Unexpectedly Intriguing!
October 18, 2010

Amazingly, a post we wrote back in February 2008 has once again become extremely relevant, as the Fed considers using inflation to solve today's banking problems.

Needless to say, that's because they haven't yet solved the economic problems of 2008, but let's take this opportunity to get inside the Fed Chairman's head back then, and apparently, now again:

Fed Chairman Ben Bernanke: A Guy with a Tough Choice to Make Let's say, for a moment, that you're in charge of the U.S. Federal Reserve. You've just assumed the top job shortly after a significant surge in prices has taken place in the U.S. economy's housing sector, during which home prices across the U.S. increased significantly as the credit needed to buy a home has become much easier for a wider range of people to get.

But now, the apparent bubble that had been driving up housing prices on increased demand has dissipated. In a number of markets, housing prices have begun falling, but too slowly to really reignite demand to establish a new level of relative stability. The banks, mortgagers and other lending and leveraging institutions that enabled the resonance effect that powered the housing bubble are now dealing with properties whose values have fallen below the amount of credit they extended.

The potential losses are staggering. The threat of the expansion of the housing sector's misery into other sectors of the economy is very real, as the financial engines of the U.S. economy are turning to tighten up the supply of credit to protect themselves and their continuing existence.

Realistically, there are only two ways out of this situation. First, you could encourage steps that would be the equivalent of a kind of shock therapy, by which you would risk a prolonged economic recession by accelerating the decline of housing prices. Doing so would first affect those who bought or refinanced their homes during the boom based on the lofty heights at which their homes came to be valued, who would find themselves exposed to the situation of having negative equity.

But worse than that are the banks and other financial institutions and their insurers who would then be on the hook for what would be the largest series of write-offs ever in U.S. history, as the value of their asset portfolios turns into huge losses. The bottom line is that one or more major financial institutions would fail, perhaps turning what might only have be a moderate recession into a severe recession instead.

The bright spot is that you would go through the pain much more quickly. Nobody would be happy with you, but at least the really painful part of the experience would be over with much faster.

Your second option isn't all that pretty either. Rather than wait for housing prices to decline to relative levels where the level of demand would eventually be able to hold them relatively stable with respect to other prices, you could instead raise all the other prices through inflation. That way, housing prices would stabilize at a higher equilibrium, but everything else gets more expensive.

By increasing the rate of monetary inflation in the U.S. economy, you could prevent the imminent failure of major financial institutions. This way, you would at least have protected the major financial institutions whose assets could stay as assets rather than change into huge losses.

The downside of this approach is that there are those who would actually enjoy that kind of pain. These are the people whose status and wealth are built on the ethereal returns of ever-increasing rates of inflation propping up and propelling the value of their assets. Once inflation gets going, they would keep demanding it and use their influence and apparently new-found wealth to push to keep it going.

The worst part of choosing inflation would be that the kind of pain involved would be very drawn out. The pain would start slowly, but as time goes by, large sectors of the U.S. population would really begin to feel it, particularly by those at lower-to-middle income levels and especially those living on fixed incomes as the prices of everyday items keeps going higher and higher.

Allowed to go on for too long, you would end up with the same kind of imbalances and economic nightmare had you chosen the shock therapy approach instead. Only now, lots of people cannot afford anything like their previous standard of living because everything costs so much more.

So which do you do - rip the bandages off quickly or slowly?

The early evidence would seem to indicate that the Fed may well have chosen to take the pain slowly (aka: inflation). With all its "potential benefits" and looming pitfalls.

We'll just have to see again what that pain is like.

Another problem with pursuing a strategy of inflation is that not all prices will rise evenly together. Some prices will respond much faster than others, creating some very unique risks of future pain for the U.S. economy.

That's an important consideration today because of what happened back in 2008.

Here, the Fed's chance to pursue an inflation strategy to cope with the fallout from the bursting of the U.S. housing bubble was derailed as oil prices began spiking in April 2008, fully pushing the U.S. into recession. Without the oil spike, the U.S.' economic situation would have been weak, but may have avoided going into widespread contraction. With the oil spike, economic recession was inevitable.

That risk still applies today as we would expect prices for commodities like oil to once again rise rapidly in response to the Fed's proposed strategy to adapt its monetary policy toward inflating prices. And one can argue that the spike we've been seeing recently in other commodity markets, like those for precious metals, is the market's very forward-looking anticipation of the strategy going into effect.

But perhaps the real problem is that the Fed is still trying to use its power over the U.S. monetary system to affect a balance sheet solution to what's really an information problem. One that requires a very different solution.

After all, the main motivating factor behind the Fed's strategy of higher inflation is still its desire to increase the relative prices of everything else with respect to U.S. housing prices as a way of arresting their fall, which is evident from the nation's growing foreclosure crisis.

That the growing scandal associated with it could also be resolved through our proposed solution to the housing crisis itself is something that shouldn't be lost on the members of the Fed in weighing what they'll need to do next. Especially if their best laid plans to implement their preferred strategy of higher inflation get derailed by real world economic circumstances. Again.


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