The Spectre of Deflation

U.S. house prices rose 13% in the year to Q3, including an astonishing 42% leap in Nevada, 27% in California and 23% inWashington DC. Prices have risen a long way on the coasts over the last 7 years with gains of 134% in California, 103% in Massachusettsand 92% in New Jersey and 89% in New York. Inland regions havegenerally been more stable so the nationwide average gains since 1997is a more moderate 65%. Nevertheless, with house price inflationaccelerating, it looks as though the United States is in the early-to-middle stages of a bubble. In the U.K. and Australia more advanced bubbles are key factors in economic performance and monetarypolicy. The United States is likely to go the same way.

One of the causes of the bubble is that people seem to have forgottenthat house prices can fall as well as rise. And the risks of a significant fall are more acute now than for over 50 years because ofthe low rate of inflation in consumer prices and the threat of deflation. Between the 1950s and the mid 1990s falling consumerprices, deflation, was virtually unknown anywhere. The world’s attention was focused entirely on battling rising prices, inflation, which had become the number one economic problem. But by the late 1990s the battle against inflation was won and deflation had emerged in several countries in Asia including Japan.

Housing Bust: Deflation

Deflation is a new and troubling threat for all of us, brought up in an era of continuous inflation. Almost nobody alive today, even the venerable Mr. Greenspan, was an active market participant or policy-maker in the 1930s, the last time the United States suffered deflation. Yet, during the 19th century and right up to the 1930s, deflation was common, indeed even normal, while inflation was usually only seen at the height of economic booms and in wartime.

In the U.S., deflation is still only a hypothetical possibility, but in Japan it is a painful reality. Japan’s stock and property bubbles deflated rapidly in the early 1990s and a series of short-lived upswings were each soon ended by a new downturn. In this weak environment, inflation gradually dropped to zero and then deflation set in, starting in 1995. As of the end of 2004 Japan’s price level has fallen a cumulative 10%.

A world of very low inflation, and potentially deflation, makes the current house price bubbles more dangerous than in the past and, from an investor and homeowner point of view, means that houses are a more risky investment. After past price bubbles, house price adjustments were limited in nominal terms by the cushion of high underlying inflation. Indeed in the United States, the nationwide price index has never fallen in nominal terms. In fact, there was a 10% adjustment in real prices in the 1990s, but it was hidden by the high consumer price inflation of the time. In some regions, the real price adjustment was greater and so nominal prices fell too. For example, Californian home prices fell 10% in nominal terms in the early 1990s, with a 24% decline in real terms.

How much effect would a fall in house prices have on the economy? The bursting of the 1990s stock market bubble wiped about $5 trillion off U.S. household wealth. It would take a 33% fall in home prices to have the same impact. A decline of this magnitude cannot be ruled out if valuation ratios for housing, such as the house price-earnings ratio or the house price-rents ratio returned to past cyclical lows, but it would only be likely in the context of a serious recession and a new rise in unemployment. However, wealth effects from declining house prices are usually found to be more virulent than those from falling stock markets, so a fall of “only” 10-20% in house prices could present Mr. Greenspan, or his successor, with a similar headache to the aftermath of the stock crash.

But a housing crash would have other effects too. In past housing downturns residential investment fell sharply, by 40% in 1980-82 and by 24% in 1988-91. This is reflected in the monthly housing starts data, which typically halve during recessions. But starts only ticked down briefly during the 2001 recession and have since risen close to past peaks. Residential investment accounts for about 5% of GDP, so a severe house-building recession would be enough to cut GDP by 1-2% on its own.

Housing Bust: Consumer Price Inflation

How likely is a U.S. housing bust? The economy enters 2005 with considerable momentum and with interest rates still low so it seems likely that house prices will continue to rise for a while, inflating the bubble further. Good news on the economic front will support house prices while rising mortgage rates (likely as bond yields move up) will threaten them. The outcome of these opposing forces will depend partly on how much mortgage rates do in fact rise. Continued good news on consumer price inflation would keep bond yields low and make higher home prices more likely. But house prices will also depend on whether the growing signs of a bubble mentality, now evident in some regions, extend further. When a bubble reaches the euphoric phase, rising interest rates may have little effect because people are entirely focused on the prospect of quick gains.

