The Deflating Bubble

Mises Institute ^ | 6/22/2009 | Doug French

[sickoflibs]

There is an epidemic of bankruptcies: Circuit City, Sharper Image, Goody's, Gottschalk's, Comp USA, Levitz Furniture, Chrysler, GM. Not to mention all the local businesses that don't make the news when they close up shop. And the rash of corporate bustouts is far from over according to consulting firm Bain & Company, who predicts nearly 100 large ($100 million or more in assets) corporate bankruptcies by next year.

We're in a period of severe losses — a cluster of errors, as Murray Rothbard described it — with thirty-seven banks having failed already this year, and many more to come.

But as gruesome as the economic news sounds, Rothbard explained that this is the recovery.

The liquidation of unsound businesses, the "idle capacity" of the malinvested plant, and the "frictional" unemployment of original factors that must suddenly and en masse shift to lower stages of production — these are the chief hallmarks of the depression stage.

Many would like the boom to continue "where the inflationary gains are visible and the losses hidden and obscure," Rothbard wrote. "This boom euphoria is heightened by the capital consumption that inflation promotes through illusory accounting profits."

But the boom is where the trouble happens — when resources are directed into malinvestments and distortions occur — and trouble we've had this past decade with a Capital T. The M-2 money supply increased 53% since year 2001, while at the same time total bank loans doubled and bank real-estate loans increased over 150%. The mistakes of bad entrepreneurs have been hidden, employment was directed to wasteful and unneeded occupations, unsound projects were built and business risk was ignored.

"The boom produces impoverishment," wrote Ludwig von Mises in Human Action.

But still more disastrous are the moral ravages. It makes people despondent and dispirited. The more optimistic they were under the illusory prosperity of the boom, the greater is their despair and their feeling of frustration. The individual is always ready to ascribe his good luck to his own efficiency and to take it as a well-deserved reward for his talent, application and probity. But reverses of fortune he always charges to other people, and most of all to the absurdity of social and political institutions. He does not blame the authorities for having fostered the boom. He reviles them for the inevitable collapse.

Many bankers continue to contend that their banks are sound, protesting that they didn't make any subprime loans like those big Wall Street banks. But the cluster of errors doesn't contain itself to one asset. Houses don't suddenly appear. First, land is purchased. Then that land must be entitled — permission from local government must be obtained to build what the owner wants on the property. This is a lengthy process than can in the best case take months and in the worst cases take decades. Infrastructure improvements are then made and finally houses can be constructed.

So, low interest rates spur consumers and investors to buy houses — in some cases creating housing shortages and exploding prices, which, in turn, cause developers to buy land and begin the lengthy development process just described. After money supply increases by way of credit expansion, businesses malinvest by "overinvesting in higher-stage and durable production processes," Rothbard explained in Man, Economy and State.

Real-estate developers by and large use debt financing every step of the way from when they buy the land to when they start construction. In the past, banks traditionally shied away from making land loans. But as the market overheated, more and more banks got in the land-loan business. Land lending is inherently risky because land doesn't produce income and gaining government approvals in a timely manner is often problematic: land is many months from being converted to a use that is salable to the typical consumer. Lending for the construction is the least risky, but still the homes must be sold to pay off the loan.

Guaranty Bank of Austin recently demolished 16 new and partially built homes in Victorville, California. The cost of finishing the development exceeded what they could sell the homes for despite four of the homes already being complete. In early 2008, these homes were selling for $280,000 to $350,000 in the bedroom community 50 miles from LA.

The Victorville demolition is one of the most dramatic ends to a bad bet made during the housing boom, but abandoned developments have become an all-too-common sight in California. Nearly 250 residential developments totaling 9,389 homes have been halted across the state, according to one research firm.

And the residential meltdown is nowhere close to being over. There is reportedly a million-house overhang in the market nationwide. But misguided attempts by government are keeping home prices from correcting to affordable levels. "If an investor could purchase a home and rent it out for close to breakeven," real-estate broker Mike Morgan writes in Barron's, "we might be getting close to the bottom. But we are nowhere close to that level in most critical markets."

Morgan points to a California program that offers a $10,000 tax credit for buyers of new homes. Thus, encouraging the building of redundant houses, at the same time homes are being bulldozed in Victorville. The annual sales pace is 300,000 homes, yet 500,000 new homes are being started that will just add to a bloated inventory.

"All of this government intervention will only spawn new malinvestments and later depressions."What Morgan calls the back half of the residential-real-estate hurricane will destroy bank balance sheets. "Our experience with banks' selling REOs is they realize about 50% — 75% of what they initially think they will get," explains Morgan.

