Policy Makers and the Depression

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In today’s essay section you’ll find plans, plans, and more plans from some of your 50,000 fellow Aussie DR readers. Last Friday we asked you to send in your plan for the coming hyperinflationary recession/deflationary depression. We’re hedging our bets on which it will be because we don’t yet how much more aggressive (or effective) monetary and fiscal policy is going to be.

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 benefitted 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 centralised and more resilient.

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 nationalisation 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.

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 nationalisation 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 of 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 awhile. 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. 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.

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.

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 world-wide 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 tomorrow.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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25 Comments on "Policy Makers and the Depression"

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Pete
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Dan you said: “Mind you, not all of the capital stock will be productive in the future.” I couldn’t agree more. And that is why it irks me when I hear people talking about “recoveries” and “longterm recoveries”. Like the title of the DR article said a few weeks ago, “a recovery to what?” A recovery to bring us to the same point we were in 2007? A recovery to a point of unsustainable growth fueled by easy credit? As Dan alludes to in this article, if you build 1000 factories to produce widgets that are then bought using credit… Read more »
Greg Atkinson
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Pete, “Mind you, not all of the capital stock will be productive in the future.”…applies to every point in recent history! Unless of course someone has invented capital assets that never break down or need to be replaced. Perhaps it has also been a while since Dan has been out to a modern production line? You can scale down just as easily as you scale up when demand increases. Sometimes demand for a certain product never returns..so? Have you guys ever heard of retooling? In the worst case the factory is paid off or closed down and here is a… Read more »
Pete
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Greg: You have the quotation literally and not in context, what is the point of doing that? You really think factories can be easily retooled? A car factory becomes paper mill? And how many mills would we really need? The OVERALL production of goods (ie volume) needs to decrease…because there is LESS ability to purchase those goods. We could make 10 million factories in Australia, and what exactly would be produce in so many factories? What does the world NEED that it cannot get already? The answer is nothing much*. If you read this site and still think there is… Read more »
beyondtool
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Abc was claiming the government have finally abolished the first home buyers grant. It will not be renewed next financial year. So yeah, expect the last minute suckers to lift prices for a month or two longer and then the house price crash should start to hit around October this year.

Also looks like gold is on the way back up, I was going to buy in this week, but it’s jumped on me so I’m not sure if this is another bump or the start of a large upwards trend..

Dan
Guest

beyondtool – the housing correction will be more of a crumble than a crash initially. The right thing (a sharp and rapid fall to the bottom) won’t happen because the govt is shifting the goalposts .. the mortgage support scheme will mean people effectively won’t be allowed to default if they lose their jobs (for 12 months), which will prevent those houses going to market early. It’s all crazy really. I personally can’t see how anyone is benefiting from all this except for the banking sector.

Greg Atkinson
Guest

Dan: “It’s all crazy really. I personally can’t see how anyone is benefiting from all this except for the banking sector”

How about the people not tossed out of their homes? I would guess they do not mind steps being taken to help them out with their mortgages?

Ned S
Guest
Average mortgage is up from about from about $230,000 in March 2008 to $280,000 in March 2009 – Which is good for builders and banks but not so good for home buyers I’d say. The real aim of FHOG (I felt) was always about stimulating the building and allied industries and helping out the banks. (Mr Rudd may well have still had a few quiet concerns about the Oz banks back when the increased FHOG was announced – Despite any public noises he was making to the contrary – I felt.) A fair bit of the FHOG money was probably… Read more »
Ross
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Pete, we don’t have much in the way of discretionary trade production in the bigger scheme of things. Like the rest of the anglophile world what we have in excess is discretionary services production. Some of those services are import trade shop fronts & retail. So mass short selling of malls is overdue. The major drag on industrial stocks has not only been the prospect of a collapse in their markets but moreso has been funding & covenant related (and subsequent capital raisings dilutions) and the merchant bank book traders shorting based on market rumours on those minimum equity covenant… Read more »
Greg Atkinson
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Pete, I wrote a reply but it is in the queue I guess…maybe because it had a link to a stock tip by one of the DR crowd a few years ago?

Pete
Guest
Dan: You said: “I personally can’t see how anyone is benefiting from all this except for the banking sector.” Some people might benefit, if they can get another job and ‘somehow’ keep their home (although they’ll have a whole heap more to pay). I do agree with your point though. If it was truly a system to “help” people, then the interest rates charged for that year of unemployment would automatically revert to a cost basis only (eg, wholesale prices). Ultimately the unemployed person, assuming they get job, would have to pay back the years interest, PLUS interest on that… Read more »
Pete
Guest

Ross:
“…the investment institutions remain norties index fixated & kidding themselves that the financials will retain over 32% of the ASX…”

Couldn’t agree more. It appears the imbalance went on for long enough for the majority to consider it the norm.

We’re funny creatures us humans…we take the smallest trends and extrapolate them into the future without considering ‘why’ they may or may not continue.

