I think when it comes to inflation, it is important to keep in mind that not everyone using the dollar has a clue as to what its future worth will be in terms of buying goods and services. If you were a really good economist, and you had all the right information, you could probably predict what inflation would be; but most often, the man on the street knows its effect because prices go up – i.e. each dollar is worth less than the ones before it, so each one buys less products and services.
I agree that fiat money made this mess possible, because if the government, while loaning money to the banks, had to transfer real wealth (either gold or money backed by gold) then it wouldn’t happen so easily – remember, we are running at a deficit, which means the government has no money to loan out. What they do is sneak in freshly printed money (on paper or via electronic transfers) into the system, devaluing the dollar, which effectively makes everyone using the dollar pay X% interest on every dollar.
Now here comes the crux of the current problem. You, the bank, has money to loan out for housing. The government says you must loan out some of it to people who cannot afford to pay the principle, especially with interest. If your bank refuses to go along with this, you get fined per customer denied and you won’t get your government loan to continue operations. A lot of your cash gets tied up in bad loans, loans you were forced to make and that you cannot retract (foreclosure) without government approval. However, you are not too worried about this, because all houses are going up in price – partially from inflation and partially from increased demand via the governmental force. So, if you do have to foreclose, some of that house has already been paid for, you take it over at a fraction of the price you had to pay for it, the price goes up, and you sell it to someone else making a huge profit, even though you had to foreclose on it. To top it off, the housing building industry is booming as new houses are built left and right to meet this artificial demand. It all works pretty smoothly until too many people begin to default because of inflation and adjustable interest rates – i.e. they could pay out $1000 per month, but they can’t handle $1300 per month.
Now the banks have lots of houses they have foreclosed on that they cannot sell, because so many new homes are on the market, and the supply has met the new demand (the artificial demand), and because of this backlog of new and foreclosed homes, prices begin to fall dramatically. It was a ponzie scheme that could only work so long as the artificial demand was there – and once that is gone, the whole system goes to pieces. As prices where going up, demand rose, because buying a house now made sense, since it would cost more a year down the road. Once prices begin to fall, people wait for a better bargain before buying. So, the banks can no longer count on people buying foreclosed homes at a profit to the banks. Instead of long-term assets, they become long-term deficits – and the banks are running out of money to lend out, which is how they make their living.
It may sound like 5%-10% default isn’t all that much, but when you realize banks only charge something like 5% interest, they don’t have a huge profit margin in terms of percents. When times are good, we make much more profit than that in the picture framing business. A few defaults hurt us, for sure, but so long as business is good, we can take the loss. For banks, a few percent profit doesn’t go very far; and when times go south, they don’t have any cash to lend out.
So, it was a combination of factors, mostly brought about by government edict, that distorted the housing market until there was way too much supply out there. And now that markets are coming back to where they ought to be in a free market, the government wants to step in because housing prices are falling, destroying their ponzie scheme, and making house values fall like a brick, similar to the recent stock market plummets. If you own a house, it might be worth one third what it was a year ago, which has not only a psychological effect, but a real effect on one’s personal credit worthiness, so the credit markets tighten. They no longer want your house if you default on their loan to you, and money gets jammed up in the system.
However, since the recent Emergency Economic Stabilization Act of 2008 doesn’t solve any of these factors, it might be a while before your credit worthiness based on your house means much to the banks. So, the Fed is going to inject more fiat money into the system to give banks cash for their bad loans, which will set off another inflationary spiral and a boom somewhere along the lines, that will likewise come crashing down.