I recently received a comment from a post I wrote last month called “Real Estate in an Inflationary Environment”.  That post was in response to a different question.  Occasionally I’ll get a good question that I think others might find interesting, so I turn them into a post.  This is one of them.

The comment was as follows:

“I came across this (http://goo.gl/vBtxt) website while doing some real estate research online. The case is made that the real threat we face is deflation rather than inflation because the vast majority of money in circulation is actually credit which cannot possibly be paid back in full by everyone. So if I understand it at all, the claim is that eventually a great deal of this “money” will implode as people foreclose, default, etc. This makes sense to me. 

It would seem that it would take enormous amounts of monetary inflation just to offset that, which is what the intent it now I would assume. 

If this thesis holds any water that would make buying a home right now quite risky. I always appreciate your take on this topic, so I’m curious what you think about this view. Is there anything to this? How does this threat factor into buying a home now? I am considering buying a second home as a single family and moving out of the duplex I own and occupy now, and renting both units out. 

Thanks.“

Someone who expects deflation in the short run is taking a different view from what I have.  I am not saying that person is wrong.  It is just that I give a higher probability to inflation in the near future, given the analysis I have done.

One area that I often disagree with deflationists is the inevitability of it.  The comment above says that “the vast majority of money in circulation is actually credit which cannot possibly be paid back in full by everyone.”  I think it is playing technical word games to say that most of the money in circulation is credit.  If this were the case, why has there been virtually no deflation for the last 70 years?

Again, I’m not saying a deflationary situation is impossible or won’t happen.  I just believe that we will see much higher price inflation before we see anything resembling a serious deflation.

There is one thing that Ben Bernanke understands.  He said in a speech back in 2002 the following:

“But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.“

The Fed can always prevent deflation.

The problem for the Fed is if it hits recession/ depression conditions at the same time as high price inflation.  We saw that back in the late 1970’s and the Fed was forced to save the dollar and bring on a deep recession.  While this could certainly happen again, we haven’t hit high price inflation yet, so I would expect the Fed to keep creating new money out of thin air until it is forced to stop by high price inflation.

So how does all of this fit into real estate?

I recommend buying investment property that you can rent out.  It is best to buy something where you have positive cash flow.  If you don’t have to sell it, then deflation does not matter to you in the short run as far as housing prices go.  Your only worry is about the rent.  But if you have positive cash flow, then it gives you a little bit of a cushion for lower rents.  The good thing is, your costs should also be lower with deflationary conditions.  Taxes should be lower and maintenance costs should be lower.  The one thing that won’t go down is your fixed rate loan, or at least until you pay it off.

I am not one of these people who advocates that you leverage everything you can.  While I am not against taking out a mortgage, I am also not against paying off your loans.  If you buy and hold a property for long enough, you will eventually pay off your loan (or hopefully your renter will), assuming you don’t refinance to longer terms.  I actually think this should be the ultimate goal of every real estate investor.  Once your loan is paid off, then your cash flow will increase dramatically.

If you are concerned about deflation and you still want to invest in real estate, then paying off your mortgage should be your primary goal.  If you have a mortgage rate of 4%, then every extra penny you put into your principal balance is the equivalent of a 4% return on your money.  This is a hedge against deflation.

In conclusion, I don’t think a major deflation is likely, at least not in the next several years.  But even if you disagree with me and think deflation is likely, it doesn’t automatically mean that you shouldn’t look at real estate investing.  It just means that you should try more aggressively to pay down your mortgage before the deflation hits.

Monetary inflation caused by a central bank or government (and not by the free market) is harmful to the overall economy and is harmful to the average person’s standard of living.  While inflation could be harmful in a free market too (let’s say a gold miner discovers a huge quantity of gold that was previously unknown), the market can also adjust and even switch to another form of money if necessary.

Monetary inflation is harmful in many ways.  It misallocates resources and causes artificial business cycles (booms and busts).  Inflation allows the government to spend more and accumulate more debt than it could have without a monopoly over money.  Inflation also redistributes wealth.  While it is a net loss overall to society, it does benefit debtors at the expense of savers.

So while our standard of living would be much higher if there were no government monopoly over money (and granted to the central bank), I want to look on the positive side and offer at least a little good news about monetary inflation.