Greg Atkinson
Guest
Pete in a nutshell my point about factories/capacity is: 1. Factories close down all the time or are reconfigured when demand drops or products are terminated etc. It the demand never returns the factory is knocked down or turned into apartments etc. I have done a few audits on production lines so I know a car plant will probably not become a paper mill…I never even suggested it. I have not sat behind a desk our entire working life..so give me a little credit please :) 2. People seem to think that China has added a lot of extra global… Read more »
Ned S
Guest
Greg Atkinson – Re “Am I the only one around here that does not think the planet is about to implode?” My thought is that there has to be demand – By people who can pay – Maybe they’ll be Chinese. Maybe they’ll be Indian. But the way things are shaping up, not nearly so many of them will be from the developed Western nations as in the past – Unless the West becomes real smart or real competitive. Our last innovative idea (AAA Rated Toxic Financial Assets) seems to have been a bit of a flop. And even though… Read more »
Guy
Guest
Greg, Hate to tell ya that though well healed both me and my Chinese relations in the US, Taiwan, and elsewhere are pretty well stretched; we aren’t Warren Buffett. Before the peak of the housing bubble we sold a rental several years ago and went multi-residential. Putting 1/2 down and living within our means is what keeps us out of trouble. If we still had the unit we sold and not the what we have, we would be “shopping” cash in hand as well as with approved credit While at it, I want to harraunge my idiot govenment. You can… Read more »
Greg Atkinson
Guest
Ned S…I am with you there 100%. Maybe this is where I am getting misunderstood because I am talking about the global economy…I am not saying Oz will do well, or the U.S for that matter. But what we are probably seeing is the erosion of U.S. financial dominance and China possibly cementing itself on the list of big guys. (as opposed to a country that churns out plastic thingo’s) Also Japan might come out of this okay…if you have been watching the business news then you will see that Japanese companies have been buying stakes in a lot of… Read more »
Gerry
Guest
Homeowners in distress without employment are people. Any assistance is welcome and the 12 month period of some leniency as temporary as it may be in a deteriorating economy is still in lieu of alternate rental you have to pay, allows some families to finish schooling in the area for another year,allows some to consolidate with family members and find a way through, take in tenants etc. To suggest nobody can benefit except the banks is cynical to the extreme and suggests some on this site would not give a thirsty dog a drink if it was not a good… Read more »
Ned S
Guest
Greg Atkinson – Re a narrowing of the wealth gap between the West and the East – I do believe that is the unavoidable mid to longer term outcome. (Happening already to a degree – But with any estimate on time frame for completion being way outside the range of my personal guestimation inclinometer – But certainly decades rather than years if I HAD to take a punt? The Chinese are a patient people.) Futher re narrowing of wealth gap: I think of lot of the West is in denial mode. And that denial is being encouraged by Western politicians… Read more »
Ned S
Guest

Gerry – Re mortgaged Homeowners not being allowed to be tossed out in very tough times – If my recollection of some past reading is correct, Oz introduced legislation to that effect in the 1930s. It has a potentially good healthy humanitarian aspect to it. Plus I doubt the banks really wanted the houses back at those depressed price levels anyway. About as close an approximation as the nation could get to a Win/Win situation in pretty difficult circumstances perhaps?

Greg Atkinson
Guest
Ned S – I think you are right about the West being in denial mode. I think the thought of power shifting to Asia is a bit hard for people in the West to handle, but some power is heading in that direction and it is a good thing. Better to have people sharing the dream then looking across at you with envy. I also see a lot of coverage about Japan in the western media that is sort of dismissive of the country, yet Japan is still the world’s second biggest economy and has done this with few natural… Read more »
Dan
Guest
Gerry – I agree that it’s unjust to simply throw an innocent family out of its home, whether it’s a tenanted property or mortgaged. But people with mortgages are not homeowners – that’s a fallacy. People who ‘buy’ a flat screen TV at Harvey’s on credit don’t own it until it’s paid in full. This is what is so wrong with the picture as I see it. Governments keep supporting the credit/debt/mortgage model, from which banks benefit and not people. Sometimes I just wish banks were prevented from ever issuing another home loan, and also prevented from ever charging interest… Read more »
Ned S
Guest
Greg Atkinson – Your thoughts in the “The U.S. auto industry bailout and some inconvenient truths” article line up with my read on history. The US also had the advantage of being the holder of the global reserve currency (and still do) – Although it is apparent that can have its downside as well – Leastways if one has not kept fully on top of the responsibilty that comes along with the advantage. Tough problem for America – She wants to keep the advantage long term of course. But would also obviously like to see the USD drop to make… Read more »
Ned S
Guest
Dan – Somehow at the real heart of all this problem with the banks and the government and the current costs of housing and the anger being felt by younger Australians who can’t afford to buy them and the fear being felt by older Australians about their retirements, I have a very strong suspicion that the real root cause of the problem lies with the fact that Western governments insist on targeting positive inflation year, after year, after year. Rather than targeting no inflation and no deflation on average. Targeting positive inflation devalues our money of course. Yet governments say… Read more »
Greg Atkinson
Guest

Ned S – it all comes down to the belief that inflation indicates the economy is growing and that we the people, like the economy to be growing because we are told more money will come our way. So governments that want to be re-elected feed the masses what they want. In Roman days the Emperor use to toss bread to the people and hold lavish games and the plebs were happy. Today it is the first home buyers grant, baby bonus and cash handouts etc that keep the public content it seems. Sadly we are rats on the treadmill.

Ned S
Guest

Greg Atkinson – Thanks. I had a sad and sorry suspicion it just might have been that basic. How truly annoying.

miguel
Guest

…b’but my darling, i’isn’t that dress a little t’too low cut for a ch’chilly night like this ?…si papasito, but to get a cab real fast, look, i need to lower my intersects rape to attrack more busy and that do not make sense? in light of current resource availability of taxi car, to make for us so fast…?..!…b’but this could cause a crash, it is risky…is she WRONG for you to like me boom-bust cycle no more…?…

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