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December 31, 2006

"Price Stability" in Inflationstan
by Paul Tolnai

Ludwig von Mises famously said "There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of the voluntary abandonment of further credit expansion, or later ..." But this can't be true, can it? Can't we just simply stop the credit expansion and end the cycle of inflation without the referenced "crisis"? Unfortunately, it isn't that simple? Like a treadmill gone berserk, one either keeps running faster or jumps off and accepts a crash.

Assets are items that generally have a rate of return associated with them and it is that rate of return that determines the value of an asset. Rising asset prices with no corresponding increase in their rate of return are an excellent indicator of inflation. Rising prices are no more inflation than a rising temperature being measles. Price level and temperature are just indicators. Inflation is monetary expansion - pure and simple. Well, you say, if that is so, why not just stop monetary expansion, thereby ending inflation and end all this talk of inevitable collapse and so forth.

Well, since prices are set at the margin and increasing asset prices can arise from excessive monetary easing (aren't I being diplomatic), then the excess money just went to facilitate the increase in price of only those assets involved in the most recent transactions. That is to say, if there are 100 items in an asset class, and y dollars facilitated 20 of those asset items clearing the market at a price 25% higher than before, money must continue to be increased to facilitate the higher price for the rest of the items in the asset class. Otherwise, there simply won't be enough dollars available for the rest of the items to clear the market at the new higher price. Prices being set at the margin is a two way street. In other words, the asset class would have to find a new equilibrium within the overall economy by either decreasing in price, or letting all the other prices inflate to the new equilibrium level.

I understand that may be mumbo jumbo for some and it might just be helpful to see some hard numbers versus dealing with abstract concepts. Therefore, I am going to pound in the point with some gory details.

#	Year	Price	% Incr.
7	1999	$ 100,000	0%
7	2000	$ 100,000	0%
7	2001	$ 105,000	5%
7	2002	$ 115,500	10%
8	2003	$ 132,825	15%
10	2004	$ 159,390	20%
12	2005	$ 199,238	25%
9	2006	211,192	6%
7	2007	211,192	0%
Figure 1

Allow me to take you to a not so distant land known as Inflationstan. It is a country with only one main town of 100 households whose domiciles are all similar. For years the residents enjoyed price stability and each domicile was worth $100,000. Typically, in any given year, 7 properties exchanged hands.

Come year 2001, Inflationstan's central banker, Ahmad Greenspanijad, decided that it was vital to begin increasing the money supply (it's all very complicated, you see, and these decisions are really best left to government experts).

Because part of the increase in the overall money supply wound up in the mortgage sector, the 7 properties that sold in 2001 were able to clear the market at a higher price because there was more mortgage money available per house sold and the increase in the supply of money to be lent out relative to the demand caused the interest rate on the mortgages to decrease as well. Figure 1 displays the number of transactions and the prices for each year.

Fortunately, for us, Inflationstan is a relatively primitive land, and the lending institutions only lend 80% loan to value on a fixed rate basis. ARM's, option ARM's, no money down, interest-only loans as well as negative amortization loans are all unknown there.

Over time, it became increasingly difficult for the citizens to save up the ever increasing necessary down payments and demanded an end to the inflation from the new central banker, Bernullah ben Ahmad (hereinafter just "Ben"). Ben was interested in placating the citizens, but ordered up a study done because Ben had a deep seated phobia of the worst of all economic nightmares - d e f l a t i o n. Below is part of the report.

CENTRAL BANK OF INFLATIONSTAN
Analysis of Mortgage Sector
Year	Mortgage	# at	Total $ Amount
1999	$ 80,000	100	$ 8,000,000
2000	$ 80,000	100	$ 8,000,000
2001	$ 80,000	93	$ 7,440,000
	$ 84,000	7	$ 588,000
2001	Total		$ 8,028,000
2002	$ 80,000	86	$ 6,880,000
	$ 84,000	7	$ 588,000
	$ 92,400	7	$ 646,800
2002	Total		$ 8,114,800
2003	$ 80,000	79	$ 6,320,000
	$ 84,000	6	$ 504,000
	$ 92,400	7	$ 646,800
	$ 106,260	8	$ 850,080
2003	Total		$ 8,320,880
2004	$ 80,000	71	$ 5,680,000
	$ 84,000	6	$ 504,000
	$ 92,400	5	$ 462,000
	$ 106,260	8	$ 850,080
	$ 127,512	10	$ 1,275,120
2004	Total		$ 8,771,200
2005	$ 80,000	61	$ 4,880,000
	$ 84,000	5	$ 420,000
	$ 92,400	5	$ 462,000
	$ 106,260	7	$ 743,820
	$ 127,512	10	$ 1,275,120
	$ 159,390	12	$ 1,912,680
2005	Total		$ 9,693,620
2006	$ 80,000	57	$ 4,560,000
	$ 84,000	4	$ 336,000
	$ 92,400	4	$ 369,600
	$ 106,260	6	$ 637,560
	$ 127,512	9	$ 1,147,608
	$ 159,390	11	$ 1,753,290
	$ 168,953	9	$ 1,520,581
2006	Total		$10,324,639
Figure 2

One school of technocrats decided that to stop inflation they had to stop monetary expansion - and hence, no increased flow of funds into the mortgage sector. They were determined to stop inflation cold! They projected NO increase in sales price for 2007. The price would remain the same as in 2006 - $211,192, which after all represented a 111% increase in home prices in just a few short years. Enough was enough.