First, inflation itself is limited, even if it doesn’t seem so.  If the Fed allows things to get out of control and we actually see hyperinflation, then the Fed would destroy its own power.  Hyperinflation means that the money would no longer serve its proper function as money.  The market would be forced to switch to something else.  For this reason, I actually don’t think we will see hyperinflation.

Second, inflation can actually counteract and correct some other bad government policies.  One example is the minimum wage and unemployment.  The minimum wage laws do not allow the labor market to clear.  There are unemployed people who do not have the skills and productivity to make it worth it for employers to hire them, even at the minimum wage.  However, if we see enough inflation and the minimum wage does not rise in unison, this could actually help the unemployment situation.  Real wages could actually go down, even if the nominal numbers do not.

This actually happened in America during World War 2.  The government was trying to keep wages up.  But the inflation that came with World War 2 actually helped in this particular area.  It allowed a decrease in the real (inflation adjusted) wages, which actually helped unemployment.  Of course, sending millions of young men off to war also caused unemployment to drop, even if it wasn’t “productive” labor.

Another example of inflation counteracting bad government policies (that phrase may be somewhat repetitive) is in dealing with the budget.  It is commonly discussed that devaluing the currency allows the government to pay back its debts with money that is worth less.  But this also can work against the government with its annual budgets.  I recently discussed the Obama and Bush budgets, and the annual spending over the last 3 years has actually gone up very little (although it started at a very high point).  If the budget goes up at say 2% and inflation is at 3%, then the inflation-adjusted government spending is actually decreasing.  While this may not seem like much, and it isn’t, I am at least trying to look on the bright side with something.

I will throw in one final last “benefit” of inflation.  While it devalues the money being collected by savers and those on a fixed income, this also includes all of the government employees with pensions.  This means that Ben Bernanke’s pension becomes worth a little less each time he inflates.  This is another reason that I believe the Fed will not go to hyperinflation.

Even in a free market economy, there is sort of a business cycle, at least in the sense that it is constantly changing.  Human wants and needs are constantly changing and this factor, along with changes in supplies, means that prices fluctuate and resources are constantly being redirected based on those prices.

However, in a free market economy, we would tend not to see the business cycle as we know it today.  We wouldn’t see the huge swings, particularly with virtually everything at once.  In a free market economy, there would be less tendencies for big bubbles and busts, particularly without a central bank (or some other institution with a monopoly over money).

The Austrian Business Cycle Theory is very helpful in explaining past bubbles and busts.  It is also helpful in telling us that artificially low interest rates and increases in the money supply are likely to lead to new bubbles.

The tricky part is that we can’t know where the next bubbles will occur.  We can certainly take educated guesses.  And even if we could take a good educated guess, it is impossible to determine the timing of when the bust will occur.  There are simply too many variables.  And one of those variables is human action, which is almost impossible to predict.  Again, we can take a good guess, but it really is impossible to say.

If it were easy to determine where the bubbles are and when they will go bust, then the Austrian school economists would be rich.  Perhaps we could say that there are some Austrian school people who have above average wealth and above average investment returns because of their knowledge.  But there are also plenty of Austrians who have gotten things wrong.

Some recognized that there was a housing bubble at the time.  Most did not understand just how big it was, but there are some people who saw it.  But some people saw it in 2004.  It would have been hard to listen to them, as housing prices increased most dramatically in the next couple of years.

The same could be said for tech stocks in the 1990’s.  Some people thought a crash was imminent in 1997.  They were somewhat right in their analysis, but a couple of years too early in their call.

The point is that these bubbles can drag on far longer than it almost seems possible.  Timing is more of a guessing game than anything.

I think that interest rates will eventually rise and government bonds will get crushed.  But I do not own one single short position on bonds because I have no idea when it will happen.

I think there is something of a student loan bubble and a college bubble in general.  I don’t think the increasing prices are sustainable, particularly when so many college graduates are unemployed.  But again, I have no idea when we will see a change big enough to actually cause college prices to drop.

I have no particular investment advice with this post, other than to say that you should always be cautious with your investing in regards to timing.  It may seem obvious to you that bonds are a losing proposition, but you have to realize that not everyone else sees it that way.  And even if others are starting to see it that way, it doesn’t mean they will act on their knowledge.  Of course, you also have to realize that it is a manipulated market because the Fed is a buyer of bonds.

