Gary’s Note: Dan Denning shows us how strangely prices can move when credit expands and contracts. Send your comments to gary@whiskeyandgunpowder.com.

Policymakers and the Depression

By Dan Denning
Melbourne, Australia
April 24, 2009

If governments wised up and ceased pumping trillions of new money and credit to back-stop assets with unsupportable values, you’d get a severe and painful deflation. The flow of money and credit would contract and the general price level would fall — most severely for those assets that benefited the most from the credit.

The upside of a severe and painful depression is that the much needed adjust in the economy would finally happen. The flow of credit to productive enterprise and real risk-taking (value creating) activities could resume. Or, if you like, new “production possibility frontiers” would open (like terraforming the great red centre of Australia so that its climate is habitable, or reengineering the national energy grid to be less centralized and more resilient).

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But history suggests policy makers will not allow the supply of money and credit to contract, or for the mistakes of the last bubble to be liquidated. That would mean someone has to take the losses. And if that happened right now, you’d have a lot of insolvent banks and foreclosed homeowners (especially in America, but perhaps later this year and next in Australia).

In fact, history shows that policy makers will do the exact opposite, pouring good money after bad into a market sorely in need of a return to the mean. Case in point is the way Congress treated the U.S. mortgage market in 2007 and 2008. It has led to the nationalization of the U.S. mortgage market, where the government now originates nine out of every ten new mortgage loans.

In 2007, the Congress passed the Federal Housing Authority Act. The Act loosened underwriting standards for Federal housing agencies in the U.S. It also allowed them to cut down payments in half (from 3% of a loans value to 1.5%) and loosened regulatory capital requirements. What’s more it raised the maximum value of loans the FHA could insure up to $417,000.

This was important. This was the size limit on loans that Fannie Mae and Freddie Mac could buy in the secondary mortgage market. But in market with inflated home values, with many home owners in desperate need of financing, the GSEs would be unable to step and provide what the private sector would not without a change in the conforming loan values.

The primary goal was to kick-start lending the U.S. mortgage market. It had to be kick-started because the non-bank lenders that sent prices soaring from 2004-2007 were out of the market. Private investors-seeing the bubble for what it was-were no longer funding the market. But that was just the beginning.

Next up was the Economic Stimulus Act of 2008, signed by President Bush on February 13th of that year. One little-discussed feature of that act raised the conforming loan limit for the GSEs from $417,000 to a maximum of $729,000 in some markets. This enabled the GSEs to buy or insure mortgages up to $720,000. This was designed to prevent mortgage activity in places like California, Nevada, and Florida from all but grinding to a halt.

The measure was pushed by folks in Congress who argued that median home values in some parts of the States were much higher than the national median. They argued that if the GSEs were to achieve their new mission of being the primary source of mortgage funds in the U.S., the size of the loans they could buy or insure would have to be raised. So it was, even though the original mission of the GSEs was to make housing more accessible to low-income and marginal buyers and NOT to prop up house prices in the most over-inflated markets.

The result, despite the subtle change of mission, was still pretty impressive. According to Inside Mortgage Finance, the GSE’s originated 73% of all mortgages in the U.S. in 2008. At the height of the mortgage bubble, non-bank lenders were stealing market share from the GSEs.

But as those lenders failed, the GSEs (Fannie and Freddie) once again find themselves as the only pillar holding up mortgage financing in the U.S. In the fourth quarter alone, if you include the FHA and the Department of Veterans Affairs, the government accounted for 92% of mortgage originations.

Did the GSEs massive expansion into the mortgage market keep U.S. house prices from falling even further? And let’s not forget the Fed, which is now buying GSE bonds in a further effort to prop up mortgage activity in the U.S. You can see the massive amount of new resources and capital that have been poured into keeping the market afloat, and by extension, preventing further deterioration on bank balance sheets that are chock-a-block filled with residential and commercial housing.

The bad news for the U.S market is that the provision to expand the conforming loan limit expired in December of 2008. Fortunately, for those interested in perpetuating the misery of the U.S. housing collapse, the American Recovery and Reinvestment Act signed by President Obama in February again raises conforming loan limits for the FHA and the GSEs to $729,750.

