Monday, March 17, 2008


Just off the top of my head, here are some “record high prices” I’ve seen articles about in the past year:

In general, inflation seems to be back. Here’s my amateur opinion. Inflation, as Milton Friedman would say, is always a money supply problem. In past inflations, the increase in money supply has been an actual increase in M1 and M2. What this means is that, while inflation wreaks havoc with contractual values and savings, generally people are no worse off on present-day transactions. This is because in the circular flow of money, the new money makes its way into higher wages. So you make five dollars an hour and bread costs a dollar a loaf, and after the inflation you make six dollars an hour and bread costs $1.20. Your savings doesn’t buy as much bread, but your current income does.

Here’s what’s different about this inflation: a lot of the new money in the economy over the past ten years has come from housing appreciation. You buy a house for $200,000 and enter a contractual agreement to pay a mortgage on a $200,000 house. Now, ten years later, your house is “worth” $1,000,000. Your contract is still for a $200,000 mortgage. You’ve gained access to $800,000 that wasn’t there before. You cash it out and spend it. You’ve increased the money supply, which raises prices. But it’s not a general inflation, meaning the money didn’t come into the market through higher wages. So people relying on wages see higher prices with no corresponding rise in wages. Bread is $1.20, but you still only earn five dollars.

Normally the new money would work its way back around to wages, but not if housing values collapse, since the money was only in the market as a result of higher expected resale values. When you go to sell your house for $1,000,000 and end up getting only $700,000 for it, you have $300,000 worth of stuff that was given to your for nothing of value in return. Like an auction with play money, you’ve bid up the price of goods without contributing anything of value to offset the higher price.

Anyway, all this inflation is kind of funny, given Alan Greenspan’s prognosis of steady global deflation in his book The Age of Turbulence. He says rising incomes in developing nations, which have less consumerism and higher savings rates, has increased global investment, leading to lower prices. That works for things like DVD players and cell phones, but not for basic staples such as food, which are seeing an increase in demand as people now make enough money to eat food regularly.

Well, that was just what I thought of while I was driving home from work on Friday. It’s probably not very intelligent. Oh well.


Erik said...

Sounds reasonable to me. Inflation is the anti-saver, so it is always irratating to think that the "mature" thing is to save your money in a way that keeps up with inflation so your savings actually increases at least as fast as inflation. If all the major banks and savings institutions are at risk like Bear Stearns was of a run on the bank, then things could get worse really fast. There is really no way of knowing if the "savings" institution that you are a part of is in dire straights from investing in mortgage backed bonds and funds. FDIC will work for our savings account, but if you were someone with a large chunk of their retirement tied up in Bear Stearns stock, then you just got kicked in the nuts BIG TIME. 5th largest Wall street back should mean something.

The Man Your Husband Is Worried About said...

FDIC only "works" with the promise of hyperinflation. At the back of FDIC is the idea that, if they need to, the government will print enough money to give everyone exactly the amount of their deposits. So you will get all of your insured $100K, but it might only buy you a magazine.
I don't know what the answer is to the "too big to fail" idea that banks have. You think, "Let the investors get screwed for their own bad investments," but most investors aren't the shareholders who actually lose money on bad investments, and allowing enormous firms like Bear Stearns to fail will harm the economy a lot more than a bailout will, so we bail them out. The lesson learned by the investors is that their behavior is acceptable, and they go looking for the next "bubble" to ride. In the late 80s it was commercial real estate; in the early 00s it was residential real estate. Nothing's changed.

JT said...

I thought that riding the bubble was the principle that drives capitalism (especially Mormon small business owners). Sectors of the economy may expand or contract, but you try to ride the market with the hope that it will all be better in the long run.

Honestly I don't see the major problems that this recession poses. Maybe it is because I have a stable government job. Conceptually, whether people took the value out of their house now or in the future (really involves the discounting rate) eventually over the long run, that money will be or would have been created? So in a macro perspective, one generation got the goods and the other just suffers a little by not being able to create or extract that value later? I readily acknowledge that isn't the most friendly of explanations, but isn't it correct?

The Man Your Husband Is Worried About said...

But I think taking the money out before exchanging the asset is what leads to problems. It's like getting paid today for all the work you're GOING to do over the next 25 years. A whole lot of money today, but nothing of value was exchanged for it, and if you can't work in the future, it becomes money that never should have changed hands.
The warriness I have about this possible recession is that it is unlike the last two, which were very mild and quite standard. This seems a lot more like the 1970s, when stagnation and inflation went together and no one knew why or how to undo it. The good news is Paul Volcker is still alive, so maybe he can replace Bernanke and bring back 21% interest rates.

JT said...

I understand the point... what if the value would have never reached the value that was extracted. That is a banking issue. They created the extra cash by allowing people to refinance and cash out the value. They should suffer from it. Some micro failures are acceptable in macro economics, just not an entire sector. While this disproportionally benefits the people who cashed out their homes, they are still left with mortgages that have to be paid to the bank, right? I still don't understand that part of the equation.
It does look like we are headed towards stagflation, and the Fed is almost out of tools to use. Actually, it appears to me like this one may be more similar to the great depression in terms of its overall reach. Like I said before, over time we will survive and ever the investors who suffered through the stock markets collapses have been better off overall by simply sticking to the game.
Just please let me buy my below market value repo-ed house before we get 21% interest rates.