Losing breath before the bubble is blown

Paul Krugman, economist and writer for The New York Times, has again written a piece that exposes the "housing bubble" ("That Hissing Sound") that is occurring in the United States.

Krugman's analysis is compelling - but then, with me he's merely preaching to the converted. The simple fact is that US house prices are unsustainable, and the market is ready for a big fall.

Interestingly, the title of his piece indicates the problem with such a bubble. While a stock price bubble can suddenly go BANG! and drop in one day, a housing bubble is different, since the buyers and sellers operate in different ways. A housing bubble, according to Krugman, never pops, it just slowly deflates like a balloon with a small hole in it. Nevertheless, it is still a bubble.

Sadly, Krugman's piece offers nothing more than a description of the events and a sort of "I-told-you-so attitude". Naturally Krugman is operating within his own economic framework, which does not offer much in terms of a solution.

Krugman laments the fact that the market has created this investment bubble and is, as a result, driving consumer demand. At the same time he notices that "the personal savings rate has fallen to zero". With the bubble ready to deflate - or deflating already - the US is in a serious economic situation. Once housing prices drop, consumer demand will decrease, and personal savings - a potential safety net - are unable to help.

But a solution does exist. The Federal Reserve should have stepped in earlier to prevent the bubble from forming in the first place. The way it could have done this would be to raise interest rates sooner. Higher interest rates would have choked off the speculative part of the bubble, prevented consumer demand being driven by this speculation, and rewarded people for saving money.

The problem is that the Fed did not have any reason to raise rates - the economy was not over-reaching itself at the time and inflation was within the acceptable range. In other words, although the Fed should have acted, no mechanism within the Fed allowed it to.

But there is a school of thought - of which I am a proponent - that believes that inflation targets set up by the Fed (and other Central banks) are too loose. The reason why a central bank intervenes in an economy is to ensure that prices remain relatively stable - controlling inflation.

But what constitutes the definition of "stable"? While money is like any commodity that can be bought and sold, it is unlike any commodity in that its only value lies in its ability to be offered in exchange for goods and services. This is the basic reason why money was invented so many centuries ago, and why we assign value to a piece of paper (or plastic) that is worth considerably less than the amount that is printed upon it.

In order for money to operate effectively as a unit of exchange, it must retain its value relative to all the things that we use it to purchase. If money becomes too valuable, we stop using it, thus robbing it of its purpose. Deflation is the result. But if money loses its value, then we begin to use other things as a way of determining value - even though it is measured in terms of monetary amount. Money which is losing value is discarded either through investing or through buying. When money loses value, inflation is the result.

The "inflation targets" that the Fed and other central banks run try to keep inflation within an "acceptable" limit - usually no more than 3% and usually no less than 1%. The problem is that, even at that low level, money is continually losing its value. It may not be as bad as the 1970s, but the situation is there nonetheless.

It would be better, therefore, if money had neutral value. Over the long term, its value should never rise nor fall beyond a set level. While the price of various goods and services rise and fall according to the laws of supply and demand, money should have a constant value, thus allowing the market to have a reliable indicator of how much something is worth. Unlike commodities and services, the provider of money - the central bank - can create or destroy money relatively quickly.

In practice, this ends up being an inflation rate of zero. Central banks that follow this policy would have inflation limits set at between 1% and -1%. In order to get to this situation, interest rates would be significantly higher than what they already are.

If interest rates had been higher in the late 1990s, we would have had no dot-com crash. If they were higher now, we never would be facing another major recession set off by housing speculation. And, if they were high now, people would have an incentive to save money. We can only hope that, in the future, we can learn from the mistakes of the present.

From the Osostrian School Department

© 2005 Neil McKenzie Cameron, http://one-salient-oversight.blogspot.com/

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