Saturday, August 09, 2008

Mortgage Crisis, the Dollar and its Future, Part 1

The popular definition of “inflation” is a general increase in the level of prices. But what causes the price level to rise? It is an increase in the money supply without a corresponding increase in goods and services; there is more money with which to bid up the prices of available goods and services. Inflation used to mean an increase in the money supply without an increase in physical assets, namely gold or silver. Higher prices are the result. Replacing the traditional meaning of inflation with the popular one, which refers to the effect rather than the cause, has obscured the fact that government is the cause since it controls the money supply. “Inflation,” writes economist Kelley L. Ross, Ph.D., “does not occur because of a 'wage-price spiral,' an 'overheated' economy, excessive economic growth, or through any other natural mechanism of the market. A government debasing the currency would not have fooled anyone a century ago. Now, through deception, a government can try to blame inflation on anything but its own irresponsible actions.”

The money supply can be increased by simply printing more paper currency—unbacked by gold or silver—or by increasing bank credit, which is the method used in the U.S. and other developed countries today.

Every period of “easy money”—loose credit—is inevitably followed by a correction that wrings the excess credit out of the system. The result is the familiar “boom-and-bust” cycle in the economy. It is commonly called the “business cycle,” but it is basically a monetary cycle. The initial economic stimulus of excess monetary credit is followed by an offsetting loss of value in the currency and an economic slowdown as markets readjust from the credit distortions. While some people may gain from inflated prices, everyone else—particularly the common people—lose because of the depreciating value of the currency. It is reminiscent of an old Russian proverb: “The shortage will be divided among the peasants.”

The central bank, in our case the Federal Reserve, attempts to fine tune the economy by tightening or loosening credit in order to control inflation and prevent the economy from sliding into recession or depression. This is a tricky task because of external factors over which the Fed has no control and an unpredictable time lag between Fed actions and their consequences. Nobel Prize-winning economist Milton Friedman says this time lag may range from 3 to 18 months, a range so large that Fed timing is difficult. As a result, the Fed is always subject to criticism that it acted too soon or not soon enough, or that its measures were too strong or not strong enough at a particular time. The difficulty of timing Fed actions led Friedman to declare that the Fed shouldn't try to fine tune the economy at all. He said this was more disruptive of economic growth than a fixed policy. He proposed that a steady but moderate growth of the money supply would be a major contribution to the avoidance of either inflation or deflation. “I’ve always been in favor,” Friedman said, “of replacing the Fed with a laptop computer, to calculate the monetary base and expand it annually, through war, peace, feast and famine, by a predictable 2%.”

Now, interestingly, the world's gold supply has typically increased 1.5 to 3 percent annually, which is right in line with Friedman's recommended figure. So, why do we need a gold standard? Why not just increase the money supply steadily by the same fixed amount without tying it to gold? Because gold never becomes worthless; paper currencies can and do. The supply of gold never decreases. And only on very rare occasions, such as the major discoveries of gold in California in the 1850s and in South Africa and Australia in the 1890s, has it increased annually by over 4 percent. Those increases were very modest compared to the price increases caused by governments inflating the money supply. Moreover, while increased gold production did push up prices, this was because of the increase in material value, not arbitrary paper value. The world really was richer. On the other hand, there has never been a paper money unredeemable in a material asset that did not eventually become worthless. Obviously, therefore, no government can be trusted to increase the supply of an unredeemable money at a fixed rate. Sooner or later, political expediency combined with monetary ignorance and shortsightedness—not to mention “good intentions”—will result in the first small steps down the inflationary road. The first few steps will seem harmless enough, and so the process will be repeated. And broadened. More and more “good intentions” will be found. And they will be more and more expensive.

Of course governments do not want a fixed monetary policy. The Fed board of governors does not want to be replaced by a laptop computer. Nor do politicians want to give up the power to be expedient and irresponsible with other people's money—all in the name of good intentions, of course. They have a vested interest in inflation. They do not want a system that would restrain the lavish spending that buys voter support for their reelections. They do not want to give up playing god with the economy and the populace. Their good intentions for both can be financed in only two ways: 1) by taking money away from the people (taxation), or 2) by taking value away from the money (inflation). Taxation is not sufficient; there is no way the voters would accept taxes high enough to equal what they lose through inflation that finances the politicians' schemes.