The same goes for price inflation.  Many Austrians have been predicting serious price inflation for the last several years.  It seems like a good guess because of the huge increases in the money supply.  But again, the human race had other things in mind.  Banks have been tight on lending and many people have been tighter than usual on spending.  This has helped offset the huge increases in the money supply.  Again, there are always variables to consider.

In conclusion, I think the Austrian Business Cycle Theory can be very helpful in understanding economics and even in making sound investment choices.  But don’t think that it can give you the knowledge of where and when bubbles and busts are going to happen, or at least not with any precision.  It is impossible to predict human action with any certainty.

There are polls showing that Congress is widely unpopular.  There was one survey that showed Congress is less popular than cockroaches and traffic jams.  For this alone, I applaud the American people for realizing that the politicians in Washington DC are generally not looking out for their best interests.

But there is a problem.  While most Americans are against the Congress, they keep re-electing the same people into Congress.  The reelection rate for 2012 was about 91% for the House of Representatives and 91% for the Senate.  So while the average American doesn’t like Congress, they find their own Congress critter acceptable.

Can they all be right?  No.

If incumbents are being elected at a rate of over 91%, while only 9% approve of Congress, then there is a major disconnect.  People aren’t looking into the mirror.  Most people think it is someone else’s fault.

While I think there are far more liberty-minded individuals today than there were 10 years ago, there is still a lot of work to do.

While a large majority of Americans are upset with what is going on in DC, they are not nearly irate enough.  They have little idea of how much they are being taken advantage of.  They don’t realize that the power of a small number of individuals rests solely on the consent of the general population.  How can 535 people in Congress rule over 300 million people?  The only way is for a large majority of the 300 million people to consent to it.

So while a large majority of Americans are unhappy with Congress, they still look to Congress to help them. They want their favorite federal programs left in place.  They think they need the politicians to keep them safe and secure.  Until this mentality changes, we will continue to live in chains and Congress will continue to rule over us, even if they are unpopular.

As a libertarian, sometimes I like democracy and sometimes I really deplore it.  While it is a widely misunderstood subject, most libertarians understand the negatives of democracy.  It is majority rule, which violates the rights of the minority.

There is a television show on ABC called Shark Tank.  It started in 2009 and is still on the air now.  It provides some great lessons in business and entrepreneurship.  Inventors, business owners, and budding entrepreneurs get to pitch their business/ idea to the “sharks”.  There are usually 5 sharks, all of whom have had their own share of success.

The person(s) pitching their idea/ product will usually ask the sharks for money, typically in exchange for part ownership.  The people presenting their idea are usually looking for capital to develop and market their product, along with the expertise of the sharks.  The sharks will then give their own offers, which can often include not being interested.

While they are called “sharks”, and it can get a little hot under the collar, it is really a two-way street.  The parties are looking to come to a deal.  The sharks want to make money.  They are putting up their own money to take a risk.  They want the reward to be worth it.  If the person(s) presenting their idea doesn’t like any of the offers, they can just walk away.

I generally like the show.  I’m not sure how much of it is staged, but it is still good entertainment.  It also teaches valuable lessons about creativity, negotiations, marketing, entrepreneurship, and business in general.  It is a good real-life lesson on the free market.

I wonder how well the show would do in other countries.  I suppose it would depend on where.

Most people on this planet want to make money.  They understand that it represents wealth.  Most people desire a higher standard of living.  But it is interesting that entrepreneurship is not looked at with the same enthusiasm in other parts of the world.

While there is a lot of red tape and a major overabundance of obstructive government (at all levels) in the U.S., there still remains a strong spirit of entrepreneurship.  I know it seems like there is a lot of class warfare, particularly with all of the talk about taxing the rich.  However, most Americans really do not look down on people who are creative and looking to make it rich, as long as it is being done honestly.  Bailing out financial institutions on Wall Street does not represent free market capitalism, so there is some legitimacy in not liking the rich, at least for a certain class of the rich.

Americans take for granted that not all of the rest of the world is like this.  In some parts of the world, being successful and wealthy is not necessarily something to be proud of.  It is the culture.  While people look to make money, the poor people are always looking down on the rich people.  Perhaps it is because they know they have little shot of ever becoming rich themselves.  In America, it is possible for nearly anyone to go from rags to riches, even if it is made more difficult by big government.

