Real Property and Deflation Jude Wanniski August 28, 2001

In his syndicated column Monday, Bob Novak again writes about the monetary deflation, this time citing former Fed Gov. Wayne Angell’s criticism of Chairman Alan Greenspan: “I think he needs to be more forceful.” Angell still publicly seems to think a more aggressive lowering of the funds rate would stop the slide in the economy and spark a new expansion, but the column hints at least he may be ready to argue for a change in the Fed’s operating mechanism, so it can target gold and commodities. On the other hand, Novak reports: “Angell long has feared an even more frightening prospect: deflation spreading to still-healthy real estate. A high-ranking administration official recently asked him what the chances are for that catastrophe. The reply: 15 percent.” Alas, as long as Angell holds to that view, it indicates he does not understand the nature of the monetary deflation, which requires a 100% adjustment of the general price level to a lower numeraire. There are always forces that can help lift the economy to delay the adjustment, but only an inflation can offset the spread of the deflation into real property.

The stories now appearing in the financial press about housing's apparent insulation from the weakness in the rest of the economy's uniformly fail to mention the cushion that housing received in the 1997 tax cuts. The $250,000-$500,000 exemption from capital-gains taxation, for a home held two years or more, was a direct transfer of wealth from the government (which was poised to tax those gains) to the people who live in those homes. This has been the primary source of fresh home equity against which households have been borrowing in the last two years, in order to hold on to their living standards and pay their mortgages. Most, perhaps 95%, of all homes, are worth less than $250,000, so the cushion has been extremely helpful to the country-at-large, as those who have homes they bought decades ago would have faced steep tax liabilities on inflated gains. That cushion would not sustain those households indefinitely, however. If wages and profits must eventually drop to a plateau 25% below the starting point to adjust to $275/gold, workers and employers will not be able to afford the home prices at higher plateau.

There are always exceptions, where productivity increases mask the deflation adjustment. The inherent value of specific properties can climb even when there is zero inflation or some deflation. Remember the Tokyo real-estate boom of the late 1980's, which was directly related to the facts that a) capital gains were not taxed at all if they were capitalized in traded equities and, b) income from interest on deposits in the postal savings system was not taxed below $30,000 annually. The “bubble” burst on the Nikkei when the holding period for favorable capgains treatment for real estate was raised to ten years, when the old rule was for only five. That began the slide, which continued to depress real property values and prices in Japan, as the government invited contraction with higher taxes and deflation with supertight monetary policies. It has not broken out of that cycle yet, 11 years later. We see that Warren Buffett is predicting eight lean years ahead for the U.S. economy. He would be right only if we stay on the same policy road that Japan traveled, a point Novak more or less made in his column.

It would not take much for the props to come out from under the housing sector. The market sell-off today got rolling when the Conference Board reported that consumer confidence unexpectedly declined in August. There is nothing in the works to arrest that process, as far as we can see. If the tax rebates were going to have an appreciable effect on the economy, equity markets would not be sliding now. We normally would expect Democratic politicians to be yelling at the President to do something to make things better, but they don’t have any idea what to recommend. Deflation is not something they have encountered and the universe of liberal and conservative economists, (and the financial writers who follow them,) are just as mystified. The new mantra at the White House is that this is a global recession that began 18 months ago in the Clinton administration, and there is nobody here but us chickens. But where did the surplus go? As anyone can plainly see, Larry Lindsey, chairman of the National Economic Council and President George W. Bush’s closest advisor on putting money into people’s pockets, ate it. Of course, Lindsey can always come back and say the Democrats made him eat it. A rebate was never on his menu.

An unfortunate error appeared in Novak’s column, you will notice: “A real estate collapse would signal deep recession while the Republican administration and Democratic Senate engage in scholastic debate over federal bookkeeping practices and Bush makes unsubstantiated predictions of 3.2 percent growth next year. If the president would drop his resistance to Senate Republican Leader Trent Lott's proposed capital-gains tax cut, the resulting liquidity would strike a major blow against deflation.” Of course, cutting the capgains tax would actually increase the demand for liquidity, which the Fed could not supply unless it changed operating mechanisms. But it is the only idea being kicked around as a spur to investment if it becomes clear in the next several weeks that things are going from bad to worse, with auto sales plunging and the mortgage delinquency rate climbing.

For those of you who don’t see Alan Abelson’s column in Barron’s, this week he quotes “crackerjack analyst” Barbara Allen of Arnhold & S. Bleichroeder, who dismisses reports of hot home sales in July as quirky. Housing trends are “worrisome,” she reports in a brief on Home Depot: “companies reported signs of weakness in the resale market; increased cancellation rates on orders due to loss of jobs; spreading weakness away from high-end product in technology regions into middle-income products across the country; an increasing inability to raise prices; increasing regulatory impediments, which are delaying the bringing of new projects to market; for the first time in many years, builders in some markets are offering incentives to boost orders; and despite strong traffic to see available product, converting that traffic into actual contracts (future deliveries, revenues, and profit) has become more difficult.”

If we could expect better news coming out of the other sectors after Labor Day, of course, these straws in the wind would be blown away. It is more likely there will be a cascade of reports of declining sales of this, that and the other thing and of employers who have been holding on to workers, awaiting the turnaround, letting people go. As our Christopher Ecclestone points out, it only takes a scattering of “for sale” signs in the neighborhood for all housing appraisals to fall. There is suddenly less equity left against which to borrow. We would be extremely happy if there were only a 15% chance the deflation would extend into housing, but are afraid it will go all the way. Then there is the Middle East to worry about....