Why We Are in More Trouble Than Many People Think...

Average annual wage in 1965 was $4658.72
Average cost of a house in 1965 was $20,700
Cost of Harvard tuition in 1973 was $3000

Let's face the facts about the inflation/deflation debate:

1 - No one really knows or can possibly know what the "endgame" will be ...

In 1998, median house prices in San Diego were $207,000. In 2005 they were $604,000. With 20% down, the monthly cost of the $207,000 house was 995 (Principal & Interest), and the monthly cost of the $604,000 house (P&I) was 2902.

(Case-Shiller shows San Diego index in 1998 of 78.23 running to a top of 250.34 in Nov 2005, which is worse than this example.)

When bank loans are paid off, deposit money is extinguished. This is in contrast to an individual who extends a loan with money he possesses where a payoff is a return of transferred funds. This is because the banking system creates deposit money when it extends a loan, and extinguishes that deposit money upon pay off of the loan.

So what happens in a situation with massive loan pay offs such as several million foreclosures?

We'll use terms that are practical and simple: "money" is the funds used to settle the purchase of goods and services, "price inflation" is a basket of trade weighted average of prices rising, where the basket is infrequently changed (or else there would be a downward bias from substituting less expensive, lower quality items), and "monetary inflation" is the expansion of 'money' used to make purchases, irrespective of whether that new money finds it's way into prices quickly or not.

Since we are considering money to be 'spendable funds', a deposit balance in a bank qualifies as money, because it can be transferred to another account (by check or other means) even though this balance is technically bank debt (the bank owes the depositor reserves). This makes sense because if deposits were to collapse, spendable funds would shrink, and we would undergo severe price deflation. The bank deposit balance also is expected to be redeemed at least at par under all circumstances. Clearly bank deposits are used economically as 'money'.

The following is the National and San Diego Home Prices compared to 3 Median CPI starting points for housing (high, mid, and low), and a projection past May 2009 (the latest data) which assumes similar behavior on the downside as the upside. The graph may help determine a probable range of values and a final "bottom" going forward (this indicates Dec 2011). Note that if housing has sold off nationally by 44% and in San Diego by 55%, it has reached the midline of "fair value" which may indicate a preliminary entry point. However, most data is lagging and this is no exception. In San Diego the market had a moderate bounce this year during the buying season. Be advised of the continuing risk.

Mid-range housing might benefit now from "move-downs" as those able to hold out longer find they've exhausted their options.

No way else to say it: the reality of the bailout is very bad.  And we're in a terrible position.  (For the solution, read past the next section.)

A "plan" means the government absorbs losses - otherwise it wouldn't be needed.  The government only transfers wealth, it does not create it.  In effect the government will take from the innocent to pay the guilty, or those - regrettably - that should have been more careful where they put their money.

To answer the question posed above, we'll first exclude the insurance, the bank, and other assets and liabilities to get a base figure, then roll in Countrywide's (CFC) balance sheet issues with poorly performing loans. Keep in mind that our question is: if an investor could buy Countrywide's lending operation only (and avoid their balance sheet), what would be the discounted present-value?

To get to a baseline figure, let's further assume a no-growth scenario where Countrywide is in a steady state: They accumulate and lose the same amount each year on their portfolio of loans, which starts at a size 5 times yearly originations (i.e. 20% go on and off their servicing platform).

In this post I will discuss:

• Calculating the rate of "money printing" the Fed has been doing
• Why prices will still rise for some time
• Why the economy could get so much credit in the 1990s but still not show inflation
• Why inflation / deflation doesn't matter
• Possible investment policy "for the next 10 years"

A Recap of 5 Essentials

(1) Money is the item of ultimate settlement: cash and reserves at the Fed. Any promise to pay money in the future is credit. Deposits are credit. Checks are credit.

The collapse of U.S. housing is an effect that far outweighs the rise in oil prices. It's $1-2 trillion in final losses, and probably $2-3 trillion in credit contraction over the next 3-5 years as old loans fail, cannot be refinanced, and only a fraction succeed. Total spending (dollars x volume) has fallen and is falling. The results have not yet been fully felt, though the final result does depend on the size of the bailout package.

The basic speculative sequence has also been missed, as many analysts assume that the short-term price effects of a deflationary policy is actually an acceleration of inflationary pressure. But that is unlikely because the sequence will probably play out differently. For example:

For the Fed to play this balancing act, some entities have to fail (and be bought up cheap) so that the capital they hold is transferred to the remaining economic entities. The buyer is bailed out of losses by early failures of the sellers. The game is "last man standing".

Here's why:

A savvy investor will realize that inflation can show in a variety of assets or goods not captured by indexes. Using that fact, an investor can clearly see no present monetary inflation shows in the U.S. after including the deflation in house prices (an effect in the trillions).

To put it clearly (and to measure inflation correctly): only a dollar-volume (price x volume) increase in non-housing prices (like commodities, energy, and grains) which EXCEEDS the dollar-volume (price x volume) drop from housing prices would indicate a present policy of inflation.