The fact that Shark Tank is a successful show should tell us something.  Americans still like to see a good rags-to-riches story.  It is not something to be ashamed of.  It is something to be proud of.  The entrepreneur spirit is still alive and well in America.  That is why I think America will lead the way towards greater liberty in the 21st century.  Overbearing government has not killed the American spirit yet and I don’t believe it will.

It is common to hear the average Republican rail against Barack Obama and his big spending administration.  Of course, Congress actually controls spending to a greater degree than the president, but there is no question that the president does have some control.  The president can submit proposals, use the bully pulpit, and, of course, veto bills.  While Congress can override presidential vetoes, that has not been the case for spending bills during the current and previous administrations.

Republicans are right to attack Obama for his big spending.  The problem is that they try to avoid discussion about what happened during the administration of George W. Bush.  They can say that it ended 4 years ago and that the past is the past, but that is not acceptable to me.  I will take seriously any Republican who fully repudiates the Bush era.  If they are not willing to condemn Bush as much as Obama, particularly when it comes to spending, then the person cannot be taken seriously.

Let’s forget about taxes, since all government spending is using resources.  It doesn’t matter if it is obtained through taxes now, taxes later, or through the hidden tax of inflation.  All government spending consists of the consumption of resources.  For the sake of this discussion, we’ll also forget the fact that all spending originates in Congress.  We can forget that because it has not been a significant factor in the budgets because of the lack of presidential vetoes.

So who is the bigger spender?  Is it Bush or Obama?

In nominal terms, there is no question that Obama is the bigger spender on average.  Obama has also accumulated far more debt, but I don’t want to focus on that.  This is partially due to the slow economy producing less in terms of tax collections for the government.

But let’s look at this on a year-over-year basis.  Total federal spending in 2001, the year that Bush entered office, was $1.863 trillion.  Total federal spending in 2009, the year that Bush left office, was $3.518 trillion.  Perhaps it is unfair to judge Bush on the 2009 numbers.  He wasn’t in office for the whole thing and it was during a terrible recession (plus it included part of Obama’s stimulus).  Even in 2008, the total spending was $2.983 trillion.

No matter how you cut it, Bush increased spending by more than one trillion dollars in 7 years.  He took spending from under two trillion dollars to almost $3 trillion in 2008 and he set the stage for $3.5 trillion in spending in 2009.

Total federal spending for 2013 is estimated at $3.803 trillion.

So while total spending has increased under Obama, it is actually to a much lesser degree than Bush.  Of course, you could argue that he started out with a bigger number in the first place.  But you could also argue that he inherited a bad economy (more welfare expenditures) and has to devote more spending to baby boomers with Medicare and Social Security.

This isn’t a defense of Obama at all.  Obama is as bad as the critics say.  The problem is that most of the critics (mostly the non-libertarian ones) don’t recognize just how terrible Bush was.  And they should also recognize that a Mitt Romney administration wouldn’t have likely cut spending either.

So who is the bigger spender?  Bush is actually much worse in percentage terms.  But they are both terrible.  And Congress is terrible too.

The state of Illinois has an unfunded pension liability that is estimated at $96 billion.  While this seems to be a widespread problem, Illinois has the highest reported liability of any state in the U.S.

According to Wikipedia, the population of Illinois is about 12,875,000.  That means that the unfunded liabilities are approximately $7,500 per person.  If every person in the state of Illinois (including children and poor people) were to pony up $7,500 right now to the state government, then the problem would be solved, at least for now.

While $7,500 per person seems like a lot of money – and it is – we should take a look at the same figures for the overall United States.

It is hard to get a good estimate of the total unfunded liabilities of the federal government.  Laurence Kotlikoff has estimated that the number is well over $200 trillion.  This is made up of mostly Medicare and Social Security.  While I haven’t seen any good analysis to dispute Kotlikoff’s numbers, I have seen more conservative estimates at between $75 trillion to $100 trillion.

Let’s go with the $100 trillion figure, even though I think it is low.  The population of the U.S. is at about 315 million.  So let’s take 100,000,000,000,000 (yes that is trillion) and divide it by 315,000,000. Every person (including children) in the U.S. would owe over $317,000.  Using Kotlikoff’s figures, it would be well over half a million.