But the current crisis doesn't end with residential real estate. Commercial-real-estate developers follow roof tops. When they see homes being built, they forecast that those homeowners will need places to shop and places to work — so the residential-construction boom inevitably leads to a commercial-property boom: office and industrial buildings as well as shopping centers. All those new homeowners will need to buy everything from groceries to garden hoses. Plus, new title company, mortgage loan, construction, and other real-estate-dependent jobs are created, meaning more office and industrial space will be required.

And lenders were there to embrace their developer customers' dreams and supply the credit. Commercial mortgages and construction loans exploded in the boom years. "Tiny cap rates, feckless lending and willful ignorance were par for the course in those years when the market could hardly seem to walk a straight line," writes Grant's Interest Rate Observer.

But with the finding of new tenants difficult and the rash of bankruptcies of current renters, commercial-property values are plunging. The Moody's/REAL Commercial Property Price Index has fallen over 21 percent since it peaked in October 2007. And the folks at Deutsche Bank see price declines of 35 to 45 percent and maybe more in commercial property, due to the large number of loans coming due between now and 2012 that will not be able to be refinanced. Not only are loan delinquency rates up and rents down, but the go-go years of aggressive loan underwriting are gone. The interest-only, high-loan-to-value-ratio loans that drove capitalization (cap) rates to the five percent range are history. Property buyers who are required to put more money down will offer significantly less for the same net operating income to achieve the required return on investment.

"Volume [of real-estate transactions] in the Americas has fallen hardest with the first quarter 2009 sales down 84% year-over-year and 56% from the fourth quarter of 2008," according to REAL Capital Analytics.

This spells further trouble for the small community banks that make up just 28% of the banking industry's total assets but are responsible for about 60% of the nation's commercial-real-estate lending.

So while many bankers contend their institutions are sound, bank attorney Gerald Blanchard told US Banker, "Across the U.S. right now there are still a fair number of community and regional banks with significant problems."

"There are banks in the sunbelt and other areas sitting on developed lots — lots that have been bulldozed, wired, and paved but not built on — worth 15 to 20 cents on the dollar," Blanchard says. "Those institutions with heavy investments are suffering big losses and big hits to capital. So yes, we will continue to see failures." Blanchard went on to say that newer banks will not be lending to builders and depending on brokered deposits to grow their banks, as they did in the boom.

A contraction of credit and liquidation of assets is exactly what would complete this recovery. Failing real-estate prices, business failures, and high unemployment signal that the economy is desperately trying to heal but the Fed is fighting valiantly to re-inflate, increasing its balance sheet 140% just to generate a 14% increase in the M-1 money supply. The folks at Grant's estimate the federal response to the current downturn to be 12 greater than that to the Great Depression, which prolonged that recovery for a decade. However, all of this government intervention will only spawn new malinvestments and later depressions. "It should be clear that any governmental interference with the depression process can only prolong it," explained Rothbard "thus making things worse from almost everyone's point of view." Further delay of the readjustments will only lengthen the depression, postponing complete recovery indefinitely.

"The larger the scope of malinvestment and error in the boom," predicted Rothbard, "the greater and longer the task of readjustment in the depression." Government intervention on all levels guarantees that this will be a very long, bumpy recovery.

[sickoflibs]

I have seen Dent on FNC many times and he sounds credible. He also recommended buying commodities.

The big threat is that the rest of the world figures out a way to live without our consumption, and No they wont be dependent on Obama green jobs technology, they will just buy cheap (to them, not us) dirty carbon energy like oil instead.

[Atlas Sneezed]

There is an epidemic of bankruptcies: Circuit City, Sharper Image, Goody’s, Gottschalk’s, Comp USA, Levitz Furniture, Chrysler, GM

---

Which of these companies doesn’t primarily make or sell crap?

They all deserved to die.

[Atlas Sneezed]

The one really big bankruptcy that isn’t mentioned here is the federal gov’t.

---

No, they’re backed up by the full faith and credit of the jack-booted tax collectors who will steal the livelihood of present and future generations of enslaved Americans.

[Southack]

"12 Ways To Prepare For The Next Great Depression "

Lousy advice in that article! OK, selling your real-estate would have been good advice in 2005, but today it's already too late.

We've still got time to sell some stocks, though. Get liquid!

This is a liquidity crisis, inasmuchas having global over-production means a reduced ability+desire to lend and a heightened awareness of the value of having cash-on-hand instead of wealth tied up in physical assets.

[wafflehouse]

FDR confiscated gold and devalued the dollar in 1933. that is not deflationary.

inflation is not symptom of the problem or the recovery, it is the guaranteed government response to the problem.

[Southack]

Wrong. The Great Depression *was* deflationary because home prices and salaries declined in spite of what FDR did.

Nor is inflation easy to create. Japan has been trying each year since 1989 to create inflation. They’ve borrowed and spent more than us.

And Japan has 15% annual deflation right now.

[AAABEST]

“Deflation” is how the markets punish surplusses. We don’t have surplusses in everything, particularly oil and food, however.

But the world has too many houses. Too many factories. Too many shopping malls. Too many cargo ships. Too many airlines.

Where there are surplusses, expect falling prices. Like salaries. See, we have too many jobs worldwide compared to demand.

I would also tend to (like to tend to?) think we would see an initial deflationary cycle first. If that winds up being the case at all, it is highly likely to be temporary for a number of reasons.

• Once those factories, malls, ships and airlines you mention begin to go bankrupt, the supply dynamo will tighten up and there will be less competition, putting upward pressures on prices.

• If energy is cheap, everything is cheap. If energy is expensive, everything is expensive. If energy cost keep rising for any number of reasons, upward pressure on prices.

• Money (not only fed reserve notes, but nearly all Western currencies) is being added to the equation in historic proportions. Unless there is someone in some secure, undisclosed location burning euros, dollars and pounds, that eventually MUST devalue money and put upward pressure on prices, at least in a nominal way. Those cows have to come home eventually.

Above are only a few reasons. Being that Southack is probably bored from reading all of my mini-novels to him, so I won't elaborate any further. Suffice to say, if we see deflation at all, it's likely to be short lived.

Right now business and industry is being savaged and has been for the past year or two, but generally speaking, can any of us really say we've seen deflation? It's great time to buy a house, and a somewhat okay time to buy a car, but on a macro level, prices are not coming down across the board - in fact they're going up. We should be seeing deflation now if the rule that says commercial and industrial slowdown = deflation were hard and fast.

I know from corresponding with you (Southack) that the following is not what you contend, some will say that inflation only happens if the economy heats up, and they will also say that the converse is true, the economy slowing down will always bring deflation.

Logically and historically speaking, neither is necessarily true. An overheated economy is only one of many factors that may cause inflation. Inflation can happen in a lousy economic environment. Respectively, a hobbled economy doesn't necessarily cause deflation. I point to Zimbabwe or the Wiemer Republic as only two examples.

[wafflehouse]

did you read my post? i fail to see how any of those three sentences were false. maybe you read too much into it. a depression will feature both deflation and inflation. deflation is the main cure to the problem, while inflation is the government response. ill bet you a hundred bucks that by the time this is over, we will have significant inflation (or dollar devaluation) compared to where we are now.

[Post Toasties]

The folks at Grant's estimate the federal response to the current downturn to be 12 greater than that to the Great Depression,

12 what? Times? Percent? This sentence is gobbledygook.

[Southack]

All of the Baby Boomers want to cash out of their McMansions and move into cheap little retirement condos. As they discover that their giants homes won’t sell, they will lower their prices more and more.

In the meantime, the slowing economy means fewer jobs. That leaves less new money available for consumer buying, and also means that fewer and fewer people can get loans.

The above combine to destroy banks and commercial real-estate as loan volume dries up and fewer people shop at malls.

This is wealth destruction at an unprecedented pace.

It is deflationary to an extreme.

To pretend that somehow the government can raise salaries, raise employment, save commercial real-estate, and make millions of McMansions go up in price (i.e. inflation) is to ignore the death spiral that the current global economy is trapped inside.

[AAABEST]

Nor is inflation easy to create. Japan has been trying each year since 1989 to create inflation. They’ve borrowed and spent more than us.

Japan was using the pre-global economy model, where a country could simply increased money supply and cause inflation in its respective society. However, in this global environment, the rest of the world didn't could care less if Japan needs inflation. Japan, being an exporting nation, can't get more for their cars, electronics etc. than the rest of the world is willing to pay.

If the were trying to create inflation, they were an island unto themselves in doing so.

Now however, EVERYBODY wants inflation. Europe and America needs it for many reasons, not the least of which being to bring the nominal value of depleted assets up, and the make the real burden of debt less painful. China and Asia want inflation. International bankers want inflation. Politicos want inflation because they fear deflation more.

All the right people want inflation, so it will happen.

[djsherin]

***An overheated economy is only one of many factors that may cause inflation***

I hate the term “over heated economy”. They say this is inflationary but at the same time don’t look at the continuous influx of money created ex nihilo (from nothing) by the banking system. The economy isn’t growing; it’s being malinvested and of course it becomes inflationary when the structure of production is distorted and the relative drop in the interest rate signals that there is more capital available for investment than actually exists. Perpetual inflation isn’t necessary for economic growth, and in fact it necessarily sets in motion the eventual bust.

