The Fed’s Failed Policy: Fighting Housing Deflation

Agricultural Adjustment Act of 1933: A Distant Mirror for Deflation Fighters

“History Doesn’t Repeat Itself, But It Rhymes”
Mark Twain
Ben Bernanke & the Fear of Deflation

Ben Bernanke has vowed to fight deflation with every tool available to him in his role as Chairman of the Federal Reserve Board of the United States. As he put it last August,“If the economy does truly get worse and deflation threatens, there are steps the Fed could take that would increase the money supply, stimulate lending, and boost demand.” Note that he doesn’t talk about banks suffering credit losses and needing additional capital, nor does he even consider the role of the Fed as lender of last resort – he focuses first and foremost on deflation. Chairman Bernanke is a student and teacher about the Great Depression, and is firmly convinced that deflation – not the Fed’s abrogation of its role as lender of last resort – was the font of all the financial misery of the ‘30’s.

I thought that it might be instructive to look back at that period, and the historical view of deflation at the time – and what was done about it – and did it work. We have embarked on a great monetary expansion, the like of which the world has never seen – all in the name of attacking Mr. Bernanke’s nemesis – the haunting specter of deflation. The Fed has expanded its balance sheet by almost 2 trillion dollars in the last three years, all in the name of fighting deflation – the official bogeyman of Chairman Bernanke’s Great Depression. In the Depression the focus was on the deflation of agricultural commodity prices, versus the focus on housing prices today. The quest then was to save the family farm, much as the quest today is to save hearth and home. Let’s take a run back in time to see how FDR’s Gang attacked deflation, and how it all worked out.

Agricultural Adjustment Act of 1933

“It is declared to be the policy of Congress—To establish and maintain such balance between the production and consumption of agricultural commodities, and such marketing conditions therefor, as will reestablish prices to farmers at a level that will give agricultural commodities a purchasing power with respect to articles that farmers buy, equivalent to the purchasing power of agricultural commodities in the base period” (1912-1918 being the Base Period).

Thus did agricultural price supports become a cornerstone of The New Deal, and a frail cornerstone it was. The base period selected was the highest point of prices in agricultural commodities in real terms in 100 years – due largely to the enormous disruptions of World War I. The American farm was about to experience the largest shock of industrial productivity growth in world history – almost 4% per year for decades. The Great Depression was on in full swing, and America was literally starving, while the capacity of production was exploding.

The AAA created a large bureaucracy to take land out of production, destroy agricultural products, and warehouse agricultural commodities that could not be sold above a base price. And still prices stagnated, while children starved. Only the combined reduction of labor and enormous increase in demand due to World War II brought back prices in nominal terms.

The message here is simple – targeted inflation is impossible to achieve, and may be wildly destructive to the economy. The simple concept that high prices would make everything OK for American farmers was nonsensical. Farm mechanization dropped the real cost of food to the lowest level in history over the next 60 years, to the benefit of the entire world.

 beneficiary of AAA price support

“It is proverbial that generals always prepare for the last war…”

James A. Field, Jr.


Ben Bernanke and the Reprise of Targeted Inflation

Ben Bernanke fears deflation the way a cat fears a squirt gun; it is an overarching fear, rooted in instinctive distaste, rather than a rational damage assessment. He is widely known as “Helicopter Ben” for once quoting Milton Friedman in suggesting that you should fight deflation by throwing $100 bills out of a helicopter. Moreover, Mr. Bernanke has a terrible history regarding price level impacts – particularly relating to housing. He did a very poor job on spotting the housing bubble on the way up, saying in October of 2005, “House prices are unlikely to continue rising at current rates, a moderate cooling in the housing market, should one occur, would not be inconsistent with the economy continuing to grow at or near its potential next year.”

This is not the keen insight of a great prognosticator. It would be hard to imagine a person in his position casting a blind eye at the tremendous increase in debt building in the economy at that time. It is impossible to look at the enormous increase in the aggregate money supply over the same period and not imagine that there was a huge pile of inflation lurking somewhere in the economy. One might consider that the enormous and unjustified increase in housing and commodity prices as possible culprits.

See if you can find the increase in Debt?


Let the Battle against the Monster of Deflation be joined!

In August of 2010, Bernanke began the march toward QE2 and began the battle against the Monster of Deflation, saying, “The Federal Open Market Committee will strongly resist deviations from price stability in the downward direction.”

Commodities ran up, and have run up again – Can you find the Deflation to Fight?

Clearly, the only conceivable deflation around to fight is housing price deflation. It is important for our friends at the Fed to understand that housing prices doubled in the last decade, and have now declined by 30%, still a fairly attractive gain – considerably better than the S&P 500 or any comparable stock index. From a simple perspective, on a nationwide basis housing prices doubled from 2000 to 2005, and are now at 145% of their prices in 2000. Where is the deflation to fight?

Housing is back on Long Term Trends post-bubble

Make no mistake, housing prices are down from their peak in the bubble, and much more than indicated by the national trend in many local markets. These declines have put enormous strain on many banks balance sheets, and bankrupt a large number of financial institutions. The pain is real for lenders and homeowners alike. There are millions of homes “underwater” in the US, and these need to be worked out, or the owners have to wait it out – just like any other investor in any other asset class.

The solution, however, is not to announce that the sky is falling and debase the entire currency of the US through reckless expansion of the money supply. America built a lot of housing in the last decade, and the new supply is still out there. More supply with constant demand normally means a falling price. Neither the New Deal nor QEx-1 will change that. We “borrowed from the future” the jobs to build that housing, and we will suffer lower employment in construction for decades because of it. Fixing this will take prudent fiscal policies and large dollops of tincture of time – not reckless monetary policies.

Housing costs (including rentals) are actually at or above pre-crash levels

This takes us back to the 1930’s, to a simpler time, when the AAA created a faceless bureaucracy to prop up agricultural commodity prices through production limitations and product destruction. It failed, and cost the US enormously in wasted treasure and empty bellies. Targeted asset price inflation failed then, and it will fail now.

Perhaps Chairman Bernanke should take a lesson from history regarding the failures of targeted asset inflation. Deflation was not the cause of the Great Depression – that was the collapse of the banking system when the Fed failed to act in its role as lender of last resort. Deflation was an obvious symptom of a collapsing money supply; but don’t confuse the symptom with the cause of the malady. We have wasted trillions (it pains me even to say it) of dollars trying to prop up a targeted asset class, in the face of overwhelming evidence that it was neither necessary nor effective. The selective targeting of assets for price appreciation did not work in the past, and is not working now. Mr. Bernanke, if you want to get out of a hole, stop digging.

Our Fed excels at money supply creation

Wes Chapman
Written by Wes Chapman