Do you have $317,000 laying around to donate to the cause?  Does your neighbor have $317,000 laying around?  Don’t forget that you have to pony up for your spouse and children too.

So while the Illinois unfunded pension liability is getting a little bit of attention in the press, it is practically nothing compared to the total unfunded liabilities of the U.S. government.

The Illinois government and the people there have a few options.  It can raise taxes.  It can drastically cut spending.  It can default.  It can do a combination of these things.  Perhaps it could raise a small sum of money from selling government assets.  It could borrow money, but that would be very limited and only a temporary solution.  Most investors would demand a high interest rate for taking on the risk of default, especially if the debt keeps getting larger.

The U.S. government has the same options.  It can raise taxes.  It can default.  It can drastically cut spending (even if it seems unrealistic).  It can do a combination of these things.  It could raise some money from selling assets.  But when it comes to borrowing money, it is a different story.

The key difference between the U.S. government and the Illinois state government is that the U.S. government has a central bank (the Federal Reserve).  It has a legal monopoly over the money supply.  The Fed can create money out of thin air.  It can buy government debt through monetization.  The only barrier stopping the central bank is hyperinflation.

This is the key difference between the federal government of the United States and the state governments.  State governments are forced to balance their budgets, or at least come close.  The federal government can keep running up debt for a longer period of time and to a much larger degree, because the Fed can simply create new money out of thin air.

This is why the fiscal/ budget situation with the U.S. government is so out of control.  There are virtually no limits.  The only limits are an irate populace and hyperinflation.  Until we get tens of millions of people who demand drastic cuts in spending or until we get much higher price inflation, then the debt will keep going up.  The game will end eventually, but it will be a painful ending when it does.

With the federal government pushed up against the debt ceiling again, get ready for more political drama.  Obama is perceived as the winner in the fiscal cliff ordeal (and it is the American people who are the losers, whether they know it or not).  In the upcoming debt ceiling debates, Congressional Republicans hold the stronger card.

There are now all of these different schemes being discussed to avoid this clash (which would make for another clash).  Some people are proposing this idea of creating a one trillion dollar platinum coin to fund the Treasury.  Of course, this is absolutely no different than simply monetizing government debt.  It is purely inflationary.  Luckily, it is being seen as the ridiculous idea that it is by most Americans.

There is also an idea that Obama could simply raise the debt ceiling by invoking a clause from the 14th Amendment.  I already disliked this amendment for many reasons.  This is just one more reason to not like it.  It has to be the most convoluted amendment ever written.  It is a perfect piece of government work.  Everything is vague and foggy.  Everything is left open to interpretation.  And of course we can always count on the Supreme Court and those enforcing the laws to interpret it in such a way as to expand the power of the central government.

Let’s just pretend for a minute that the Republican politicians in the House of Representatives actually did care about smaller government.  Let’s pretend that they aren’t really just lying to their constituents about less spending and lower taxes.  Let’s pretend that they really do want a balanced budget.

Even if Obama pulled one of these schemes to circumvent the debt ceiling, the Republicans in the House can still balance the budget.  All spending bills are supposed to originate in the House.  The Republicans control a majority in the House.  They can simply refuse to pass a budget.  Or they can appropriate just enough money (still well over $2 trillion per year) so that there are no more deficits.  It is really that simple.  But don’t worry.  It won’t happen.  The Republicans in Washington DC just like to talk and pretend about smaller government.

I frequently hear statements in the so-called mainstream media that the government will default on its obligations if the debt ceiling is not raised.  But this is completely false.  There will still be a couple of hundred billion dollars per month flowing in from various taxes.  This is more than enough to pay the interest on the debt.  It is even enough to fund Medicare and Social Security.  After that, it will get really tight.  Most everything else would need to be cut drastically or eliminated.  Perhaps this would be a default on promises made to Americans by politicians running for office.  But these promises always get broken anyway.

As always, the Republicans in the House will capitulate.  They will raise the debt ceiling for some bogus cuts that take place in the future and aren’t even actual cuts.  Both sides will continue to play this game until the Fed has to stop monetizing debt due to higher price inflation.  At that point, interest rates will go up and the federal government will be forced to cut spending.  The laws of economics are not limited to Greece.