Friday, 01 April 2011 07:01

Inflation Misconceptions Hide A Downright U-G-L-Y Real Estate Landscape! - Part 1

Here's a quiz for you. An ages old correlation that has pretty much remained rock solid is now upon us. Real estate has been highly correlated to inflation and has acted as an inflation hedge for a very long time. This makes sense, since hard assets that both throw off income and have an actual demand for physical use (in other words, they have have intrinsic value) that hold when fiat currencies assimilate toilet paper in both value and use as input prices skyrocket. The question du jour is, "What happens when you have a glut of unused real estate supply abound in a tight credit environment, a guaranteed increase in rates AND higher input prices?". Of course the smart people out there (in other words nearly everyone with the impetus to read BoomBustBlog) are then forced to challenge the thesis, "So is this time different? After all Reggie, you have been bearish on real estate."

The short answer is, no this time is not different. It rarely ever - if ever - different this time. The key is the terminology. You see, many in the media are throwing around the word "inflation", and understandably so as they see prices (particularly staples, commodity and input prices) and money injected into the system go up appreciably. The problem is that the core real assets are not only in a deflationary cycle, but in a downright depression - reference . How can you have inflationary input prices and deflationary real asset prices amid stagnant employment? The answer is STAGLFATION! I have been calling for stagflation since 2008, and it definitely seems as if I called it correctly. Keep in mind that this will be one of the corner stone topics discussed in the ING Real Estate Valuation seminar in Amsterdam on April 8th, which has now sold out its capacity of 250 seats -see www.seminar.ingref.com. Amsterdam is a very interesting city to have such a discussion, for the pundits there are calling for a 25% office vacancy rate at a time of increasing inflationary pressures. On top of that, they have actually called in the world's leading real estate bear as the keynote speaker! It should be fun. I actually have an implementable solution to this mess. I wouldn't necessarily call it light at the end of the tunnel, but it is a way of pricing, valuing and transacting in these depreciating, illiquid assets correctly. Something that is currently lacking. Let's dig in, shall we...

Input Prices Skyrocket world wide just as Reggie Warned back in 2008, but the media mistakenly calls it "Inflation"!

Inflationary aspects abound in the US, Europe, Asia and particularly in China. China is the exception here, for China has true inflation (not merely inflationary aspects) with increasing money supply, increasing input costs, increasing labor costs, increasing commodity prices and increasing (bubble???) real asset prices. Then again, I also believe China is in an inflationary bubble that needs to either burst or be deflated, You don't get 30 years of growth in 3 years without breaking something. See What Are the Odds That China Will Follow 1920’s US and 1980’s Japan? and Chubble (The Unmistakeable, Yet Thoroughly Argued Chinese Bubble)...

[iframe http://bcove.me/gai3xors 540 500]

Choice quotes from the retailer with the most pricing power in the whole, wide world!

Inflation is "going to be serious," Wal-Mart U.S. CEO Bill Simon said during a meeting with USA TODAY's editorial board. "We're seeing cost increases starting to come through at a pretty rapid rate."

"Every single retailer has and is paying more for the items they sell, and retailers will be passing some of these costs along," Long says. "Except for fuel costs, U.S. consumers haven't seen much in the way of inflation for almost a decade, so a broad-based increase in prices will be unprecedented in recent memory."

Wal-Mart, for example, could have "access to any factory in any country around the globe" to mitigate the effect of inflation in the U.S., Long says.

Still, "it's certainly going to have an impact," Long says. "No retailer is going to be able to wish this new cost reality away. They're not going to be able to insulate the consumer 100%."

We also have the WSJ reporting Euro-Zone Inflation Hits 29-Month High

The euro zone's inflation rate jumped unexpectedly to its highest level for 29 months in March, strengthening the case for the European Central Bank to raise interest rates.

To add to the above: South African Producer-Price Inflation Accelerates by More Than Expected. How about those input prices???

