The View From 1776

Responding to Liberals’ Wall Street Pirouette, a reader wrote, among other observations:

I was right with you until…
“the huge overproduction of housing would not have
occurred.”

What “over-production”?

Remember: supply, demand and price balance except where
force or fraud intervene, in a theoretical environment of
scarcity. So, how do you precisely define
“over-production” or “over-supply” or “surplus” or
“shortage”?

My explanation:

Bottom line: the crash of the housing industry, the subprime mortgage meltdown, and the securitized debt disintegration that threaten the financial community originated with the Federal Reserve.  In the extended period during the 1990s and into recent times, Fed Chairman Alan Greenspan kept interest rates artificially low by flooding the market with excess money.  Chairman Bernanke, who believes that the Depression was caused by the government’s failure to spend enough, is carrying on that destructive policy.

The Fed’s current emergency actions may temporarily bail out Wall Street, but they will only impede and prolong the workout in the housing industry.  Continuing inflationary expansion of the money supply will keep us at square one, with unqualified buyers who will have no equity in the properties they aim to buy using mortgage loans which their incomes are insufficient to service.

The interpretative problem originates in Keynesian macroeconomics, part of the religious dogma of liberal-progressives.  Keynesians assume that aggregate demand and aggregate supply for the economy as a whole are single “things” that can be reduced to one supply-and-demand graph.  This is an oversimplification that masks a huge complexity of demand and supply factors, along with widely differing time scales of production.

Keynesians’ oversimplification leads them to the assumption that, if aggregate demand is less than aggregate supply, then the government has only to put more fiat dollars into consumers’ hands to increase consumption and to re-energize economic production and employment.

What in fact occurs is that additional artificial-money handouts from the government simply drive up prices, prolonging and aggravating the distress.

Instead, government needs to butt out and let normal market processes take place.  Wage rates, housing prices, and housing inventories need to fall as fast as possible in order to clear the market.  Once inflation fears are quelled by restricting the money supply and new lower costs and prices enable buyers to qualify for sound mortgage loans, the housing industry can rebound on a profitable basis.

I find the Austrian economic school version, as I understand it, a more reliable analytical tool than Keynesian doctrine. 

Ludwig von Mises, Friedrich Hayek, et al focused upon the lengthy time scale that applies to production of capital goods (which includes all the intermediary steps from raw materials to manufacturing the machinery and tools for production) that are necessary for the production of goods for immediate consumption.

Monetary manipulation by the Fed sends misleading signals to the very large part of the economy that is involved in long-cycle production of capital goods.  Excess expansion of the money supply leads capital goods producers to over expand their investments in production capacity to meet an illusionary, credit-based consumer demand.  Additionally, the artificially low, Fed-managed interest rates make investment in capital projects appear to be profitable, though they may be uneconomic at free-market interest rates.

Capital goods producers, in our present case, are home builders and building materials suppliers.  They are parts in a long time-scale of production that cannot possibly respond to short-term government consumer handouts or to the Fed’s low interest policies implemented by expanding the money supply.

Homebuilding, in most jurisdictions, is a very lengthy process, commencing with locating developable sites, demographic analysis, securing options on the land, drawing up site preparation and building plans, getting them approved by local authorities (usually with months or years of lawsuits and other community action opposed to any new development), and finally obtaining land financing, construction loans from banks, and arranging packages of permanent mortgage financing for home buyers when the finished product eventually hits the market.

It is not unusual for builders of multiple homes on large sites to have two to five years of time, effort, and money invested before they see a dime of income.  In most cases, their profit on a development deal is realized only at the back end, after several years of building homes, when all the original capital investment and land acquisition financing has been paid off.

That is why real estate, and to some extent all capital goods production, is such a boom-and-bust business.  Once having embarked on a large project, the developer can’t just stop it or put it on hold, because the interest meter is always running on his land loans and construction financing.

Misunderstanding the nature of the problem, Congressional liberals aim to end recessions by churning out an endless array of government spending programs, and the Fed accommodates them with a flood of money. 

That over-expansion of the money supply and, in the early stages, the artificially low interest rates for loans make developers think that consumers have sufficient real savings to buy their products and that the projects will be profitable.  Remember that developers must make multi-year spreadsheet projections of costs and revenues to determine the economic feasibility of a project and to persuade lenders and equity investors to finance it.  And their spreadsheet projections must employ assumptions about interest rates.

The result is commencement of long-term projects that lead to oversupply of finished goods several years later.

Whenever we experience economic shocks such as the current subprime meltdown, the natural, though misguided, tendency is to search for a villain, somebody or some institution whose malfeasance caused the problem.

In fact, such shocks are inherent in the Fed’s creation of excess money supply and artificially low interest rates.  Once the dollar begins falling in foreign exchange markets and inflation worries begin to take hold, the Fed has to slow down creation of money in an effort to keep inflation within its policy limits and to fix interest rates at what its bureaucrats have selected as the appropriate level of market interest rates.  When the Fed begins to change course, the game is up. 

Deals that appeared several years earlier to be profitable no longer are when inflation drives up production costs and selling prices.  But the capital goods capacity expansion and finished goods oversupply are already in the pipeline.