Wednesday, December 1, 2010

Inflation? If it happens, what will it look like?

This morning I am attending a class about disclosure, taught by Bill Gray, the former owner of the Arizona School of Real Estate and Business. He talked about one aspect of the health care bill, which for individuals earning more than $200k or couples earning more than $250k, imposes a 3.8% tax on the profit from selling properties.

And generally the attitude is that it doesn't really apply to anyone. But let's think for a moment what happens if inflation comes. Say prices rise by a factor of 5. (I'll talk about whether this is possible or not in a moment) If this happens, your $200k home you owe $300k on is now worth $1,000,000. When you sell it, the tax for the health care bill will be about $24,000 (depending on down payment and commissions.)

At this point in history, the national debt is larger than it has ever been, at it is at a point where history shows us that the United States might collapse. Historically a nation which has a huge debt compared to gross national product is in danger of collapse. However, in the 1930's, due to a shrinking of GNP, debt reached as much as 128%. So it doesn't always happen. And even in that time in history, inflation did not occur. Instead we had deflation.

Two things helped in the recovery at that time. First, home ownership became a priority. Prices were low, and in 1934 the FHA was created. Home ownership was seen as a way to get the nation back to work. The government subsidized loans to promote home ownership. People who buy homes also buy furnishings, refrigerators, radios, curtains, etc. and this drives manufacturing. The other thing that helped lift us out of depression was the onset of war, which also drove manufacturing.

And if you look at history, the path for many nations out of depression is war. Not that the wars help, but rather the people are so miserable and distrustful of the government that war becomes inevitable.

So what is our government trying to do now? They are trying to cause inflation, because deflation is just too scary. In a deflationary environment, asset prices fall and the banks (who now bear most of the risk) have little hope of recouping their investments. But if we are in an inflationary environment, asset prices rise (in terms of our fiat currency) and the banks can recoup their investments, as in the example at the beginning of this post. It is vitally important to the banks, particularly to the Federal Reserve, to cause inflation -- and lots of it.

It hasn't been able to do it. The Fed tried quantitative easing, pumping more than a trillion into the economy and nothing happened. QE2 is another $600 billion. The only thing they haven't done is to give money away on the street corners. There are some signs of inflation, though, as we see commodity prices and food prices rising, even as housing prices continue to fall. Prices today are the lowest they have been in 10 years, for resale homes in the Phoenix area. The least hard hit areas are in Texas, especially in oil related areas.

Parts of Arizona are also doing better -- due to rising commodity prices, such as copper. I don't understand why, but this is likely exactly the opposite effect desired by the Fed. They want to inflate real estate prices and not harm commodity prices; that would be the best answer. Unfortunately, foreign trade does not often invest in single family homes, rather, they buy goods ... and commodities. So a weak dollar does not help the housing market, and increases prices in things we need to buy.

I wish I had better news.


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