Of course, if the ECB raises rates, its game over for that European CRE that looks towards a 25% vacancy rate in the upcoming year according to ABN Amro. Reference the Dutch financial rag  Financieel Dagblad with a rough translation courtesy of Ernst's blog:

The number of vacant commercial and  office buildings in The Netherlands will only increase the coming years. Influenced by the “new working” trend, the need for office space will drop by 10%. [New working is working at home instead of at the office, using modern communication tools, like computers, smartphones and mobile internet. The countrywide coverage of broadband (mobile) internet enables people to stay at home and do their normal day job – EL]

At this moment already 14% of the office buildings in The Netherlands is abandoned. This is stated by a report of ABN AMRO. The bank fears that in 2015 this number will be about 25%. Also a diminishing civil service is one of the causes. “These factors have a sturdy negative impact on the appraisal of Commercial Real Estate (CRE). Especially in the eyes of the large banks”, according to Erik Steinmaier, manager of Research at the CRE branch of ABN AMRO.

The increasingly serious vacancy of CRE is a millstone for financial companies and pension funds. Steinmaier estimates that banks financed in average 60% of the office buildings. This would mean that banks have for about €30 bln in CRE loans on their balance sheet. A lot of these office building are currently appraised at a too high value. It is unclear how much has to be written off in the bleak scenario of ABN AMRO. Since 2007 the value of investments of institutional investors in CRE has diminished by 15%. And according to Steinmaier the financial crisis in CRE hits silently like an assassin. “The worst has yet to come”.

Consultancy firm Twynstra Gudde that assisted in writing the ABN AMRO report states that one third of the large users of office space is planning to fit up flexible working spaces. Working at home should eventually lead to a decrease in demand for office space of 3 mln sqr meter (32.2 mln sqr feet), according to ABN AMRO. The government, using about 21% of total office space in The Netherlands, will have cutbacks up to 2.75% of the civil service labor force. Civil service currently uses 6 mln sqr meter (64.4 mln sqr feet) of office space. Especially The Hague, The Netherland’s own Washington, is hit disproportionately by these cutbacks. Vacancy of CRE in The Hague could hit the 30% mark.[…]

I am on record saying the same thing on BNR Dutch News Radio just a few months ago. That very same radio station broadcasted an interview with Maarten van Poelgeest, alderman of the city of Amsterdam, who states (summarized, again translation courtesy of Ernst's blog):

In some areas of Amsterdam the vacancy of CRE hits the 40% mark.Of this about 60% is structural vacancy. These office buildings need a different purpose of usage, as they will probably never be rented anymore. The local government needs to change the zoning schemes for these office buildings and should turn them into homes for students or tennants that have no access to public housing, as their income is too high. A lot depends on the owner of the building, i.e. the large banks, big realtors and pension funds. They should take their losses on CRE.

I called this as far back as 2008 and just did a lecture on the issue a couple of months ago.

[youtube MukxtjCVc5o]

As we all know, the US is not one to gloat on the CRE issue. The derivatives based on CRE have actually outperformed, and if you looked at the performance of MBS and REITs, one would have thought that the US was in a real estate bull market, pre-2007. Alas, that is the nigh fraudulent representations of derivative paper traded between insiders. The truth lies in the streets, where you see bricks, mortar and dirt falling in prospective value - particularly if you have your eyes open and just look a few quarters towards the future. I have went over this in detail in . It should be read by anybody who is bullish on CRE. Keep in mind that the difference between Dutch CRE and US CRE is that our central bank is much, much more adept at the extend and pretend game, while the Dutch are more on the delay and pray side of things. Look at it from an interest rate increase perspective, which is bound to happen in an inflationary environment:

Listen up people, HERE ARE THE NASTY FACTS!!!

Real estate is a highly rate sensitive asset class. Capitalization rates (the popular method of pricing real estate) is explained in Wikipedia as:

Capitalization rate (or "cap rate") is the ratio between the net operating income produced by an asset and its capital cost (the original price paid to buy the asset) or alternatively its current market value.[1] The rate is calculated in a simple fashion as follows:

 \mbox{Capitalization Rate} = \frac{\mbox{annual net operating income}}{\mbox{cost (or value)}}

Without going into a CRE class, when interest rates go up, cap rates generally go up as well and the value (or cost to purchase) of the property goes down in sympathy unless the rise in interest rates is offset by a commensurate or greater rise in net operating income. Now, either everybody believes that unemployment is going to drop towards zero  in an era of US austerity (reference Are the Effects of Unemployment About To Shoot Through the Roof? then see Budget AusterityGoldman Sees Danger in US Budget Cuts - CNBC) at the same time that historically low interest rates that actually went negative are going to get lower (see the Pan-European Sovereign Debt Crisis) ---- or cap rates are about to skyrocket. I'll let you decide!