***Respectively, a hobbled economy doesn’t necessarily cause deflation.***

And deflation doesn’t necessarily cause a hobbled economy.

As for what’s going to happen in our current economy, I believe the fed and the feds are dead set against deflation and will do whatever it takes to keep prices rising. There are many deflationary factors to be sure, but the central planners are trying very hard to prevent the necessary corrections in the economy from taking place, and thus trying very hard to cause inflation.

[wafflehouse]

i said nothing about salaries, employment or real estate. The government will inflate or die trying.

[AAABEST]

There are many deflationary factors to be sure, but the central planners are trying very hard to prevent the necessary corrections in the economy from taking place, and thus trying very hard to cause inflation.

Bingo.

ALL of the central planners (international bankers, Western governments) want inflation. They need it to sustain themselves. Therefore it will happen. This isn't "Japan."

It's happening already. Despite the fact that the few who are qualified to borrow money won't (and the rest can't), interest rates are going up. Few are lending, few are borrowing. Few want to "buy" money, yet the price of "buying" money (i.e. interest rates) is going up.

[Southack]

"It's happening already. Despite the fact that the few who are qualified to borrow money won't (and the rest can't), interest rates are going up. Few are lending, few are borrowing. Few want to "buy" money, yet the price of "buying" money (i.e. interest rates) is going up."

That's deflationary, not inflationary. Higher interest rates and a higher cost to borrow discourages borrowing and discourage spending.

Deflation.

[AAABEST]

That's deflationary, not inflationary. Higher interest rates and a higher cost to borrow discourages borrowing and discourage spending

I thought after I posted that, that my thinking would seems backwards.

What I'm conteding is that higher interest rates are (likely) a bellwether of inflation or coming inflation. Think the Carter years. Interest rates went through the roof yet prices were sky-high.

I went to Toy-R-us today and it cost me $40 for a puzzle, a DVD and 2 boxes of crayons - all made in China.

Ask yourself, despite high unemployment, crummy retail sales, low money velocity and failing businesses, in your neck of the woods, are you paying more for everything or less?

See what I mean?

[Southack]

Higher interest rates, because they are deflationary, can be used by central banks to fight inflation.

Interest rates have been lowered, however, worldwide because central banks are fighting deflation. Poorly.

The world is still stuck in a deflationary death spiral.

[Southack]

"I went to Toy-R-us today and it cost me $40 for a puzzle, a DVD and 2 boxes of crayons - all made in China. Ask yourself, despite high unemployment, crummy retail sales, low money velocity and failing businesses, in your neck of the woods, are you paying more for everything or less?"

30 years ago a single video disk would have cost you $150.

Deflation.

High end shoes and suits are half off. Deflation.

Computers and watches are cheaper. Deflation.

Cell phones and phone service (Vonage!) is cheaper. Deflation.

Satellite TV is cheaper than cable. Deflation.

High speed internet is cheaper today than dial-up was in 1990. Deflation.

Homes are cheaper today. Rents are lower today. Salaries are lower today.

Deflation.

Wal-Mart sold $140 Billion worth of groceries in the past 12 months by being cheaper than grocery stores.

Deflation. Limes are 15 for $1. Ears of corn are just $0.27 retail.

Deflation.

You can download new release movies for $5, or rent all of the movies that you want to see each month (Netflix!) for $10.

Deflation.

Cars are cheaper, aircraft are cheaper, and boats are cheaper today than in 2007. Used and new.

Deflation.

Prescription glasses were $300 to $800 last year.

This year you can get them online from Zinnioptical.com for $30 to $80.

Deflation. Even airline tickets are cheaper this year. Deflation.

[AAABEST]

The world is still stuck in a deflationary death spiral.

But Southack, if that's true, why then is the price of everything (save for a few anomalies) going up? The price of money, wine, toys, food, energy, commodities - nearly everything.

Am I living in some alternate universe, or are you seeing this where you live also?

[Southack]

"But Southack, if that's true, why then is the price of everything (save for a few anomalies) going up? The price of money, wine, toys, food, energy, commodities - nearly everything."

Nope. Wine is cheaper. Two Buck Chuck. Toys are cheaper.

A higher price for money is also *deflationary*.

Energy was not in surplus. That's like having the lambs blood on your door during Passover. You get skipped.

Commodities are a mixed bag. Up from their lows, but down from their highs last year.

...and none of that is as significant as the major items like homes and salaries. Both are down. Deflationary.