Time to Panic?
By Arnold Kling
There are a number of deflationary factors behind my campaign to get the Fed to permanently inject new cash into the banking system and deal with the dysfunctional commercial paper market — as well as the general credit freeze-up.
There’s housing price deflation: The Case/Shiller home-price index is off 3.5 percent over the past year.
There’s commodity deflation: Gold prices are off nearly 15 percent from their 2006 highs. Stock prices for materials are off nearly 13 percent since July 19, while metal and mining shares are off 16 percent.
There’s the deflation of loan values, both CDOs and CLOs.
And there’s the deflation of the Treasury bill rate from 5 percent to 4 percent.
The Fed needs to stop this deflation by pouring in new cash.
I’m sorry, but I measure deflation the old-fashioned way, using broad price indexes for the economy, such as the CPI or the GDP deflator. When those start falling, let me know.
Meanwhile, Robert Reich writes,
For the financial market to work well — to ensure fair dealing and to prevent speculative excess — government must oversee it. This mess occurred because nobody was watching. The Fed and other central banks now have to clean it up. But regulators in America, Europe and Asia have to make sure it stays clean. Hedge funds have to be more transparent. Credit-rating agencies must not have any relationship with underwriters. Banks and mortgage lenders should be better supervised. Finance is too important to be left to the speculators.
Again, I’m sorry, but I don’t think that the regulators were any more on top of this than the speculators. Was Robert Reich out there two years ago complaining that the finance industry was making housing too affordable by coming up with too many innovative approaches to supplying credit to first-time homebuyers? I must have missed that column. Yes, I’m sure that some government officials were on top of the problem, but so were some of the speculators. The reality is that unless you want to stifle innovation completely, you are going to have to expect occasional excesses and mistakes.
By the way, thanks to Mark Thoma for the pointer.
Finally, Zimran Ahmed writes,
I think one inevitable requirement of unwinding the housing bubble market is that housing prices have to come down to fall in line with historic trends. In some areas this means very dramatic decreases — maybe 40%+ in real terms? I’m not sure what a “deflated housing bubble” would look like if it did not bring prices back to historic norms.
I’m sorry, but unless by “some areas” you mean areas the size of a 9-digit zip code, we’re not going to see 40 percent declines in house prices.
Think of the equilibrium house price as the equilibrium rent times the equilibrium price/rent ratio. I do not see rents falling in real terms. Housing starts are below the level needed to keep supply in line with new household formation, especially in an economy with relatively low unemployment. So, if anything, rents are going to be drifting up.
The price/rent ratio is a bit harder to judge. I use a 4 percent real interest rate to arrive at an equilibrium ratio of 25 times annual rent. This in turn means that the price ought to be 300 times the monthly rent for equivalent rental properties. I call this the “rule of 300.” I think that price/rent ratios are below that in most of the U.S. Real estate is, if anything, cheap today. In the short run, it may get a bit cheaper in some places, but I would not want to be sitting on a big short position in house price index futures.
Even if the price/rent ratio needs to fall, one limiting factor is that as house prices fall, builders supply fewer new homes, and this tends to push up rents. If homes do get cheaper over the next year, the subsequent bounceback in prices will be even stronger.