The Age of Inflation

In Part I of this two-part essay, Dr. Hans Sennholz examines the factors bearing on the housing market…and in Part II, which can be found on our site, he concludes that Americans need to stop refinancing as though they were receiving money for nothing…and brace themselves for the bubble burst…

With stock prices down considerably since 2001, and apparently heading lower, many Americans have taken a liking to real estate. They have bought homes in record numbers as easy credit and low interest rates have enabled many to buy rather than rent a home. And just like stock prices during the 1990s, the value of homes keeps rising, as does the debt incurred to buy them. According to Federal Reserve data, American homes now are worth some $13.6 trillion, which is 92% more than a decade ago, while mortgage debt more than doubled to $6 trillion. With all that money rushing into real estate, does it blow bubbles, as it did in the stock market, does it reflect chronic inflation and dollar depreciation, or does it manifest rising incomes and growing ownership aspiration?

Searching for an answer to these questions, we must raise and answer yet another question that enfolds the former: Is the capital market that guides and drives economic activity allowed to function freely, or is it controlled and manipulated by government regulators? In other words, is an unhampered market rate of interest allowed to direct the employment of capital and labor and thereby shape present conditions, or is the rate commanded and managed by mighty controllers? The answer is obvious: It is set by the governors of the Federal Reserve System who thereby modify all interest rates and manipulate the capital markets. In recent years, they chose to keep interest rates far below market rates, and thus guide economic activity along lines that differed greatly from those an unhampered market would have directed. They caused massive increases in money and credit and brought about what economists call "maladjustments" which are the very mainspring of economic recessions and depressions.

Housing Bubble: Real Estate Maladjustments

Maladjustments in real estate differ visibly from the afflictions of stock and bond markets, which are national or even international in range and scope. Landed property is an inherently local asset that is affected by a great number of local demand and supply factors. The housing market in San Jose, California, has little resemblance to that in Grove City, Pennsylvania, although both are affected by the same Federal Reserve monetary policy. Some places may suffer stagnation or price declines while others experience feverish booms. There may be bubbles in some parts of the country while stagnation and recession hold others in their grip. Yet all prices undoubtedly are much higher than they would be in absence of chronic inflation and dollar depreciation.

The Office of Federal Housing Enterprise Oversight informs us that average housing prices rose 38.3 percent from 1997 to 2002. This knowledge may be of interest to economic historians, but of little use to real estate investors. They are intrigued and lured by local conditions and the possibility of earning high returns through debt financing when prices soar. A home buyer may put down ten percent of the purchase price and borrow the rest; a price rise of ten percent would double his investment. An annual price increase of just five percent would yield a return of 50 percent on his investment, year after year. While the mortgage loan continually depreciates in purchasing power, the owner’s equity rises in step with the rising price of his house. In fact, in less than ten years, a ten percent annual bubble rate will shift one-half of the value of his house to him, without having made a single loan payment. Surely, he will have to maintain the property and pay an interest on the mortgage loan, which may be less than the rent he would have to pay if he were to rent the house.

This leverage of debt financing also works in reverse. When the bubble bursts and housing prices readjust, many new owners would soon lose their entire investment. A ten percent fall in prices wipes out a ten percent owner equity; a thirty or forty percent decline, which is rather common in a bubble crash, not only stamps out his investment, but also may inflict additional losses – unless he walks away from his house, and thereby shifts the losses to the financial institution that granted the loan. When the decline is severe and many owners choose to unload their losses on creditors, the crash may jeopardize the solvency of financial institutions that financed the bubble.

Housing Bubble: Let the Bubble Increase Your Equity

Despite such occasional reversals, our age of inflation has made ownership of a home the most effective way to increase personal wealth. While inflation tends to raise interest rates by adding the anticipated depreciation rate to the basic time-preference rate, it also lowers the debtor’s risk premium, which may offset the higher depreciation rate. The owner’s equity increases in step with the rising price of the house, which simultaneously reduces the risk to the lender. Before the age of inflation, a homebuyer needed a down payment of 30 to 50 percent of the purchase price; the age of inflation gradually reduced this rate to 20 or 10 percent, but sometimes 3 percent or less. The lender’s price risk is minimal; the buyer may just sit back and let the bubble increase his equity.

Politicians and government officials look with favor on home ownership, as they themselves do benefit from such favors. Homebuyers enjoy big tax breaks. They can deduct property taxes and the interest on their mortgages from their taxable income. And when they sell their homes they may exclude up to $250,000 in capital gains from taxable income; married couples may deduct $500,000. And they can do this again and again, as long as they live in the home for two of five years before selling.

The prices of manors and mansions have soared above all other housing prices. When the stock market began to retreat and disappoint in 2001, many underperforming funds sought refuge in real estate, and thus caused housing prices to take off. The nouveaux riches of the stock market now sought safe harbors in real estate, and those speculators who could not afford such luxury could at least borrow against the equity in their houses and raise their standards of consumption to manor levels. A "refinancing" mania gripped the real estate market and lifted the level of mortgage debt. To take advantage of the current low rates, many debtors chose "variable-rate" mortgages that are readjusted frequently. If interest rates should ever return to market levels and cause real estate prices to decline, many such refinanced houses would not be worth the debt standing against them. In the meantime, most homeowners rejoice about their rising equity, which they calculate in nominal prices. If they would compute prices in inflation-adjusted dollars, their profits would be much lower or even turn to losses. In some parts of the country, nominal prices continue to rise moderately, while inflation-adjusted prices actually stagnate or even decline

National statistics tend to understate the risk of loss for many homeowners. They obscure the extreme price swings in individual towns and cities, and blur the particular forces that may reduce or compound the maladjustment. During the 1980s, for example, several West Coast cities enjoyed feverish high-tech and defense-spending booms. Real estate prices soared. A few years later, when high-tech production spread to China, India, and many other places, stagnation settled over many places and prices fell noticeably.


