In my previous post “The real losers when the housing bubble bursts”, it appears that many people did not understand what kind of inflation that I’m talking about. Apparently, you don’t read my past posts, and are not familiar with were I stand on the US economy. I’ve pulled together three charts which I thought must be seen by everyone if you are reading any other blogs. The first chart is on the historical inflation-adjusted value of US housing prices. The second chart is what US Fed Reserve has been doing to our money supply. The third chart shows you how Fed is using housing market to prop up the economy.
On the above chart (originally by Robert Shiller and thanks to financialsense), the first question that you may ask is whether the housing prices will go back down. You may argue that this is a new era, and it just won’t fall. However, human history is littered with bubbles that went bursted. Every time, the participants believe in the new era argument, and every time we may do have a new era, but the “new era” becomes old, and newer things come. The prices eventually go back to historical norm. This is true for the South Sea bubble, 1928/29 US stock market bubble, Japanese bubble in 1989, NASDAQ high-tech bubble in 2000, etc. So many times, people have said, “this time is different”, and yet things are more of the same than you can believe.
I believe in learning lessons from the economic history. Past is the only thing that we can rely on in the attempt of divining the future. I believe in the historical out-performance of stock markets at , and therefore I have fully expected a lackluster performance of stock market since year 2000. It is my expectation too that housing prices will revert back to the past norm.
The second question that you may ask yourself is that do you really believe that the housing prices in general will fall 50% outright in the terms of nominal prices? If it does happen that way, it will do a big damage to the US economy for sure. What is more likely in my opinion is that the absolute prices will not fall that much, but the inflation-adjusted prices will nevertheless fall fully by 50%. The evidence is in what US Fed has been doing in chart #2, and what they will be doing, and what they don’t want to tell you and me. What does that mean to you and me? It means that the inflation will be higher than usual almost for sure.
If you use 200% as the peak in the chart #1, and assume that it will go back to 100%, then the amount of fall in absolute prices, must be compensated by the amount of inflation. Let’s assume a fall of 25% in the absolute price. In that case, total inflation must be 50% over that period, since 200% * (1-25%) / (1 + 50%) = 100%. How long the housing prices will deflate is hard to say? If the inflation-adjusted price bottoms in 6 years, then the previous numbers are telling you that in the next 6 year, US housing prices on the average fall 25% in absolute prices, but the inflation for the next 6 years will be compounding at 7.0% (to reach a total of 50%). You can use any other sets of number, and crank out a different scenario. But I think housing prices on the average will fall, and inflation rate will be high in general.
The “smartest” player in all these is of course US Fed Reserve. To avoid to be caught in action and seen in inflating money supply to create inflation, US Fed has stopped publishing M3 money statistics right before Bernanke takes over from Greenspan. They know very well that if all their repurchase agreements (repo) are exposed, and M3 money statistics is exposed, US dollar exchange rate will start falling like a rock. So instead of letting everyone know what they are up to, they want to operate in dark. Other governments around the world are not stupid either, and have been inflating their own money supplies at a heightened pace to combat the fall in the $US and maintain a competitive export business. But you will never hear from the government or the Fed that “hey, fellow citizens, I just printed another 10 billion US dollar today freely for the profligate US government to use, but will dilute the values of all of your US dollar based assets.”
Certainly, their intent in all of these is “benign” for the US as a whole and to save all the debtors, whether it’s consumers or US government. When the real inflation-adjusted value of US dollar is reduced, the real value of debt is also reduced. While I don’t know how smooth their operation can be, but historically government’s interventions in the capitalistic system only generated bigger waves of unbalances. The recent lowering of interest rate down to 1% is probably the best example. Yes, US Fed saved the US from any setbacks from a high-tech bubble, by simply creating the biggest housing bubble in the US history. I don’t know where all of these will end, but I think hyper-inflation may be likely towards the end.
So who may be the real losers in all these mess (that are yet to happen)?
I try to look forward 10 years plus. I do know for certain that if we do reach such bottom, I will not be pessimistic at all. At such bottom when I look forward 10 years plus, I will be more optimistic than ever, because after cleaning up, it will be prosperity awaiting for us. History teaches us that things go through cycles instead of a linear development. From excess to shortage, and from shortage back to excess. I try to take the contrarian view to plan and prepare for my future.
P.S. Here is the chart that shows housing market is becoming the US economy. One day if this trend keeps going (when housing reaches 100% of the GDP, wrong, just wasn’t thinking straight) , will everyone become a realtor, and have the illegal immigrants to do all the rest of work, from house cleaning to high-tech R&D, 
? Sources taken from www.prudentbear.com.