The ideal outcome from here would be a period where house prices were broadly stable, allowing earnings and rents to catch up and valuations to moderate. A small fall in the market of 5-10% would help that process along, without causing too much hardship, though a nationwide 5-10% fall would almost certainly imply falls of 10-20% in parts of California and New England and other particularly high-priced areas. The most dangerous scenario is if house valuations are still extended when the next major shock hits the U.S. economy. Stock prices would likely be falling too, so that the economy would face a double dose of asset prices effects adding up to a much more lethal mixture than in the aftermath of the stock market bust.

A large correction of house prices at some point, 20% for example, would be a painful process for homeowners as well as investors in housing. Moreover prices would likely only recover gradually since inflation and incomes growth would likely be very low at that point. Hence it is probable that prices would not return to their peak levels for 15 years or more. This might not worry some owner-occupiers. Many will have bought before the peak of the bubble so that, while they will see some erosion of their equity and perhaps suffer some disappointment, they may not be losing much, except on paper. Moreover, since mortgage rates would likely fall, people would be able to refinance at lower rates.

Housing Bust: Negative Equity

However people relying on future appreciation to help fund their retirement could be very disappointed. Moreover some people would find the value of their house falling below the outstanding on their mortgage, i.e. negative equity, because of the greater decline in nominal house prices.

For an investor in housing the scenario above would, to say the least, be a huge disappointment, because there is no capital gain for more than 15 years. Of course, provided he could find tenants and provided rents did not fall, his net rental yield should be positive so there would be some income after costs, though not much given the low level of rental yields, especially in the more bubbly areas. It is difficult to define exactly where the investor would end up, because a great deal depends on how big a loan he has and what rent he could obtain. But there is no doubt that this is what disappointed investors call “a very long term investment”, or in other words a mistake! The choice is either sell and accept the loss or wait it out, but then miss the opportunity to make money elsewhere.

A big adjustment like this is most likely when we see a sharp slowdown or recession and especially if house prices continue to rise rapidly in 2005, as seems likely unless mortgage rates rise very rapidly. The United States avoided a major recession in 2001, with the help of massive fiscal stimulus and rapid cuts in interest rates. But another downturn will come one day and, if house building and consumer spending crashes too, the recession will be more severe than in 2001. In a low inflation world, housing bubbles are a much more dangerous phenomenon.


John Calverly
Baltimore, Maryland
December 21, 2004


“Fannie Mae storm swirls around CEO,” reads a Reuters’ headline.

Rarely, dear reader, does a story so succinctly jive with the themes we explore here at the Daily Reckoning.

The public spectacle at Fannie Mae finds CEO, Franklin Raines, wonder-boy from a disadvantaged background, facing an “unexpected twist in his career that had seemed likely to vault him into a prominent role in national politics.”

Of course, this doesn’t come as shocking news to loyal sufferers of The Daily Reckoning:

“While Raines and Chief Financial Officer Timothy Howard said they believed they were using correct accounting,” the Reuters article continues, “the Securities and Exchange Commission confirmed the errors last Wednesday and told the company to restate earnings from 2001 through mid-2004. Fannie Mae has warned investors the restatement could include after-tax losses of as much as $9 billion.”

Ironically, Raines is credited with being the first budget director, a post he held in the Clinton administration, in 30 years to balance the national budget.

The board governing Fannie might save Raines bacon, but the writing is already on the wall for CFO Timothy Howard. As the spectacle unfolds… we find ourselves enjoying our front-row seat. We hate to say, “I told you so,” but…more on this below…

More news, from our team at The Rude Awakening:


Eric Fry, reporting from the center of the financial universe…

“‘If Santa Clause should fail to call, bears may come to Broad and Wall.’ I am under the assumption that a good decline is coming for stocks, probably right at the start of January…All kinds of gauges are flashing danger, and just because the market has ignored them so far doesn’t mean it will continue to.”