As you can see above, CRE drops in value whenever yields spike more than the + delta in NOI. Looking below, you can see that US CRE actually runs to the inverse of the 30 year Treasury.

That visual relationship is corroborated by running the statistical correlations...

The relationship is obvious and evident! In addition, we have been in a Goldilocks fantasy land for both interest rates and CRE for about 30 years. CRE culminated in the 2007 bubble pop, but was reblown by .gov policies and machinations. The same with rates. Ever hear of NEGATIVE interest rates where YOU have to PAY someone to LEND THEM MONEY!!!

So, BoomBustBloggers, where do YOU think rates are going to go from here? Up of Down??? Let's ask Portugal or any of the other PIIGS group. I have shown, very meticulously, how Portugal can not only afford the path that they are on (record high interest rates) but the losses that will come when they restructure (default) - for all to see. I have done the same with Spain, Ireland and Greece (for subscribers only). See The Truth Behind Portugal’s Inevitable Default – Arithmetic Evidence Available Only Through BoomBustBlog followed by The Anatomy of a Portugal Default: A Graphical Step by Step Guide to the Beginning of the Largest String of Sovereign Defaults in Recent History (December 6th & 7th, 2010). Be sure to carefully and very thoroughly peruse the spreadsheet below to see the many scenarios present that show the NPV of investor losses due to haircuts and restructurings...

Yesterday's post takes the Portugal risk situation to the next level: Portugal Is On The Verge Of Tapping Out, UFC Style – You Knew It Was Coming, Here’s The Analysis!

Since this has turned out to be quite the lengthy post, I have chopped it up into parts. Part 2 will be forthcoming. In the mean time, anyone who wants to find out more about me can follow this link  - Who is Reggie Middleton!!! and/or follow me on Twitter.

Last modified on Thursday, 14 July 2011 04:43

23 comments

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  • Comment Link Reggie Middleton Thursday, 14 April 2011 19:30 posted by Reggie Middleton

    I will probably get to China later this year.

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  • Comment Link John Thursday, 14 April 2011 01:59 posted by John

    Reggie, You doing any work on China? Any posts coming up on them?

    With your excellent work on Europe and with China pegged to the dollar, their fiscal system looks slightly similar to the European system, ofcours if china removed the peg, they would be more like the USA, but they do have a peg and they have crazy inflation becuase if it.

    That said it seems like a good area for you, at least hoping you are doing something on China?

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  • Comment Link Reggie Middleton Monday, 11 April 2011 11:12 posted by Reggie Middleton

    Input costs are direct expenses in commercial real estate. Input prices dictate how much it costs to build property and how much it costs to operate it. The higher the costs, the less the building is worth due to lower incomes (profit). This is commonly known to those in the RE industry.

    Graph input costs over time and prices and you will see an inverse relationship between higher costs and operating income, potentially offset by higher rental rates which is made possible by true inflation. When you have excess supply, higher input costs and potentially lower lease rates, how do you arrive at higher prices?

    There are not a lot of signs of real estate bottoming. If you feel they are then feel free to list them.

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  • Comment Link Plaxico Monday, 11 April 2011 09:27 posted by Plaxico

    Since Reggie hasn't responded I will let you know why Faber thinks it. Reggie points to "input costs" and unemployment. Look at the input costs and unemployment in San Fransisco then look at real estate prices there. Or Tokyo or many other highly desirable locations. There is no correlation, in fact if anything they are postively correlated meaning higher input costs are associated with higher real estate costs.

    Unemployment is double what is was, that still means 80% of people are employed. 30% of people own their home outright. It is hard to know how much equity the rest of homeowners have but even with the drastic downturn it could be safely assumed that another 30% have a fairly large amount of positive equity. In other words the sky is not falling.

