Monday, October 06, 2008

Inflation worries

I've been thinking about what's likely to happen with this financial mess we're in, and I'm not very optimistic.

The root cause is over-inflated housing prices. Too many people bought too many houses for too little cash up front.

Possible solutions to the problem:
A. Keep housing prices high by increasing the demand for houses.
B. Keep housing prices high by decreasing the supply of houses.
C. Let housing prices keep falling until demand meets supply.
D. Ramp up inflation so that house prices stay stable (but the price of everything else goes up).

The bailout is plan "D". $700billion is going to magically appear and go into the financial system to prop up failing mortgages. A trillion or more is already committed to propping up Fannie and Freddie and AIG; all that money going into the system means more inflation.

The politicians would never choose options A, B, or C. "A" basically means you need more people here to buy houses, and I don't see any political will to adopt a more lenient immigration policy.

"B" would make for really bad PR-- "The department of Housing and Urban Development bulldozed 600 foreclosed homes in Detroit last month..." might be sound economic policy but it makes for heart-wrenching pictures on the TV news.

"C" means more foreclosures and middle-class people feeling poorer because their $350,000 home is suddenly worth only $200,000. That ain't gonna fly.

The beauty of plan "D" is that it's mostly painless for the politicians. The $340,000 6% mortgage on your $350,000 house will be worthless to the bank when inflation is at 10%, but it's a very good deal for the middle-class home-owning taxpayer. If wages don't keep up with inflation, or if taxes have to be increased to pay for all this, then they'll be worse off, but that's a problem the next administration can deal with.

I can't figure out how they're thinking they'll avoid more bank failures in a higher-inflation economy, though. I've got a 30-year fixed-rate mortgage with Florence Savings Bank at 6% interest that will be less than worthless to the bank (it's "net present value" will be negative) if inflation climbs above 6%. Do small banks hedge their inflation risk somehow?


Anonymous said...

Hi Gavin,

I don't think the heart of the matter is over-inflated housing markets although they contribute. I think the problem is that "financial institutions (defined broadly)" have used the same equity multiple times, so that for instance, a $200,000 morgage of a home is now, through the insane practices of wall street through this pyramid scheme of multiple morgage selling, to now worth much more (on paper). If it were simply morgages than my rough estimate would mean the trillion or so of "bailout" money (all the "bailouts combined) would be sufficient to buy perhaps ALL the risky morgages. I used a lot of assumptions like 5 million homes at an average of $200,000 (multiplied together = 1 trillion).

So the whole deal really stinks to me since it seems like there is much more to the story than "stupid home buyer who knew they couldn't afford their morgage" and those that have lost their jobs and can't continue to pay them.


Gavin Andresen said...

Well, their over-leveraged house of cards would have been just fine if housing prices had kept on going up.

Now it's fallen down along with housing prices. True, it wouldn't be a major disaster if they hadn't created all the complicated, bizarre securities, and we should figure out WHY they decided to do that, and figure out if there's a way of preventing that kind of thing happening again in the future.

But I think the heart of the matter IS an over-inflated housing market. I just heard president Bush say the same thing (scary that we agree on something...)