They projected that the market would return to a turnover of 7% of the housing stock (7 homes selling) with a stable price. Furthermore, they analyzed the projected mortgage needs. Below is that projection.

2007 Sales Projection & Mortgage Funds Retired
#	Amount old Mortgage		Funds Retired
3	$ 80,000	old	$ 240,000
1	$ 84,000	old	$ 84,000
1	$ 106,260	old	$ 106,260
1	$ 127,512	old	$ 127,512
1	$ 159,390	old	$ 159,390
7	Total $ Retired		$ 717,162

They projected that of the 7 anticipated sales, 3 would carry an older mortgage with an amount equal to $80,000, and 1 each as listed above. The amount of mortgage funds retired by extinguishing the older mortgages came to $717,162. Since, price stability meant no increase in the money supply, and hence no increase flow to the mortgage sector, the funds retired would be recycled into new mortgages. That would leave an amount equal to $102,452 for each of the contemplated transactions. Now with a loan to value ratio of 80% , that would translate into a selling price of $128,065 !

Ja Allah, that can't be! That would represent a full 39% decrease in selling price over the projected stabilized 2006 price of $211,192. And without even decreasing the money supply! Ben would have their heads, for with Ben, nothing was worse than deflation! Notice that in the mindset of Inflationstan, an increase in the average selling price of an asset from $100,000 to $128,000, in a few short years, meant deflation. Just like in Inflationstan's bureaucracy, where an increase in their budget allotment to $700,000 from 600,000 a year meant a budget cut, if a new budget of $750,000 had been anticipated.

Yes, there existed a few fanatical voices, belonging to the gold dinar school who advocated a price regime where price stability meant the asset price would essentially remain the same, or vary according to the asset's anticipated return,- but its leaders were locked up long ago. Nevertheless, the unitary Vizier of Inflationstan, Ghazi Walid Bashar, was taking new, stepped-up surveillance measures against these unpatriotic folks.

Quickly the technocrats figured out how much new mortgage money would have to be created in order achieve "price stability", in Inflationstan speak.. They figured that each of the contemplated sales would need a new mortgage of $168,953 (80% of a "stable" $211,192). Below is the full calculation:

In short, $1,182,674 of new mortgage money would be needed for the 7 anticipated sales, and $ 717,162 would be retired, leaving a net increase of mortgage money needed of $465,512. Since the mortgage base at the end of 2006 was $10,324,639 (see Figure 2), that would translate into an increase of mortgage sector funds of 4.5%. Now since Inflationstan had a primitive economy and the percentage of funds flowing into each economic sector never varied, that would mean that the money supply would have to increase by 4.5% overall in order to provide the funds necessary just to achieve "housing price stability". But that was higher than Ben's guideline. So they tested the elasticity of the price with respect to increase in the money supply. Maybe, just a 3.5% increase tweak wouldn't hurt so badly. They calculated and found out that a 3.5% increase in the mortgage funds would result in a 9% decrease in home prices over the 2006 price. That was it, if they valued their heads, 4.5% would be the recommendation.

Another group looked at the larger picture. Nine homes sold for $211,192 in 2006 and therefore had the maximum mortgage of $168,953 and the other 91 homes all would have mortgages of lesser amounts. Over time, these homes would need to clear the market at $211,192 in order to achieve "price stability", and at a normal sales rate of 7 per year, that process would take 13 years. The total amount of total mortgage dollars needed over the 13 years would be $15.4M, but the base in 2006 was, again, only $10,324,639 (see Figure 2), so an increase of over $5M of mortgage funds would be needed just to achieve housing price stability. Thus a 3 + % yearly monetary increase would be needed over the entire 13 year period! Since it was not possible to target the increase to a particular economic sector, the core rate of inflation was established for the next 13 years - again just to achieve "price stability" in the housing sector. (Interestingly, had this "name your price, I'll buy it" asset price inflation game gone on for just a few more years, the % of monetary increase "required" over the next 13 years would have gone up dramatically. Play with the numbers and amaze yourself. Inflation is, after all, a compound interest sort of phenomenon).

The alternative is, going back to the quote by von Mises, "whether the crisis should come sooner" and let the housing sector sink (to only a 28% increase in average selling price). But with Ben mightily spooked by deflation (actually real price stability), we shouldn't expect to be seeing gold dinars back at $550 an ounce anytime soon.

Obviously the American economy is far more complex than the model I've laid out here and many of the assumptions I've made are way too simplistic and do not even touch upon the dynamic relationships of the different sectors of the economy and the disharmonics that reverberate throughout those sectors by inflation. But the point of this exercise wasn't to develop some sort of economic model. Rather, it was simply to put some hard numbers behind some abstract concepts to help those readers who may be new to Austrian economics. On the other hand, the above discussion makes its point without needing to broach exacerbating issues such as re-financing with "to the max cash take-out", or creative purchase money financing for the credit challenged or just plain daring members of the public, or delinquencies, foreclosures, etc.

What this discussion hopefully does show, is that once an economy gets on the inflationary roller coaster, it can't get off until the ride's over, unless, of course, you just hit the brakes and let everyone climb back down to terra firma. And in Inflationstans of old, some of the rickety coasters never made it back to the loading platform. So whatever the inconvenience, the "crisis" of disembarking would clearly have been the preferred choice for many.

Paul Tolnai

Paul Tolnai, MBA USC (email) is President of Drovers Financial in Fort Worth, Texas.

Copyright © 2006-2008 Paul Tolnai

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