Housing Deflation, Current Inflation, and Politics

OK, the rhetoric in public is that the bailout plan is designed to get money circulating again to "stimulate" the economy; the theory that the Keynesians are advancing is that this will pull us out of the recession. On the other hand, the Austrian school and the Chicago school are predicting inflation, even hyper-inflation from the bailout. Since the dry-up of the credit markets is the result of a housing bubble, it should be interesting examine what needs to happen in order for the bailout to loosen up credit again.

Looking at median housing prices over the last 35 years corrected for inflation (red line on chart), we can see that prices were relatively flat in terms of real value from 1975 until about 1997, when prices started to climb dramatically. This is even more interesting when we consider that the Bureau of Labor Statistics changed the way the Consumer Price Index is calculated around 1980 so that it reports inflation about 3% lower than it did before. If inflation was actually 3% more than the chart corrects for, the run-up in prices is even more dramatic.

Looking at the chart, it appears that the "real" cost of a median house went from about $140,000 to about $265,000; almost doubling. This is the "bubble" that burst. If I'm a bank looking at this chart, I'm going to predict that prices will need to fall back to the 1997 levels before I can make a loan secured by a home. Otherwise I'm risking having the value fall and the borrower ending up in a negative equity situation; an open invitation to default. Banks don't do that. Banks that have done it by mistake end up failing. This is what happened in 1930. The values of farm land in the midwest started to fall and wiped out hundreds of small farmers and a large number of banks.

But what happens if we dump a lot of currency in to the money supply? Well, history tells us that this always causes inflation. Amounts as large as the bailout and Obama budget could easily cause hyper-inflation. Will this cause the economy to stop contracting? Maybe. But what it will do is cause the value of the dollar to shrink. So if that median house falls from $265,000 to $140,000 in real dollars, but the dollar is devalued by inflation by 50%, then the current (inflated) value of the house will be $280,000.

So, is it the plan in Washington and among the G20 to fix the current crisis by creating a monsterous inflation rate? I hope not. It will certainly change the political landscape if they do.