Could the US deflate its way out of a financial crises?

In theory, what if…

You let those who are about to be foreclosed on be foreclosed on. Bank inventories would rise, and house prices would fall. This is called correction, and in many circles it is considered healthy. Rather than pour capital into the inevitably failing cause of bailouts, relax restrictions on the purchase of foreclosure properties. Lenders provide capital to those that qualify, instead of requiring investors to show up with a check for the full purchase price. Potential buyers sitting on the sidelines (with healthy credit ratings and plenty of savings) move in because there is now the visible possibility of a return on equity. Prices stabilize.

Meanwhile, people that probably shouldn’t have been owners in the first place – they didn’t have a down payment and/or had to fudge their income – go back to renting. Rents rise with demand, and price/rent ratios move towards historical equilibrium. Those highly credit-worthy borrowers with an understanding of the basic concept of return on capital and positive cash flow (please move over, Carlton Sheets crowd), move in further. This time they are buying to maintain, rent out, and garner a long term return on their investment – not flip to the next joker two days after they close.

Lenders are already putting the kibosh on home equity lines, so there is no need to argue this will bring the consumer-led economy to a screeching halt. Prices of everyday goods are taking care of that, and much of the non-core inflation is a direct result of interest rates and the falling dollar. Yes, demand will fall, but a significant amount that demand is consumers’ insatiable appetite for foreign goods. If the influx of good manufactured outside the US slows, you trip a decline in commodities prices – foreign demand in foreign currencies slows as a result of shrinking sales to the US, exacerbated by a stronger dollar on the back of dwindling supplies of it.

While markets aren’t keen to consider the effects of negative growth with a smile, maybe they should consider the effect of rising margins too. Falling prices means decreasing cost of goods too. Meanwhile, price conscious consumers see bargains everywhere, which negates some of the revenue declines and the unemployment associated with it.

Heck, we’re a services economy anyway, and it’s going to take plenty of accountants and attorneys and bankers to get those foreclosed homes into the right hands. And plenty of plumbers and electricians and interior designers to fix them up. Retirees make crap a few bricks while watching the Dow correct itself, but if you have 2/3rds of the savings you had before while a gallon of gas costs 1/3rd what it did while you were socking away, why would that matter? We might also see rising interest rates under this scenario, which means fixed income portfolio losses (on paper) but plenty of extra cash flow to support daily needs.

Yes, it all means some pain, especially for trading partners. I suspect the far east economies wouldn’t be particularly pleased at the thought of forced moderation to their now improving lifestyles. And first you have to buy into the idea we do truly live in a global economy – and that decoupling doesn’t exist.

Could it work?

UPDATE: Some of this might happen whether we like it or not – the Fed is finally already warning on inflation.

UPDATE 2: More on housing price/rent ratios. Note that the forecast doesn’t reflect rising rents – the spike is caused by projected housing price adjustment.


M. Berg says:

Could the shrinking capital base sustain a stable/growing population?

Michael Gracie says:

Not sure, Ms. Berg. I suspect it would depend a lot on price correction, and when staples (such as housing and food) reached an equilibrium state. That, of course, may never happen in an exploding population, but there are always going to be some substitutes being created.

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