While I was on vacation, I did read some more of Hazlitt's The Inflation Crisis and How To Solve It. I know, it is a short book and I should have finished re-reading it weeks ago, but I have a four year old, so it takes a very long time to read anything. In any case, while reading it, I ran across some interesting section on the ways in which inflation causes incorrect estimates of earnings, inspiring companies to allow for insufficient depreciation or inventory costs, and in the end resulting in the erosion of capital by paying excess dividends. All fo which is the reason inflation, rather than hitting everyone evenly, tends to enrich some at the expense of others.

Reading this made me realize why the past two inflationary booms have been in the housing and dot com sectors. Granted, the government pushed the housing sector a bit, but even without the government, the housing sector is a natural for inflationary excesses.

Let us start by looking at the dot coms. While heavy industry was underestimating costs and thus overestimating profits, they also were facing massive replacement costs for both inventory and equipment, which resulted in ever increasing operating costs and a liquidity crisis, despite the excess of cash in the marketplace. The dot coms, on the other hand, saw none of this. Granted, they did have some operating costs in terms of computer hardware, but in general improving technology and economies of scale raced ahead of inflation in that case. And when it didn't, hosting companies freed the dot coms of the need to own their own hardware. As a result, their only costs were employment costs, which are either locked in by contract, or, in the worst case of employment at will, still lag behind inflation in the early stages. And so the dot coms paid their relatively modest costs in pre-inflation dollars, while receiving investments and profits in inflated dollars, causing automatic increases of 5% or more in profits per years due to inflation alone.

Thanks to the absurdly overstated profits, the dot coms began to attract the excess investment money that inflation created. And that in itself began to bid up the stocks. As the stocks began to rise for solely monetary reasons, other investors and speculators were attracted, causing even more inflation in value, until we had the absurd spectacle of stocks rising 10,000% in less than a month after the IPO of an almost unproven company, mainly thanks to the company name containing an industry buzz word (VA Linux, when "Linux" was the word du jour).

Of course, such absurd estimations of value cannot last forever. As inflation continues, many began to notice the constant increase in profits was more of a monetary phenomenon. Eventually wise investors started to sell off the overheated stocks to garner what profits they could before the crash. And such sales then started the cascade of collapsing values and failing companies, as firms founded entirely on the ready availability of endless venture capital (mainly to pay off operating losses) faltered. A few survived. Google managed to transform from a money pit into a profitable enterprise thanks to rethinking their advertising approaches. Similarly, the established firms, Intel, Sun, Apple, Microsoft and so on, managed to weather the storm. Many survived because they produced physical goods rather than nebulous on line "presences" or "branding", others because they actually concentrated on turning a profit before recklessly expanding, but most, seeing endless cheap money, were not so sensible, and when the crash came they found themselves to meet their daily expenses.

And the same pattern applies to the housing boom. One needed only to watch the many sub-morons on television who were getting fat off flipping houses to realize this is the case. Yes, a few were good businessmen, adding real value to the houses they bought and renovated, but many were foolish dabblers who were simply riding an inflationary wave.

To go back to the beginning, Carter passed the Community Reinvestment Act, directing lenders toward granting more subprime loans. However, it really had little market impact at the time. Even when Clinton reduced the requirements greatly, subprime lending was still something of a backwater. Only after the dot com bust did subprime lending come into its own.

How so?

Clinton, faced with the dot com failure, started to rev up the printing presses. He and Bush after him, both kept the presses running to keep interest rates absurdly low. This led to a sudden boom in the housing market. With money so cheap, many began to look at more expensive homes, and as a result, houses started to rise in price. At the same time, with inflation leading to excess money being left on the market, more and more risky loans started to look appealing. Even without the CRA, some of this money would have entered the subprime market. But, facing government pressure under the CRA, not to mention the government indemnity through Fannie and Freddie, the subprime housing market looked like a very attractive market for high yield loans. And that too led to more and more houses being bid up.

And so the housing boom was born.

Very soon, the boom started to fuel itself. With housing prices continuously rising, many amateurs decided they could get rich by taking a short term, interest only loan at the absurdly low prevailing rates, purchase absolutely any house, pay a month or two and then cash out with profits. Some tried to increase profits by renovating the houses they purchased, but, by and large, the profits were pure inflation. In fact, even renovations were helped by inflation, as the materials were purchased up front then sold at an inflationary price a few months later.

And that is why housing is similar to the dot com bubble. The costs were all up front and pre-inflation, while the profits were distorted by being paid in inflationary dollars. Not just that, but the loans themselves were taken in pre-inflation dollars and paid in increasingly depreciating money, while the interest rates were held low by a combination of creeping inflation and a cheap discount rate set by the Fed. So once again we have an industry where costs are all up front and pre-inflation while profits are made in inflated currency.

And just as with the dot com, the housing bubble burst when someone started to reevaluate the real value of the underlying properties. Despite the constant bidding up of houses, eventually banks became wary of valuing houses as high as the market was. Not only that, but in some regions the absurd price inflation was pricing the bulk of buyers out of the market entirely, leaving no one to pay the inflated prices. Both caused the market to slow, and, as with all overheated markets, this slight stumble caused many to rethink the prices being paid, leading to a general collapse.

Unlike the dot com crash, the housing crash spread, taking out the entire subprime market. As many had gambled on ARMs, or had taken oversized loans, expecting future appreciation would provide equity they could use to pay off previous debts in a sort of appreciation Ponzi scheme, not to mention the many speculators caught with short term loans and overvalued property, the financial markets started to face a liquidity crisis. This, in turn, led to the rapid collapse of the entire inflationary structure. And thus we find ourselves in our current economic mess.

So, what's my point?

That is simple. Thirty years ago, Henry Hazlitt described pretty well exactly what took place in the last two economic slow downs. Despite all the politically motivated claims that this is an "unprecedented crisis" or "the market failed", nothing could be farther from the truth. Everything we have seen is nothing but the inflation of the money supply, which is almost inevitable in a politically managed currency backed with absolutely nothing.

So when someone tells you that we need more inflation, even if it is disguised as a stimulus bill financed through bond issues, do not believe it. As I said before, we will have to face the music now or later, and it will hurt less now. There is no way to put off indefinitely the negative effects of inflation, and putting off for a while will only make things worse.

What we need now is to suffer through this contraction, after which we need to restore our money to a sound footing, such as gold. Barring that, at the very least we need to make the Fed stop pursuing the absurdly low interest rates they have been, as well as close down Fannie and Freddie. That won't solve all our problems, but it will fix most things a whole lot less painfully than all the present bailout schemes.