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It’s enough to make you sick at your stomach. The U.S government is actively preventing an adjustment in U.S. house prices that would bring about a market-clearing price and lead the way to a recovery. House prices are falling anyway. So all the government has really achieved is the nationalization of the mortgage market, putting millions of Americans in mortgage purgatory.

What’s worse, you could credibly argue that the U.S. housing market is worse off today than it was two years ago-even after a 20% fall in national median home prices. More people have been sucked back into mortgages at values that are not sustainable. Look for higher default and foreclosure rates. And for the banks? You don’t even want to know...

As for Congress and Bush and Obama: nice work, fellas. Hope you’re proud of yourselves. If you wanted to put a whole generation into massive debt-above and beyond the Federal budget-you couldn’t have come up with a more devious series of laws to do it.

Here in Australia, the government is being coy about how long the First Home Buyers grant will be available to prop up home prices. However, the big story was consumer prices not house prices. And there were conflicting signs from the Australian Bureau of Statistics and the Reserve Bank about the real rate of consumer price inflation in Australia.

The ABS showed consumer price inflation increasing 0.1% month-over-month and 2.5% from the same time last year. But the RBA’s trimmed mean measure of inflation showed inflation up 4.4% year-over-year. That exceeds the RBA’s goal of between 2-3% inflation per year.

In any event, this should put to rest the “deflation” bogeyman for a while. And by the way, what is so bad about falling retail prices anyway? Nothing, as far as we can tell. If you’re a consumer, it means your dollar is stretching further and further.

It’s odd that people consider high prices and high wages a sign of a healthy economy. And besides, it’s not the number that matters. It’s what real wages actually are. Real wages are wages adjusted for inflation. If consumer prices are falling and real wages staying the same, consumers benefit with enhanced purchasing power.

The trouble for policy makes is that not all prices move in the same direction. If financial asset prices fall, this is “bad” because the value of shares and property are falling. That’s why we hear the deflation argument in consumer prices used as scare tactic to lower interest rates and prop up financial asset prices (good inflation).

But it does raise an interesting point: some prices can rise while others fall, even during a period where the general price level is rising. For example, the ABS reported that pharmaceuticals were up 13% in the March quarter. Secondary education fees were up 7.6%. Vegetables were up 6% and electricity was up 3.6%.

But some of those everyday higher prices were offset by the 14.1% fall for “deposit and loan facilities” and the 8.1% fall in prices for automotive fuel. Prices for domestic and holiday travel fell by 5.1% and overseas and holiday travel prices fell 4%.

That paints a picture of an economy in which prices for every day real expenses (food and medicine and rent) are rising, while prices for discretionary items (loan and vacations) are falling. So what?

Well, it means that in a hyperinflationary period, you could have plummeting stock and bond prices (in real terms) AND rising food, energy, and other prices (in real terms). So don’t go buy that house just because you think inflation is going to boost house prices. In real terms, a hyperinflation destroys value. It doesn’t add it.

Here’s the thing to remember: all the physical capital stock that gets built in an inflationary boom doesn’t go away. The factories are still there. The houses are still there. The capital goods are still there. And the cars are still there. But the value of that capital stock has to fall once the inflationary boom goes bust.

Mind you, not all of the capital stock will be productive in the future. How bad the bust is depends on how much capital was sunk into boom-time investments that don’t produce any return-ever. There are some people, for example, who argue that housing is a wasting asset, a sunk cost, or even the largest generational misallocation of capital ever [like Whiskey contributor James Howard Kunstler — ed.].

Whether it is or it is not is beside the final point in our notes. What we’re watching for now is whether it’s really possible to sustain the inflationary boom in financial assets and the consumer economy with an even greater amount of credit and debt. We suspect it is not. And that’s what’s scary.

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Ever since the early part of this century, governments have been managing the contracting phase of the business cycle with the introduction of more credit. The ripple effects of the monetary expansion have steadily widened over the years, drawing more of the globe into the game. It culminated in the 200-2007 worldwide boom in all asset classes across the planet-the blow off top of 90 years of rising fiat money, if you will.

Once a global inflationary boom has been expanded to include every market everywhere, how do you keep expanding it? Is this what an IMF-backed global currency is about? The ultimate expansion of fiat money worldwide for a global policy of inflation? Is that the final frontier of fiat money? We’ll explore that space next week.

Regards,
Dan Denning
www.dailyreckoning.com.au