In 1896 William Jennings Bryan brough down the house with his Cross of Gold speech, in which he railed against the gold standard. Americans responded because many felt they had indeed been crucified upon a cross of gold by the bankers and the rich men of the east. Today, it’s their houses they’ve been nailed to, and it’s their houses they’ll go down with.

As in Bryan’s day, today one of the main problems in the US is the monetary system, but unlike in 1896, when tight money was used to keep debtors, most especially farmers, in their place, today it has been loose credit and repeated inflationary asset bubbles driven by uncontrolled money creation which threatens the middle class. While the uncontrolled creation of money isn’t limited to the housing bubble, or what is laughably called "sub-prime", since the problems extend far past sub-prime, understanding how real-estate and housing work is integral to understanding the impact, because for most Americans their home is the most important asset they own.

To talk about Housing one has to first talk about what money is. In the modern world money is generally created as debt. The simplest form is where someone goes to the bank, say "I have asset X that’s worth Y and I want to borrow money." The bank takes a look at the asset, checks you out and if they think you can pay them back, they give you the loan. Because a bank can loan multiples of the money it has been given to keep for other people (deposits) most of that money is, in effect, created out thin air.

That’s the fractional reserve system, and it creates money.


Now before this system, the US and most other countries were on gold based monetary systems. In that system the money supply could only expand as fast as the supply of gold or a multiple thereof (although since notes were redeemable in cash, a gold economy was always in danger of bank runs). Since the supply of gold doesn’t have much, if any correlation to the size of an economy, that meant that gold backed economies were often short on liquidity–there just wasn’t enough money to support the economic activity of the country. At other times you might get a Gold boom (say in California or Alaska) and gold would flood the economy. Again, this didn’t havemuch to do with the fundamental growth rate of the economy, just with how the gold mining sector was doing.

The end result of this, especially as industrialization increased the rate of economic growth by an order of magnitude over pre-industrial periods, were repeated financial crises. If you pick up a history of the economy in the 19th century you’ll be numbed by the number of recessions, Panics and yes, even Depressions. The 30′s Depression was called the "Great" depression not just because it was so bad, but to distinguish it from other depressions that had occured.

This also sets the background of the silver movement, and William Jenning Bryan’s "Cross of Gold". The US at the time was on a bimetallic system, but silver was much more common and farmers were paid in silver, but owed their debts in gold. They wanted pure silver and were aware it would lead to inflation and that’s what they wanted because they were mostly debtors. They owed money and they wanted to pay it back cheaper. And they wanted more money so there’d be less panics etc… (And they were very economically literate. Farmers would listen to multiple-hour, in-depth debates by candidates or even just paid speakers.)

When the US and other countries went off gold, and onto the modern lending system of creating money the basis of how you decided how much money to create changed. Instead of it being "how much gold is there", it became "does someone have an asset which can be used to pay the loan back?"

Now, for both individuals and companies this can simply be "I have an income". A company can say "well, we make X million dollars a year of profit and therefore we can pay you back." An individual can say "I have a job, and my expenses are low enough that I can pay you back."

But for big loans you generally needed collateral. For businesses real estate, or a factory, or perhaps an equity stake in the company. For individuals it might be a car, but most often it was a house, or real-estate of some variety.

Indeed, for the median houshold, as of 2000, almost 75% of their net wealth is tied up in their home. Since then, with the decline in US savings rates and the rise of housing prices in the bubble, that number will have only risen.

A huge chunk of the money generation in the US since the thirties, then, has been driven by house loans and the majority of the net wealth of Americans is tied up in house values.

This made sense, not so much because people would buy the house if someone defaulted on their mortgage (though they generally would) but because the house had value, beyond simple shelter, for a number of reasons.

The first is based on location. Real Estate in general, and a house in particular is valuable if it has access to good jobs, to sewage, to water, to power, to shopping and so on. To examine the truth of this, simply note that houses in the middle of nowhere almost always sell for much, much less than those near metropolitan centers. And in general, the further you are out of the city, the less real-estate costs. There are exceptions to the rule, sure, but they have specific explanation such as white flight or the hollowing out cities (which is a confirmation of the rule–when an industry moves out, the real-estate is worth less because there are less jobs.) So real-estate is worth something because you can make money from it (retailers and manufuacturers locating near ports or railway depots are other examples.)

Housing though has another value, especially in America. Because schools are paid for from property taxes, neighbourhoods with high real-estate values tend to have well-funded schools. All other things being equal those schools perform better than schools with less money. And credentials are how the American middle and lower upper classes have attempted to pass their status down to their children. Eventual earnings track educational attainment better than anything else. So a house in a good area is one of the best things you can do for your children’s future prosperity.

And houses are retirement accounts. It’s not an IRA that funds most people’s "golden" years, it’s their house. Borrowing against the house, or very commonly selling it, moving to a southern state with lousy property values and cheap labor (to take care of you when you can’t take care of yourself) is very common. Much of the middle class lives and work where the good jobs and good schools are, then move to where the lousy jobs are when they get old.

With housing doing all of these things it might seem to be good for it to become more expensive. Bigger retirement accounts, better schools–what’s not to like?

Leaving aside that when housing becomes too expensive it pulls up the ladder and strands young adults, or forces them to take on too-large loans the real problem is that the US’s cost structure is too expensive and real-estate costs are just another area where this is true. If you have to spend six hundred thousand to live near a decent job, that job has to justify the payments on a $600,000 house and, more to the point, the job has to be profitable enough for a corporation to justify a salary large enough to pay that mortgage and those property taxes.

When there are countries like India and China where employees can live for much less, and therefore can be paid much less and still live very well, that’s a problem. (Indeed, a computer programmer in India earning half what an American does has a much better standard of living in most ways than that American.)

So high real-estate prices, while they allow for increased money supply, also require that American enterprises be much more relatively productive than domiciles with lower real-estate costs. And while American productivity is generally higher, it’s not that much higher, especially when you add in artificially low exchange costs, various taxes and so on.

The money supply is still created, mind you, but instead of being used for production in the US, a large amount of it used to buy foreign goods, or floods out of the country as US assets (including mortgages) are bought up by foreign governments and investors. The remainder pools in the US, and is one of the main causes of inflation–both in basic goods like food and energy and in assets like housing itself. A bubble is a case of a self-reinforcing upwards spiral.

When a bubble bursts you get a self-reinforcing downward spiral and a real chance at deflation. I’ve said for a long time that I expect stagflation first, but after that one of the real options for the US economy is deflation (the other is hyperinflation). That’s a large topic, but at its base it’s simple enough. If you have a house you bought for 1 million, and no one will buy it for more than $500,000 and you borrowed $1,1000,000 against it, a combination of you and the bank are eating a loss of $600,000. That’s money that effectively just dissapears. Poof, it’s gone. And it can’t be loaned again, because the house (which you probably don’t own, since it’s been foreclosed) is now worth only half a million, the money supply can’t be increased as much as if it was worth a million.

The same thing can happens with stocks (see Internet bubble). It is currently happening with entire classes of bonds. What matters is when it happens in salaries–when pension funds have no choice but to unilaterally cut payments, when companies unilaterally cut wages or go under, when school boards have to cut jobs and wages.

People have less money–not only because they can borrow less, but because they’re earning less. They have to sell even more stuff–houses, cars, stocks, bonds, consumer goods, and the price on those items collapses because they’re desperate and everyone else is poor and cheap.

And as the assets that everything is borrowed against collapse in price, the money supply starts to, for a change, actually contract. And just as more money in an economy, given the same amount of economic activity, transalates into inflation, the reverse is true.

Now deflation is only one scenario after stagflation, the other is hyperinflation. Hyperinflation would occur in almost the same scenario except that instead of prices for goods collapsing they explode, because the money supply is so much higher than the amount of economic activity. And it’s not yet clear to me which will happen or if we can avoid both because a large amount of what will happen will occur due to deliberate policy choices made by the Fed, Congress, the President and various regulatory agencies and government-sponsored companies.

But there is certainly a great deal to worry about, and it’s because housing prices aren’t just about housing, they’re about money supply, education, competitiveness, retirement and much more. As the largest store of wealth for most Americans, they are one of the lynchpins of the US economy, and if they get knocked out the very foundations of the US economy will be disturbed.

As many have noted, the last time the US saw widespread housing price declines was the Great Depression.

That’s not an accident.

*edited to correct description of the monetary system in the late 19th century*