ebreen

Why Is Deflation Scary?

One problem with the discussion is that you have to define deflation as a monetary phenomenon apart from a fiscal result. Index measures of inflation/deflation capture supply/demand imbalance as well as monetary imbalance. A slight monetary deflation could take place in a diversified large economy and not result in an immediate reduction in output growth. This is what happened in the U.S. economy in the run up to the Asian monetary crises...we were running a deflationary monetary policy that was absorbed in out economy but that could not be absorbed in those smaller economies that tied their currencies to the dollar...so imported the deflation and did not have the capacity to absorb it. A similar effect occurs in the inflation of the dollar where the inflation is translated to smaller economies (due to reserve character of $) and can lead to big problems in emerging markets magnified beyond the effect on our market. The issue in a depression is really the effect of a credit collapse. Fisher's theory addresses the spiral of collateral asset devaluation that occurs when credit collapses in a previously leveraged economy. That credit collapse, which you call a "shock" does not need to have strict monetary predicate...as in the case of the Collapse of theh Knickerbocker Trust that sparked the credit collapse that lead to the panic of 1907...you can have a fiscal or market or bubble event that collapses credit and then leads to a collateral asset devaluation as the panic and defaults spread...not exactly a deflation cause ...if you define deflation only as an imbalance in the suppy of money in relation to the demand for money. In any case, once you have a collateral asset devaluation spiral in progress the result is one of expected decline in asset values until you find a market clearing price and a managed return to credit liquidity.

The Misuse of Language in the Financial World

It is not necessary to embed the misuse of language in a long philosophical history to understand the simple immediate problem...which is that most of the commentators and participants in the discussion are ignorant, or worse blind, with regard to the meaning of what they are talking about. It's a stupid discourse of the stupid leading the stupid.

The Demographic and Economic Record Prior to the Housing Meltdown

You neglect to discuss the effect of tax law change on home ownership during your sample period. Housing has long been the most popular tax shelter for the common man because the mortgage interest is deductible from earned income and the capital gains had been deferred until retirement with a high deductible on those gains. This feature becomes more important during times of high inflation as the inflation pushes the common man into higher tax brackets. The scheme was made even more attractive in 1996 when the tax law was changed to exempt the first $500,000 of capital gains from primary residences on a current basis so that there was no need to wait until retirement to capture the deferment and the mortgage interest remained deductible. The 1996 tax change had a significant effect on the appreciation of home prices during the period 1998 to 2008.

With regard to Gabe's comment above, the real mistake that Greenspan made was not so much his reducing the interest rate to 1% after he had made a deflationary mistake the collapsed the Asian Currencies the Argentine peso and the US manufacturing base...after all there was no real inflation during the period Greenspan left the FFR at 1%...the real mistake was the way he raised the rate, experimenting with "Gradualism". Greenspan theorized that by telegraphing to the market that he would raise rates incrementally by .25% each month as he sought to find the holy grail of interest rate 'neutrality' (don't ask Alan what it is but be sure he will know it when he gets there). This was terrible mistake as it was based on a rate raising policy that was supposed to fight an inflation that was not present but had the unintended effect of causing future transactions to move forward in a way that created inflation. Stated differently, by telling the market that he would raise rate a little bit each month indefinitely, he encouraged all potential borrowers and developers to move thier plans forward in order to avoid the promised higher rates. This exarcerbated the housing demand and refinancing demand that was already being pushed by low interest rates and tax law subsidy and drove a housing appreciation bubble. It also put false information about supply and demand into the market encouraging builders to overbuild to meet the false demand that was actually a pulling forward of future demand. When the trough finally hit as the rate increase accumulated we were in a terribly overbuilt and overbought situation. The evolution of mortgage backed securities during this period turned the real estate bust into what has now become a credit collapsed fueled by asset collateral destruction.

Monetary Mechanisms: Then and Now

You neglect to point out the effect of inflation that followed the breakdown of Bretton Woods as the driver for the demise of Reg Q and therefore the antecededent cause of the transformation of homes into phantom savings accounts.

New Accounting Practices Will Boost Bank Equity Values

The critical problem with mark to market theory is how it interacts with Sarbanes-Oxley and the present state of securities law. This issue is usually left out of the discussion as it has been here in your post. Mark to Market has always contained an alternate method of valuation when there is no functioning market provided the rational for the alternate value is fully disclosed in footnotes. However, in practice where SarBox has criminalized accounting practice that turns out to be overly optimistic and where the securities bar targets all grey area decisions, there is no reward for any CFO or Accountant Firm to apply any leway where there is some market value information, no matter how distorted that infrormation my be. There is simply too much risk..including the risk of personal freedom and liability...to apply an alternate risk adjusted mark to maturity value where there has been any reported market sale no matter the duress of that market sale. So, the real problem is SarBox defeats the flexibility of FSB 157 and causes a mark to non-market lowest value. SarBox is the law that needs the reform.