real proof, yet, for this theory that was postulated in 1999 (stagflation that results from loose monetary policy).

The most often cited example of Stagflation came in the 1970s and was the result of supply shocks (in oil and base metals). The supply constraints, accompanied by rapid demand increases in Asia (as Japan and Korea underwent a huge expansion) did result in inflation. But monetary policy probably had little to do with it. A wage inflation spiral was a reaction to the “materials” inflation, but that was in a time of powerful unions that no longer exist. It took Volcker’s interest rate shock therapy in 1980 to break the cycle of wage increases gained by striking unions ending the phenomenon known as “inflationary expectations”.

The “stag” term suggests flattish growth that is behind the rate of inflation. If inflation is at 5% and nominal growth is at 4%, that is stagflation, and not really so bad. It is just important to be invested in hard assets during such a period so that investment earnings beat inflation.

But this scenario is a lot different than the Depression that many are predicting, which requires a Deflation. I say we already have a housing depression (deflation), as compared to the 30s for example. But the other elements of the 30s Great Depression, are not in place and very likely won’t be if the Fed keeps the economy from panicking by pouring on liquidity.

packerbacker // Apr 29, 2008 at 5:52 am

Brian-

I think you are smart. I like what you say, but someone should slap you for this. You say, “we are already in a housing depression-as compared to the 1930’s” A quick google would show you that during the Great Depression, around 25% of people were forclosed on, unemployement was over 20% and household income dropped 40%.

Brian McMorris // Apr 29, 2008 at 6:20 pm

Thank you for the compliment and comments. But see that I limited my statement to “housing depression” which I borrowed from Dr. Shiller himself. He is the greatest authority maybe in the world, on the history of housing pricing, and has lots of historic data to back up his comparisons. So I am comfortable with that statement.

Average national price is down about 15% from its peak now, and more or less in freefall. He concludes, and I have no reason to differ, that it could easily drop another 15% before it bottoms. That will be as big a drop as the 30s. I am not sure the source where 25% of homes were foreclosed in the 30s. I have not seen numbers that high. I don’t necessarily believe everything I read when I google.

As for unemployment and household income dropping, this time is different. I am not saying we are in another Great Depression, just the contrary.

What makes this time different, is we have the lesson of the 30s to teach us how to respond to the housing depression, so problems will not be magnified. We will probably not have 40% foreclosure, because this time, the banks started acting early to deal with their bad loans. The Fed also got into the act early because of Bernanke’s expertise on dealing with conditions that lead to broader economic depressions, including acting aggressively to cut interest rates and simultaneously supply liquidity (in numerous ways) to keep the banking system from imploding.

It did implode in the 30s and that is why foreclosures went so high, the banks could not afford to negotiate with the home owner, do short sales, or hold bad mortgage portfolios. The banks then were S&Ls with no where to go for help (there was a Fed, but it wasn’t ready for the problems it faced).

If you find economics interesting (you can probably tell that I do), I will share with you a very credible source on Depression era statistics, causes and effects: Mr. Ben Bernanke. Here is a speech of his from 2004 (so not colored by the current situation):

http://www.federalreserve.gov/boarddocs/speeches/2004/200403022/default.htm

In it Bernanke quoted a study by economist Milton Friedman, published in 1963, that proves that monetary contraction was the proximate cause of the Great Depression. There are many examples given as evidence, but I will let you read it there rather than fill this space with quotes. This is why we see Bernanke’s Fed has been so dramatically increasing liquidity, much to the consternation of CBass and others. But Bernanke and others are on record saying it is much easier to fight easy-money induced inflation, than contraction-induced deflation. The housing crisis on its own contracts money supply (basically evaporating paper money in the form of mortgage liabilities). Bernanke’s Fed has responded by expanding it in other places, probably for a net zero effect. But we won’t know for a few years.

So, I stand by my earlier positions defending monetary expansion, but appreciate the opportunity to explain why.