    All this coupled with a tripling in the amount of money can only lead to higher prices in the long term 5-10 years. Is this the bottom? Who knows, there are lots of signs it is. Shorting the dollar through a mortgage , assuming you can handle the monthly cash outlay, looks to have very good prospects.

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  • Comment Link BK Friday, 08 April 2011 14:49 posted by BK

    Reggie,
    How do you interpret Marc Faber's commentary on US Real Estate being fairly valued - I don't agree that now is a good time to buy. But, I don't have your track record or Mr Fabers track record to support my hunch.
    I imagine its possible to find some good values in Florida - but, it seems like there is still lots of froth in the Northeast and West Coast market. I also struggle with how some of the expensive communities will deal with property taxes and inflation.

    What are your thoughts on Mr Faber's commentary on US Real Estate?

    Thank you.

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  • Comment Link Reggie Middleton Thursday, 07 April 2011 14:49 posted by Reggie Middleton

    I'm not talking my book. I'm not short real estate. I'm talking fact!

    "Shadow inventory looks to be declining"
    I run shadow inventory every quarter. It is not declining unless you fail to take in foreclosures that have been halted due to moratorium or legal reasons. Excluding those defeats the purpose of calculating shadow inventory. The reason you run the unpublished numbers is to get to the truth.

    "Cash purchases are skyrocketing and there is lots more on the sidelines."
    This means prices must come down since leverage through credit is how prices are raised beyond what is called for from a cash yield.

    "I completely disagree with you here. Bubble blowing is very sustainable it has been going on for years now there is no reason I see to believe it will end anytime soon."

    So three years now means it is sustainable. Every bubble of this millennium lasted three years, were ANY of them sustainable???

    "I do not see how the US government can afford anything much higher than 0 or negative interest rates, I also don’t see how banks could handle a real flight to cash which would bring on cascade of redemptions which would be too much short term pain for today’s society to handle. As Einhorn said we have a bad case of shortermism."

    You've made my point for me. I a have little else to say on the topic.

    "People will front run future increases to get in to housing before 10% hits. Lots of cash is sitting on the sidelines ready to be activated."

    That's nonsense. I'm in the business, you're not. Why don't you identify this "lots of cash".

    "Also as those foreclosures come into the market that creates renters who no longer have the credit worthiness but do have cashflow providing further support for the bottom."

    It also provides more supply in the rental market if not the sale market.


    " houses and precious metals are two of the only decent places left."
    Maybe if you don't want your cash :-) Listen, the biggest bubble and the biggest bust in the history of this country and you expect it to be all good in 3 years! When the normal cycle is 10 years??? If you really feel that optimistic, I suggest you go buy several houses.

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  • Comment Link Plaxico Thursday, 07 April 2011 12:00 posted by Plaxico

    Yes, I am buying a home right now, not as an investment but as a home. I am ok with a major downward price adjustment because I like the home and location and there are few homes in the neighborhood coming on the market. With that said I don't think that is a valid argument. To a degree we are both talking our book.

    Shadow inventory looks to be declining. I don't doubt there are more foreclosures to come but the number is declining as of now. Stronger hands are replacing weaker hands. Cash purchases are skyrocketing and there is lots more on the sidelines.

    "Are you forgetting to factor in the massive stimulus and bubble blowing on behalf of the government that is no longer sustainable?"

    I completely disagree with you here. Bubble blowing is very sustainable it has been going on for years now there is no reason I see to believe it will end anytime soon.

    The US is not Portugal. As Ben said he has a printing press they don't. This makes for a very different set of circumstances. I do not see how the US government can afford anything much higher than 0 or negative interest rates, I also don't see how banks could handle a real flight to cash which would bring on cascade of redemptions which would be too much short term pain for today's society to handle. As Einhorn said we have a bad case of shortermism.

    And it looks like I am in what I consider "good" company

    Listen to Marc Faber here...

    http://kingworldnews.com/kingworldnews/Broadcast/Entries/2011/4/7_Dr._Marc_Faber.html

    Assume rates did go up they aren't going to 10% overnight. People will front run future increases to get in to housing before 10% hits. Lots of cash is sitting on the sidelines ready to be activated.

    Also as those foreclosures come into the market that creates renters who no longer have the credit worthiness but do have cashflow providing further support for the bottom.

