Is property a good hedge against hyperinflation?

June 25th, 2008

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Today, we will answer another of our readers? question from our earlier article, What is a crack-up boom?,

A question on property: If the masses inflation expectations get high enough, and they rush to buy assets at any cost, would this make property prices soar even higher? Or…would this be curbed by interest rates or lack of credit availability? See I would think the prices would soar as housing is the ‘asset of masses’ – a fairly simple and needed asset that most people can understand.

Another question on property: If the central banks do not put up rates to force a recession or at least reduce inflationary pressures, wouldn’t the banks just do it themselves anyway? In Australia the RBA has been increasing rates, yet the banks have also been increasing rates at times when the RBA has not. It seems to me that banks would take lending rates into their own hands, in hyperinflationary crisis, even if the RBA did not?

Reading between the lines of this reader’s question, we re-phrase it as such: is property a good hedge against hyperinflation? No doubt, in times of hyperinflation, property prices can soar, along with prices of ‘stuffs’ in general. But does that necessarily make property a good hedge against hyperinflation?

Before continuing, we have to get some definitions right. First, when we talk about hyperinflation here, we do not mean the high inflation of the 1970s. Hyperinflation is far worse than that. Weimar Germany in the 1920s and Zimbabwe today is the hyperinflation that we mean in this article. Both of them began as low inflation, developed into high inflation before finally ending up as hyperinflation.

Does property fulfil the purpose of preserving your purchasing power in times of hyperinflation?

First, a good hyperinflation hedge has to be liquid so that it can be readily exchanged for money or bartered. With property, even though its imputed value may soar with hyperinflation, it is not a liquid asset (see Spectre of deflation for an explanation of what “imputed” value is). To liquidate property, one will have to go through a lengthy legal process. As we quoted Ludwig Von Mises in What is a crack-up boom?, in the final stage of a crack up boom,

Everybody is anxious to swap his money against ‘real’ goods, no matter whether he needs them or not, no matter how much money he has to pay for them.

It is much faster to swap your money against general ‘stuffs’ than with property.

Next, a good hyperinflation hedge has to be easily divisible. Suppose you want to purchase a sack of potatoes for your daily meal. There is no way you can sell 1/30000th portion of your property to pay for that sack of potatoes. Thus, though owning a property may preserve your net worth’s purchasing power theoretically, it is of no use if you cannot use it to acquire goods for your daily needs.

Next, purchasing property as a hedge introduces a major risk to the buyer. This risk is often ignored by ‘experts.’ Nowadays, almost everyone purchase property through debt. That is where the risk lies. As we explained before in Does inflation (deflation) benefits the borrower (lender)?,

Debt servicing burden = (Debt payment rate – Growth in wage) + Price inflation rate

In a hyperinflation, prices of ‘stuffs’ rise very rapidly. In fact, they can even rise by the hour (exponential rise). However, wage rate may rise much slower than the general price levels. That was what happened in Germany in the 1920s. Real wages fell, reducing the workers’ quality of life even though there was hardly any unemployment.

At the same time, you can expect bankers to raise borrowing rates very quickly to protect their profits. To understand why, imagine you are a banker in Zimbabwe. If you are to lend money to home loan borrowers, what is the interest rates you should charge? In a crack up boom, prices are rising by the hour. By the time the official statistics for the CPI inflation rate is released, the information will be outdated because prices are increasing exponentially. If you do not charge high enough interest, your profits will be consumed by hyperinflation very quickly. But without any stability in the value of fiat money, there is no telling what level of interests is sufficient. Therefore, for bankers, it is either they charge extremely high cost of borrowing (which is very punishing for borrowers) or they exit this business altogether (which makes credit scarce).

Therefore, for those who purchase property on credit in the belief that it can serve as a hyperinflationary hedge, this can be a decision of regret as they get crushed by the debt servicing burden. The only way out is to sell the property. But if the liquidity of property dries up during a crack up boom, then this only escape route is being cut off.

Finally, with property already highly over-valued due to the prior boom in credit binge, we have doubts that property can even maintain its real value. If the crack up boom is of the stagflationary flavour (i.e. rising prices AND rising unemployment), there are reasons to believe that holding property may even result in losing wealth in real terms. In the United Sates, they are now experiencing falling property prices AND rising price inflation. For those who are thinking of gearing into property to hedge against inflation, the current situation in the US should serve as a warning.