Is Not Capitalism Fools

Though they clashed on the inputs necessary for economic growth, John Maynard Keynes and Ludwig Von Mises had very similar views on the economic impact of falling currency values. In his Tract on Monetary Reform, Keynes wrote that when money is losing value, the "practice of borrowing from banks is extended beyond what is normal" with tangible commodities such as gold, art and real estate the regular beneficiaries of monetary mischief. Von Mises was more succinct in Human Action, noting that there is a "flight to the real" in times of inflation.

Greedy capitalists are increasingly blamed for the moderation of real estate prices that has led to the subprime meltdown, but a more realistic culprit is our own Federal Reserve. Dollar mismanagement there drove lenders and individual consumers into the housing market; both understandably chasing the rising returns that always result when the unit of account (in our case, the dollar) is cascading downward. History has once again repeated itself.

Though home prices continue to rise according to the broadest statistics offered by the Office of Federal Housing Enterprise Oversight (OFHEO), the big annual gains of 2001-2006 have vanished in a way that has imperiled the marginal homeowner. Amidst the aforementioned boom, it was easy for the latter to regularly refinance home loans given the desire of lenders to chase the performance of an asset class aided by the "money illusion" wrought by a currency rapidly losing value.

Gold, the single best market indicator of a currency's true value, hit a high of $740 in the summer of 2006, and its 12 percent fall since then neatly foretold the troubles borrowers and lenders are experiencing today. With property no longer bolstered by a falling dollar, the pullback of lenders from the housing market became more certain.

Interestingly, there's a broad consensus today that the Fed's switch in bias towards rising interest rates in June of 2004 tells the tale of the present problems. History suggests otherwise. Rather than a market driven by low nominal rates of interest, the single best indicator of housing's health is the price of gold given its useful measure as the best proxy for the dollar.

Indeed, in the aftermath of President Richard Nixon's 1971 decision to leave the gold standard, housing, according to Rice University historian Allen Matusow, "emerged as the most dynamic sector" in the U.S. economy. Importantly, with the dollar having lost credibility absent its gold definition, the former went into freefall while the latter skyrocketed. That interest rates were rising at the time did not detract from the shine that the falling dollar brought to property.

Moving ahead to the Carter years, George Gilder wrote in Wealth and Poverty that, "America's middle class was doing better in the housing market than all of the shrewdest investors in the financial and capital markets of the world." While the prime rate rose from 6 to 19 percent during the time in question, housing was not deterred given the stunning rise of gold from $150 to an all-time high of $892 in February of 1980. The weak dollar once again propelled nominal housing returns skyward, and served as a "middle-class hedge" amidst the dollar's rout.

Since 2001, the tragedy that was 9/11, Sarbanes-Oxley and a renewed protectionist sentiment in Washington were all dollar negatives such that gold rose 56 percent from mid-summer of '01 to May of 2004. Then the Fed began raising rates in June of 2004; the 425 basis points of hikes occurring alongside a further 87 percent rise of gold against the dollar. Not surprisingly, real estate emerged yet again as the ultimate hedge in times of dollar weakness. From 2001 to 2005, the Bloomberg/REIT Index rose 19.1 percent while the S&P 500 fell 3.2 percent.

Interest rate levels, when it came to home prices, were yet again a sideshow. Indeed, James Grant of the Interest-Rate Observer has written that prior to the recent property moderation, the three major bear property markets occurred in 1974-75, 1980-82, and 1990-92. It should be noted that interest rates were falling amidst all three of the aforementioned downturns.

Looked at in today's light, the dollar's 12 percent rise versus gold began in late summer of 2006 when the Fed chose to end its pattern of rate increases. Counter-intuitive as it may seem, history shows that rate increases work against dollar strength, so it was in fact the Fed's pause that has arguably done the most damage to the housing and subprime markets. Continued rate-hiking would have taken the dollar down further, while driving housing returns higher.

Returning to Keynes and Von Mises, the former wrote that capitalism "presumes a stable measuring-rod of value, and cannot be efficient - perhaps cannot survive - without one." Von Mises more succinctly pointed to the "mal-investment" that results when money is unstable. The Fed's failure to the right the dollar's fall for most of this decade, similar to its previous failure in the '70s, led to excessive lending towards the housing market that drove prices higher.

With the Fed expected to begin cutting rates in September, history says that the dollar and equities will rally, while housing will underperform to an even greater degree. Regarding the continued subprime fallout that will result from Fed ease, it will be easy to blame aggressive lenders and overeager borrowers. Capitalism is always an easy target that can't talk back. But if we're realistic, we should look no further than a Fed lacking any commitment to maintaining a stable dollar defined in the constant that is gold.