    Yes people have been saying it for 4 years and when they said I thought they were nuts for the exact reason you state , artificial prop ups through home buyer credits but that is not happening any more as far as I know. Home credits expired some time ago.

    Rents are starting to come in line with 30 yr mortgages providing the smell of investment opportunity for people with cash that is quickly being devalued. There are very few options for storing wealth... houses and precious metals are two of the only decent places left.
    Unless you really believe people are going to start desiring cash which has just increased 3 fold? Talk about a housing glut, the glut is in cash.

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  • Comment Link Reggie Middleton Thursday, 07 April 2011 08:45 posted by Reggie Middleton

    You are looking at this as someone who wants the market to get better as opposed to someone who is observing whether the market is actually getting better. For isntance:

    "Let’s see across almost all ranges sales both pending and completed are up. Inventory is down, number of foreclosures are down,"

    Foreclosures are down and inventory is down because all of the major banks who produce that vast majority of foreclosures have been halted pending investigations. Many of those pending foreclosures will be drug out even farther due to legal challenges from the defendants. Many of whom will win, which will throw chain of title into limbo, and reverse previous sales. These events are common knowledge and covered in this blog in detail. Despite this, you conveniently forget this and note that foreclosures are up and inventory are down when record foreclosures have been halted both by the legal system and the private sector. Tell me, what do you think happens to those stats when the foreclosure process resumes and the massive amount of halted of halted foreclosures hit the markets???

    "New notices of foreclosure were unusually low in February and March will no doubt end up with a higher count, but still far
    fewer than in the past two years."

    Duhhh! See above...

    "This market is clearing. That is how market support is formed. The people who couldn’t afford the home from to much leverage and those who were layed off and therefore could not afford the home are being replaced by cash buyers who are getting 30% ROI on rents. "

    Most major markets cycle about 10 years or so. Even without the record bubble and bust that we had, the up cycle would be rather premature. Factor in the biggest bubble in American history, and why would the market clear after just 4 years???

    "There is no doubt more clearing that will take place but there and possibly even some price weakening still ahead but a bottom is in or very close to it."

    We've been hearing this for 4 years now, since the bust. Hasn't been right yet. Are you forgetting to factor in the massive stimulus and bubble blowing on behalf of the government that is no longer sustainable? MBS and treasury purchases? QE? Home buyer tax credits? When those wear off (right about now) rates will move up. Do higher rates make housing cheaper or more expensive? Whee are we in the rate cycle now? The top or the bottom? Hint: negative interest rates!!!!

    "Do you need any more hand holding?"

    You can't be serious with a comment like this. It sounds as if this is out of your league. Sales have been brisk in the $200k and below market, but in order for that to clear inventory much of the housing stock must drop to that level. Is that a good sign or bad sign. ECB raise rates this morning as Portugal cries uncle to to excessive interest rate pressure, so the rate storm has begun in essence.

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  • Comment Link Plaxico Thursday, 07 April 2011 06:46 posted by Plaxico

    Let's see across almost all ranges sales both pending and completed are up. Inventory is down, number of foreclosures are down,

    This market is clearing. That is how market support is formed. The people who couldn't afford the home from to much leverage and those who were layed off and therefore could not afford the home are being replaced by cash buyers who are getting 30% ROI on rents.

    So a basic lesson in supply and demand. Less supply coupled with demand equals higher prices. There is no doubt more clearing that will take place but there and possibly even some price weakening still ahead but a bottom is in or very close to it.

    Do you need any more hand holding?

    Market Information Source Reading 3 Month Trend
    Supply Active Listings 5,996 Down 10.8%
    Current Demand Pending Sales 1,827 Up 30.4%
    Recent Demand Sales per Month 1,193 Up 11.6%
    Sales Pricing Avg. Price per Sq. Ft. $102.87 Up 1.8%
    Active Pricing Avg. Price per Sq. Ft. $111.85 Up 0.2%

    Foreclosures
    New notices of foreclosure were unusually low in February and March will no doubt end up with a higher count, but still far
    fewer than in the past two years. Trustee sales volume is up in March and likely to be the highest for many months as
    ©2011 Cromford Associates LLC - Page 2
    trustees process the backlog from Bank of America’s moratorium. As a result of these two factors, the inventory of pending
    foreclosures is falling extremely fast.