Addison Wiggin, back in Baltimore:

*** What will happen to Raines? We have no idea…and the clammed-up corporate spokesperson couldn’t help us either. He just said that the investigation was “an ongoing process.”

More instructive is this comment from Fed President William Poole, spoken in March 2004:

“Some crises, such as the one that brought down Enron, are well contained and do not spread to other firms. Others…have wider effects. There is no question but that a crisis affecting either Fannie Mae or Freddie Mac would have widespread effects because these firms are so large.”

Hmmmm…could it be that we weren’t the only ones anticipating a scandal at Fannie Mae? Our very own Fleet Street editor, Chris Mayer, predicted that the mortgage-lender would crumble in 2005, but it seems the news beat him to the punch…and it’s already happening! No matter, Mr. Mayer has six more predictions that will astonish you…and, according to Prediction #1, this won’t be the only scandal in 2005.

*** The Dow hit a new three and a half year high today…

But that’s nothing…when compared to the Russell 2000. The benchmark small-cap index hit a new all-time high at 648 last Friday. “Small-caps, as they are known in the business,” writes a Bloomberg columnist, “came into the year looking fat and sassy. The small-stock Russell 2000 index had beaten the big stock Russell 1000 for five straight years, including a 45.4% to 27.5% shellacking in 2003.”

Bloomberg continues: “How convenient, as events unfolded, to see the small stock index prevailing again in ’04, this time by a resounding 2-to-1 ratio through the first 11 months of the year. The Russell 2000 was up 15%, while the Russell 1000 gained 7.5%”

“How convenient indeed,” Carl Waynberg might add. Carl is a specialized small-cap analyst and spends his time pouring over companies that are so small, they’re totally off the radar. What does he do when he finds a “Jumper?” He takes a large position of course.

So what is a jumper? Addison refuses to tell us. He says it’s a secret and promises to tell us on Christmas Eve…

*** An intelligent comment and argument for a secular bull market in stocks from a reader of The Rude Awakening:

“Do you want a really contrarian idea? Say this out loud ‘We are in a new secular bull market.’ Now doesn’t that sound totally absurd and crazy and go totally against what your gut tells you? Now tell me, who else have you heard say that we are in a secular bull market? No one! Look at all the Wall Street forecasts for ’05. Not a single person is expecting ’05 to be a big up year for stocks. You want a sentiment gauge – how about the $1 trillion dollars that have rushed into hedge funds over the last three years – all people who are trying to avoid market risk. When everyone is trying to avoid market risk, it’s a great time to start taking market risk. In the bear market a VIX reading this low was bearish. But if you look back to ’94 and ’95, the VIX did exactly what it’s been doing lately, gradually trending down. Then when in fact it did start to rise, it was because volatility in the market picked up…in a bullish direction! All of you ‘we’re in for a decade of low returns’ guys all are saying that rising interest rates are going to pop the debt bubble because China, et al are going to start selling Treasuries, yet everyone who’s a secular bear is also bullish on Asia. So Asia is going to boom, they’re going to have a bunch more money flowing in, and they are going to stop buying Treasuries? No, they’ll keep buying Treasuries as long as their countries are doing well, because the only way they do well is if the U.S. consumer keeps spending. Thus, there is going to be a lid on the U.S. yields as foreigners continue to increase their purchasing. So while there is a debt bubble, it’s not going to pop any time soon because rates are not going up.

“I normally enjoy reading your daily email, and I enjoy truly contrarian ideas (I almost fell out of my chair when I heard you say that you, a perennial bear, think the dollar is a buy – I think that’ll turn out to be a great call.) However, don’t confuse bear with contrarian. A true contrarian figures out how everyone is positioned and does the opposite. Currently, all the hedge fund money is implicitly in the secular bear camp. Even the mutual fund managers whose job depends on a rising market don’t believe tech is going up. You want to be contrarian – tell me why Ford is a great buy here (which it is) or why Google and Taser are actually great bull stories? Do you really think the market is going to crash when you’ve got Fortune covers questioning whether Google is worth $165?”