The gold standard produced remarkable price stability. The Bank of England, founded in 1694 as a private company (nationalized in 1946), acted responsibly in issuing paper money. Its banknotes were “as good as gold” and led to Great Britain adopting the gold standard in 1816. Historical research by David Ranson and Penney Russell shows the stabilizing effect of this monetary policy. Ranson holds four degrees, including an M.B.A. in finance and a Ph.D. in business economics, and taught at the University of Chicago Graduate School of Business; Russell, a mathematician, is executive vice-president of H.C. Wainwright & Co. Economics, of which Ranson is president and director of research. Their research shows prices were lower in Great Britain at the beginning of World War II than in 1800. In the U.S., cumulative consumer-price inflation from 1820 to 1913, when the Federal Reserve Act was passed, was zero. According to the inflation calculator on the U.S. Bureau of Labor Statistics website, the dollar has lost more than 95% of its purchasing power since 1913.

In the 1920s (and even prior to 1920), the Fed rapidly expanded credit. This produced an enormous boom in the economy and a growing wave of optimism about continued prosperity. The result was a bubble in prices, most notoriously in the stock market. In the 1920s, stocks could be bought on margin for only 10 percent, the remainder being on credit from the brokerage houses. By 1926, they could be bought on 5 % margin. In September 1922, brokers' loans totaled $1.7 billion; by December 1926, they were $4.4 billion. And by September 1929, they were $8.5 billion.

The credit bubble of the 1920s was also evident in real estate. Henry Hoagland, a Federal Home Loan Bank board member, later wrote: “After a prolonged period of insufficient home construction during the World War, a tremendous surge of residential building in the decade of the twenties turned villages into cities and added tremendous acreage to our urban centers...[There was] a demand for modern homes greater than had ever been experienced before. This demand was matched by an ever-increasing supply of homes on easy terms.

“The easy-terms plan has a catch in it. It usually accompanies high prices and small ownership equities, giving superficial covering to a mountain of debt. When the crash came in 1929, a large proportion of home owners had but a thin equity in their homes. Only a small decline in prices was necessary to wipe out this equity. Unfortunately, deflationary processes are never satisfied with small declines in values. They feed upon themselves and produce results all out of proportion to their causes.” Sound familiar?

After the crash of 1929, stock market margins were never that low again. Since 1974, the margin rate has been 50 %. But we should not be surprised by the recent price bubble in residential real estate. For several years it was possible to buy a home for as little as 5 percent down, then 3 percent, and finally in many instances with no money down at all. According to a survey of first-time buyers by the National Association of Realtors in late 2004 and early 2005, a stunning 43% had put no money down.

The Great Depression led to greater involvement by the government in the economy as it tried to alleviate problems its monetary policies had caused. As a remedy for the disaster in the housing market, the government created the Home Loan Bank system in 1932 patterned after the Federal Reserve system, with 12 regional banks. That proved insufficient. Banks were still failing, and people were still losing their homes through foreclosures. So the government decided another agency was needed to make more credit available on easier terms. The result, in 1934, was the Federal Housing Administration (FHA), which originally required 20% down payment. Then more agencies were added to make even more mortgage credit available. In 1938 the Federal National Mortgage Association (Fannie Mae) was created. Freddie Mac (Federal Home Loan Mortgage Corp.) was created in 1970 to supplement Fannie Mae's role.

FHA, Fannie Mae, and Freddie Mac met with public approval but planted the seeds of future problems. Vernon L. Smith, a Nobel Prize-winning economist and professor of law and economics at George Mason University, says the government “set the stage for housing bubbles by creating those implicitly taxpayer-backed agencies, Fannie Mae and Freddie Mac, as lenders of last resort.”


Kelly said...

Excellent post.The information on how the mortgage crisis have its effect on Dollar and future has shown very excellently i this post. thanks for the post.

Steven Jon said...

This is indeed one of the best explanations of government-encouraged bubbles and their aftermath that I have seen anywhere.