Tuesday, February 15, 2011

Inflation, Hyperinflation and Real Estate

By Gonzalo Lira:

"Hyperinflation accompanied by a housing collapse is simply impossible - by definition."
- None-too-clever financial blogger.

Most people in the advanced economies - including most economists - really don't have any idea what inflation and hyperinflation is. They don't have a clue because they haven't lived through it, or were children when it happened in the States and in Europe during the Seventies.

They think it's nothing more complicated than a rise in prices that ripples through the economy - like a spectator in a football stadium who stands up, obliging the people sitting behind him to also stand up, so that they too can see the action on the pitch, which in turn forces the people behind them to stand up too, until finally, the whole stadium is up on its feet.

That's what these people seem to think: Inflation - and the more severe hyperinflation - affects all goods and services and asset classes equally, in a rippling effect. Sort of like a rising tide.

Because of this very foolish fallacy, many economists and interested observers think that real assets - commodities, land, buildings, factories & machinery - all rise in price equally during an inflationary spell, whereas financial assets - bonds, stocks - uniformly fall.

But this is wrong: It is at best sloppy thinking, at worst dangerously stupid.

Inflation - and hyperinflation - affects two things immediately: Near-term necessities (such as food and fuel), and credit.

The effects on basic necessities is obvious - but the effects on credit are more subtle and complex.

How does inflation and hyperinflation affect credit? By driving up interest rates - obviously. But what is the effects of rising interest rates in an inflationary/hyperinflationary environment?

Real estate price collapse.

Lenders - on seeing prices rising and purchasing power deteriorating in an inflationary economy - naturally raise the interest rate they charge, on the future expectation of inflation during the period of their loan. Obvious: If I lend money for a year, and expect the inflation rate to be 10% for that year, I'll naturally lend out my money at 15% interest - or more, if I think inflation is accelerating.

Borrowers on the other hand - on seeing interest rates rise, while their wages and salaries are at best playing catch-up to rising prices - curtail their borrowing: They either borrow less, or don't borrow at all.

Therefore, real estate sellers - who depend on lenders to provide their buyers with credit in order to sell their properties - are forced to lower their prices, in order to attract buyers. Law of supply and demand: They cannot force up the price of their real estate to match the pace of inflation, because if they do, they will simply not have any buyers.

Thus, in an inflationary environment, real estate prices either remain static or indeed fall on a nominal basis, even as inflation is debasing the currency, because real estate sellers will not find buyers willing to take on usurious debt in order to buy the property.

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