Friday, April 18, 2008

Why not “Muddle Through”?

Mises said credit bubbles are resolved through deflation (where prices drop) or hyperinflation (where monetary value drops). But can’t there be a middle ground, where asset prices only drop a little, and the dollar is only modestly devalued?

In “muddle through,” growth proceeds until asset prices at the end of a bubble are no longer such poor investments. The economy catches up to where assets again generate reasonable dividends in accord with their cost. (For houses, that means rents would be comparable to mortgage payments. After you factor in property taxes, insurance, maintenance, and the possibility of vacancy—even treasury bonds of late have been a better investment than a house. Given the risk, effort, and extraneous costs involved, houses should outperform treasuries to be a rational purchase; so rents must increase considerably.) Since muddle through requires growth, albeit slow, it is not possible during recessionary times.

Normally, once the peak of a bubble is reached, asset prices deflate. Alternatively, regulators can try to keep prices high by devaluing the dollar, such that (hopefully) wages increase, and spending increases, and rents increase, to the point where it makes sense again to buy instead of rent. This is perhaps a nice compromise—at least for those who do not want to cede the high price of their house. Certainly it may be desirable for some, the question is, is it possible?

Right now, regulators are trying to mitigate the natural course of deflation by increasing liquidity, so people can borrow easier and buy more to stimulate the economy. But this isn’t working; we are in a system now that is “credited out.” People aren’t borrowing, and banks aren’t lending. We are at “zero hour,” where further attempts to inject credit into the economy no longer benefit GDP.

In that case, printing becomes the only option to increase money supply. If you print a little bit of money you get inflation. If you print a lot of money, you get hyperinflation. Will printing a little bit of money be enough to prevent the incipient deflationary event from the credit bubble? This is a judgment call, but I believe the credit bubble is too big to be corrected by a small amount of printed cash. Rather a massive injection of currency would be needed to keep bubble peak prices afloat. If so, the only ways to resolve the bubble would be deflation or hyperinflation.

Almost certainly, regulators will try to split the difference between asset depreciation and dollar devaluation, so whether such would be possible is a hypothesis that will soon be tested. If this fails, regulators will choose deflation over hyperinflation.

No comments: