A slmple solution to the III nouslng cns|s

By John Krier JLK Global

A S THE enormity of the global banking rescue packages .Cl,continues to make once unthinkable money transfers an everyday occurrence, it seemed to me there must be a simpler and cheaper strategy for our "leaders" in Washington.

Many people are unaware of the global extent of the housing price inflation phenomenon. As of 2008, the U.S. is among the laggards in nationwide housing appreciation. Since 1998, U.S. appreciation is approximately 80Vo after last year's sharp drop in median prices. Countries in the E.U. are still holding three-figure increases. Other countries have reached mega-inflationary levels, such as South Africa at close to 400Vo. Even China is affected, with their big-city property markets tanking along with the others. The point here is that this recession is not going away any time soon.

But the meltdown started here and recovery should begin here. It is now clear that overly accomodative Central Bank policies and global trade/savings rate imbalances have created the conditions for another asset bubble and this time of historic global proportions. But what is being done to fix the problem at ground zero here in the U.S.?

After the evisceration of the $700 billion TARp initiative (that would have been effective if not turned inside out by the Congressional sausage factory) solutions have been limited to throwing money at any institution with the slightest resemblance to a large bank. This creates the very real possibility of igniting an inflationary spiral somewhere down the road.

So with all this liquidity available, why do financial institutions like Citi and AIG keep coming to the well? It is because asset prices are still dropping. The primary villain is still housing, but now commercial real estate is joining the party. Just when the bank accounting teams think they have a handle on asset values underpinning their various Structured Investment Vehicle (SIV) holdings, the CaseSchiller releases another housing price report and the spiral continues. (SIV is the broader title for packaged financial products such as mortgage-backed securities).

If U.S. housing is really the disease, why are we only treating the symptoms? Home prices are still falling and deflation, by definition, is self-perpetuating when the psychology locks into the consumers' collective minds. Why buy now when it is going to be cheaper next month? All the liquidity in the Fed's arsenal is not going to break that psychology until at some point housing becomes much harder to buy and much easier to finance.

The builder/developers have done a decent job of lowering new home inventories, which are cunently at historical lows. But until the huge numbers of existing homes are sold and occupied (or, in extreme cases, torn down), there will be no recovery for housing or the economy in general.

While pondering this morass, I was struck by the idea that the problem is two-fold. That housing is too expensive is a given, so prices must retrace to affordable levels. But the second problem is less obvious, but more pernicious. What if, like unemployment (5Vo is generally the figure used by economists for sustainable "full" employment), there is a maximum percentage of homeownership that is sustainable with the current state of the U.S. economy?

Before the insanity driven by banks, hedge funds, rating agencies, and government social engineering (think GSEs), a 60% homeownership rate was considered a healthy level. Then in 2005-2006 the paradigm changed, and 70Vo seemed not only attainable but somehow sustainable. But advocates of the new paradigm forgot one thing: markets, like water, find their own levels of stability. It would appear that 6O-62Vo is still that level.

The latest U.S. mortgage statistics show a combined 1O7o rate of defaults and problem loans with more to come. If you reduce 707o ownership by 10Vo you get 63Va,which is very close to our proposed benchmark. It is possible or even probable that markets are forcing a reversion to a realistic ratio of homeownership to rentals.

With this in mind, we are left with three avenues of approach. Approach one is currently de rigueur. The government is taking the "sledge hammer" option, pouring trillions into banks or anything resembling a bank that is "too big to fail." So we have the spectacle of Goldman, GMAC and others magically turning themselves into your friendly neighborhood banker. And don't get me started on Detroit bailouts.

Proposed subsidies to encourage more building just adds to the unsold inventory problem, and giving subsidies to people who can't afford the house under any circumstances only prolongs the agony. But it does make for great political press.

Now we have proposals for "stimulus packages" that approach $1 trillion. Do people honestly think that Congress will invest that money in the most effective and efficient manner?

The second approach, advocated by the more stubborn free marketers, is to do nothing and let things take their course. They believe the government, with these massive spending programs, is eroding our economic liberties through regulatory regimes and stealthy nationalization of whole sectors of the economy. I would agree that these risks are real, but the alternative would almost certainly be a protracted depression.

This kind of economic stress creates a much greater temptation for government to curb liberties in the name of saving the nation from catastrophe. The FDR Administration in the 1930s should give free marketers pause as this was the start of the socalled "Imperial Presidency." FDR's attempts, in large part successful, to stack the Supreme Court, strengthen sedition laws, and create programs that became known as "entitlements" (but are in reality intergenerational wealth transfers) were a result of perceived economic exigencies.

However, there is a third way. For the last two years, private money has been moving away from risky assets to the sidelines. One look at the 30year Treasury note shows how hesitant investors are in putting their money to work in traditional asset classes. The pendulum, as usual , has swung between two extremes. Two years ago investors were ignoring risk premiums and now it seems that no premium is high enough. High quality assets are going begging for lack of buyers.

But what if a one-year monster tax credit for buying existing empty housing was offered to anybody who could truly afford it? This would include absentee landlords as well as owner occupants, whether they are first-, second- or fifth-time buyers. An irresistable short-term opportunity with an expiration date and a minimum multiyear holding period (keeping out the spinners) would overcome fear, rotating private money back into this asset class. This would have two salutary effects. Stabilizing prices would finally give the banks an accurate mark-tomarket target, shoring up their balance sheets and breaking the logjam in secondary markets for their SIV paper. Better yet, in the long term it would bring the owner/renter ratio back into a sustainable balance.

Simple? Sure. Overly simple? I don't think so. Targeted tax incentives are the most effective way to change economic behavior. Expensive? Yes, but much cheaper than what is already in the pipeline. A $40,000 tax credit (not a loan) for as many 1.5 million empty houses and condos would cost the government $60 billion in lost tax revenue. This is chump change in today's brave new world. And, yes, it would borrow against future demand. But it would also clean up the excesses and allow the market to start fresh with tight inventories, giving a shot in the arm to the homebuilders.

Politically feasible? Probably not. The economic neophytes in government and the media would start screaming about rewarding the wrong people using the usual sophomoric catch phrases like rewarding "fat cats." Plus, after spending the last eight years repeating this mantra ad nauseum, it would be a jarring turnabout even for the masters of spin and hypocrisy in Washington.

The Federal Reserve has been out front and Chairman Bernanke was among the first to realize the dangers and actively pursue an expansionist policy, while the "experts" were still hand wringing about inflation. But monetary policy is not enough. Worse, if the heavy lifting is left to the Fed while Congress keeps blindly handing out ineffective stimulous plans and make work programs a la FDR, inflation or stagflation will be the result.

Because I am a dyed-in-the-wool free marketer, recommending any government intervention is difficult for me. But in these circumstances, the alternatives to effective government intervention are too catastrophic to contemplate. Unfortunately, what we have seen so far may eventually accomplish its purpose, but in a grossly inefficient and enormously expensive manner. And look for the added bonus of more and more onerous regulations, throwing up more hurdles for the credit markets in the process. Throwing the baby out with the bathwater is a specialty of our government.

- Mr. Krier is a 30-year veteran of the lumber industry. Formerly president of Stora Enso Timber U.5., he is now president of JLK Global Inc., Tigard, Or. You can contact him at john@jlkglobal.com.

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