Of course, given the prevailing readiness massively to expand the powers of government in order to deal with short-term crises, it is also possible that the government will enact wage and price controls in its efforts to fight the consequences of its inflation. If and when the controls are subsequently removed, there will again be a crisis of rising prices that, if not accompanied by still more inflation, will be followed by a major financial contraction. If the price controls are not removed, the economic system will be paralyzed and ultimately destroyed.
The upshot is that there is no good way out of the present crisis other than by meeting it through the free-market’s means of a fall in wage rates and prices, mitigated to the maximum extent possible in ways consistent with the principle of economic freedom. What is required is a way out that once and for all ends the boom-bust cycle of inflation and credit expansion followed by deflation and contraction. The free market, a freer market than we have had up to now, is the only such solution.
Economic freedom and economic recovery both require that prices and wage rates be free to fall and that all legal obstacles in the way of their falling be immediately removed. In order for that to happen, as many people as possible must understand that falling prices are not deflation but the antidote to deflation.
***
Postscript: Two points need to be briefly addressed that I could not deal with in the body of my article. One concerns the effect of the prospect of falling prices on the postponement of expenditures. This postponement applies only to the case in which the fall in prices is in response to a fall in demand, not an increase in production and supply. In this case, if prices do not fall, demand falls further, as I showed.
However, the prospect of falling prices resulting from increased production and supply does not imply a postponement of purchases. This is because in this case the prospective fall in prices is not the result of any decrease either in spending or in any other major monetary aggregate. On the contrary, here the prospective fall in prices means an increase in the prospective buying power of all accumulated savings as well as of the income that will be earned in the future. In this way, the process of economic progress portends being financially better off in the future than in the present. The effect of this in turn is to enable people to afford to consume more in the present. This counterbalances the benefit to be derived by waiting to take advantage of lower prices in the future. In other words, falling prices due to increased production and supply are essentially neutral in their overall effect on the relationship between spending for present consumption versus saving for future consumption.
The second point that needs to be addressed concerns housing prices. It is often asserted that falling house prices are responsible for bank failures and that the continuation of falling prices for housing must result in more such failures and therefore must be stopped.
Falling home prices are not in fact responsible for bank failures, any more than falling prices of aging automobiles are responsible for bank failures. The fact that homeowners may owe more on their homes than their homes are worth has no more fundamental connection with defaults on mortgage loans than the fact that many or most automobiles purchased with installment loans are worth less than the outstanding loan balances owed on them. Indeed, the mere act of driving a new car off the dealer’s lot is often sufficient to put its resale value below the value of the outstanding loan balance on the car.
What leads to defaults, whether on home loans or on automobile loans, is the inability or unwillingness of borrowers to honor their financial obligations, not the market value of the homes or cars.
Only decades of inflation and credit expansion could make it possible for people to think of the houses they occupy as an investment. In reality, a house is a consumers’ good, just like an automobile or a refrigerator. The only difference is that it depreciates more slowly than they do. Only a long string of years in which inflation took place more rapidly than houses depreciated enabled their prices to rise every year and people to come to regard them as a source of financial gain. If not for inflation and the rise in prices that it produces, it would be very clear that housing is a wasting asset, a slowly wasting asset to be sure, but a wasting asset nonetheless.
If not for inflation, the price of new houses would not rise. They would probably even fall from year to year. In addition, the price of a house that was 5, 10, or 20 years old would be significantly less than the price of a new house. Thus even constant prices of new houses, let alone falling prices of new houses, implies that the price of a house declines as it ages. That is the normal situation. That is the situation in the absence of inflation.
The accelerated credit expansion of recent years and the rapid rise in house prices that it caused made it appear for a while that it was profitable to buy houses for no other reason than quickly to resell them. It also made it appear that people could live off the rise in equity in their homes, by borrowing against it. The frenzy of the housing bubble was such that at its peak the price of the median house could be afforded only by people earning the top 15 percent of incomes.
There is no reason to attempt to maintain artificially high house prices and to rescue the borrowers and lenders who were responsible for them. Furthermore, the attempt to do so must perpetuate the suspicion that the lenders are still basically unsound and cannot be counted on to be able to meet their own financial obligations. Such bad loans must be owned up to and cleared off the books of the banks and the other financial institutions that made them, before confidence can be restored in the financial system.
The fall in housing prices that is taking place needs to go further. The median home price is still considerably higher than the median income level. Calls for stabilizing house prices are a demand for government intervention on behalf of reckless borrowers and lenders, paid for by taxpayers.
The lower home prices that will result from the freedom of the housing market from government interference will reduce the size of the mortgages that are necessary to buy homes. If a house sells for half a million dollars instead of a million dollars or for one-hundred thousand dollars instead of two-hundred thousand dollars, then the amount of mortgage financing required to buy it is correspondingly reduced and the housing market comes into alignment with the reduced overall supply of credit that is available.
[1] For a discussion of the subject, see the author’s Capitalism: A Treatise on Economics, pp. 959-962.
[2] I have discussed it at length in Capitalism; see pp. 580-587.
*Copyright © 2009, by George Reisman. George Reisman, Ph.D. is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. He is also a Senior Fellow at the Goldwater Institute. His web site is
Capitalism: A Treatise on Economics and his blog is
George Reisman's Blog on Economics, Politics, Society, and Culture. A pdf replica of his book can be downloaded to the reader’s hard drive simply by clicking on the book’s title Capitalism: A Treatise on Economics and then saving the file when it appears on the screen. The book provides an in-depth, comprehensive treatment of the material discussed in this and subsequent articles in this series and of practically all related aspects of economics