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  • Comment Link Tom Wednesday, 06 April 2011 14:00 posted by Tom

    How could you have possibly seen anything but negative in that article.

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  • Comment Link Plaxico Wednesday, 06 April 2011 11:52 posted by Plaxico

    Uh oh, the evidence is mounting. There is still time to reverse course and save face.

    http://athomeinscottsdale.com/wp-content/uploads/2011/04/Cromford-March-2011-Monthly-Report.pdf

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  • Comment Link Plaxico Monday, 04 April 2011 19:47 posted by Plaxico

    I am not arguing that some asset prices go up and some go down. I am saying using terms like real estate provide no value to investors or really anyone for that matter.

    Each market must be evaluated and then the actual property itself must be evaluated. A big mess of different entities doesn't help understand what the speculative opportunity is in one entity. There are easily enough people with enough cash to drive prices up in some markets, add to this the fact there are still a bunch of people who can qualify for financing. Add to this that the current owners of property that are owned free and clear can provide their own financing in a reverse mortgage of sorts. There is plenty of money and not plenty of good locations. That is a recipe for higher prices.

    Yes some values are down but that is normal for markets. Support is in the 2004 price right now. Could it go lower sure but with 3 times the amount of money and even more that is soon to be floating around prices will rebound above 2004 and then take out 2008. Good news is we can let reality be the judge over the next 5 years :)

    Take care, enjoy your takes on Apple which I think are spot on.

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  • Comment Link Reggie Middleton Monday, 04 April 2011 19:00 posted by Reggie Middleton

    You use a single home purchase to indicate what??? A single transaction is really indicative of nothing of substance, as are transactions in a single location.

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  • Comment Link Reggie Middleton Monday, 04 April 2011 18:58 posted by Reggie Middleton

    "A house 40 miles from Timbuktoo is not a hospital in Manhattan"
    Yes, and the house from Timbuktoo and the hospital in Manhattan (and Brooklyn and Qneens) are all depreciating. Look up hospitals in NYC, one just closed near me.

    "A hospital in Manhattan is not a vacation home in Vale"
    True, but are vacation hoes in Vale and Florida appreciating lockstep with inflation? They're not in Florida.

    "A vacation home in vale is not a condominium in Lake Las Vegas."
    No it's not, but the condos in Vegas are dropping price as input costs are rising. It now costs much more to build a condo than it does to buy one.

    By now you should get the hint. I am actually rather well versed in real estate, but can still admit when I am wrong. I just have to be wrong in order to do it.

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  • Comment Link Plaxico Monday, 04 April 2011 18:47 posted by Plaxico

    You are not only off you are way off. Don't worry I can help. Just like GDP is an anti-concept your use of "real estate" is an anti-concept. A house 40 miles from Timbuktoo is not a hospital in Manhattan. A hospital in Manhattan is not a vacation home in Vale. A vacation home in vale is not a condominium in Lake Las Vegas. A condominium in lake las vegas is not a rental property in Montana but according to you they are all "real estate"

    Keep using anti-concepts and you will keep arriving at conclusions that have little value except to make you feel smart.

    Or is this the stagflation you are talking about?
    http://www.sfgate.com/cgi-bin/blogs/ontheblock/detail?entry_id=86119

    And what do you think the people he bought it from are doing with that 100 million? They went and paid top dollar for another home etc etc etc

    An anti-concept is an artificial, unnecessary and rationally unusable term designed to replace and obliterate some legitimate concept.

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  • Comment Link Pieter Monday, 04 April 2011 04:01 posted by Pieter

    Reggie,

    This is the first time I’ve read a clear explanation of the term “stagflation”. Again I’ll resend your blog to a political party but they tend to choose and read only what fits in their stupid party program, written for lazy people.

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  • Comment Link Mark Hankins Sunday, 03 April 2011 21:37 posted by Mark Hankins

    The term stagflation is of course from the Ford/Carter era, when it really should be blamed on Nixon closing the gold window.

    But what is the difference with the newer term "biflation"?

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