Hans Sennholz
for The Daily Reckoning
December 1, 2004

P.S. The housing bubble is on the verge of collapse, and it could happen any day now…but we don’t think that you should have to get trapped under the wreckage.

What a gray day it is in London. We walked along the river. The river was the same color as the sky – both a dull gray. You could barely tell where one ended and the other began…except for the red piping on the Blackfriars Bridge separating the two.

Yesterday was so different. The dawn was so rosy red; it was as if a nuclear power plant were melting down in Braintree.

Aside from the weather, what has changed?

Mr. Blunkett is still on the cover of the British press. We are following the story for you, dear reader. The Home Secretary seems to have fathered two of another man’s children. Now, the papers are making a big stink about it; the opposition is calling for his removal. But you shouldn’t blame him, say English friends, The Home Secretary is blind; he couldn’t see what he was getting himself into.

We wondered about the mother. A California girl, it turns out, with too much charisma and not enough shame. We saw a photo of her. She looked like a good mistress for a blind man.

This has nothing to do with investments, but not much has happened in the financial world since we left it yesterday. The dollar fell again, to a new record low against the euro – more than $1.33/euro. Americans have not noticed, but everyday they get poorer. In terms of real money – gold – the average American’s income has dropped by more than 30% since George W. Bush took office. In euro terms, too, his income is down.

Meanwhile, holders of U.S. dollar assets continue to lose money. The U.S. stock market has gone approximately nowhere for the last five years. But, the value of the American stocks in euro terms has dropped. A European investor has seen his U.S. stocks lose more than a third of their value. The Japanese, meanwhile, watch in horror as the dollar drops. They have 800 billion worth of dollars in their central bank vault. Each penny the dollar loses, takes $8 billion off their balance sheet.

Bill Gross comments:

"The U.S. spends too much; eats too much; drinks too much; TOO MUCH, (thank you, Dave Matthews). And we pay for it with our debt and 80% of the world’s excess savings. In so doing our creepy crawly balance of payments deficit has inched its way up to 6% of GDP – a level never seen in the United States, and reflective of Third-World Nations in financial crisis. The imbalance has been tolerated by those nations on the surplus side of the ledger – read "Asia" – in a strange sort of mercantilist Faustian bargain that promises China and Japan the benefits of a strengthening economy now for the perfidy of falling dollar denominated Treasuries bonds later, an arrangement that once again will prove that there is no free lunch, or that Hell often follows Heaven on Earth."

But for the moment, Heaven, not Hell dominates the headlines. Yesterday brought news that the U.S. economy grew at 3.9% in the last quarter. No one noticed that – in the present circumstances – the more America grows, the poorer she becomes. It is as if we had borrowed a million dollars and went on a spree. The more we spent, the more the GDP numbers would rise. Everyone would feel richer: not only us, but the restaurateurs, the wine merchants, the shippers, the travel agents, the airlines, the bartenders, the taxis, the shopping malls, the tax collectors and so forth. But what about the million dollars? How will it be paid back? When? No one bothered to ask.

More news, from our team at The Rude Awakening:


Tom Dyson, reporting from New York City…

"It was late on a Sunday evening, and we were in a hurry to get home. The establishment’s owner was helping his staff clear the restaurant and stepped over to our table. When he noticed cash already waiting for him on the tablecloth, he pulled a face and said, ‘I’m sorry sir, that money’s no good here.’"


Bill Bonner, back in London:

*** Nobody feels the weight of the falling dollar more than Americans living in Europe. What used to be expensive is now very expensive. The U.S. Army, responding to howls from its troops stationed in Europe, has had to increase living allowances. Alas, no such succour comes to those of us out of uniform.

*** What can we do to protect ourselves?

"Buy gold," says James Turk. James is the man behind – a service that makes it easy to own the real stuff without paying hefty commissions or digging holes in your backyard. He came by the office on Monday. We sat down at the Paradis and had a drink.

"People think they’re buying real gold when they buy the new gold ETF [Exchange Traded Fund]," James explained. "But it’s not clear at all that they actually have the gold. And when you buy the ETF you don’t actually own gold. What you own is shares in a fund that tracks the gold price."

Goldmoney, on the other hand, works like a custodian. When you buy goldgrams, you actually own the real metal, which is stored for you in a vault in the Channel Islands. Apparently, you can take delivery if you want…or transfer your holding to someone else. Or even, use the system to buy things. The commission charges are low; there is no storage fee.

As James described it, the Goldmoney approach to owning gold sounded easy and inexpensive. At the very least, dear reader, it is a simple way to protect yourself from the falling dollar.

*** We, here at The Daily Reckoning, wrote recently:

"Back in 1984, the last time the US dollar faced a similar crisis of confidence… the wealth of every American was cut in half in three years’ time…"

To back this statement up, my friend, Steve Sjuggerud, tells me, "In March of 1985, you and I could have bought 28,000 Swiss francs with $10,000. Just three years later, we could only have bought 14,000. In just three years’ time, the dollar lost half its value against the Swiss franc – just sitting in your bank. The United States lost half of our world purchasing power – which means half our wealth.

"When I left Geneva, in 1948, one dollar was worth 4.80 Swiss francs. The rest is history."

*** If Iraq is lucky, says columnist Jeff Jacoby, it will get democracy before we d "Thanks to modern gerrymandering; most congressional districts have been turned into Democratic or Republican monopolies – Constituencies meticulously mapped to lock in one-party supermajorities…"

The Daily Reckoning