In last year's annual letter to Berkshire Hathaway (NYSE: BRK-A)(NYSE: BRK-B) shareholders, Warren Buffett gave a three-part recommendation on how to solve the housing crisis.

First on his list: "Blow up a lot of houses."

His tongue was firmly in cheek, but the idea is exactly right. Falling prices aren't the problem; they're a symptom of a bigger issue, which is that there were too many houses built during the boom. Detroit already figured this out: Mayor Dave Bing has a plan to bulldoze 10,000 empty homes over the next three years.

Congress, sadly, hasn't. Last week, three House members introduced a $15 billion stimulus bill to provide homebuilders with construction loans. Yep -- the plan is to build more houses in an attempt to save the housing industry from its oversupply of houses. Irony just died.

If you build it, they will come (at lower prices)
The bill is mostly being pushed by small, privately owned homebuilders upset that the big boys -- Beazer (NYSE: BZH), Lennar (NYSE: LEN), KB Homes (NYSE: KBH), and Pulte (NYSE: PHM) -- rode out the bust with easy access to capital markets and a smattering of stimulus-backed tax breaks. The little guy wants fair access to the dole, which you can't blame him for.

Or maybe you can. There's ample reason to believe this bill will do more bad than good, and arguments used to justify its existence are easy to shoot down.  

The National Association of Home Builders, for example, wrote that without this bill and its fostering of new construction, we'd threaten "to end the budding housing recovery before it has time to take root." That's so perfectly wrong, it hurts. You have to put the laws of supply and demand in a medieval torture device to come up with an example of additional supply healing a crash caused by oversupply. When the price of something is falling, increasing supply accelerates the drop. Conversely, removing supply (blowing up houses) lifts prices. No secrets. No magic. No tricks. They call these the laws of supply and demand because there aren't practical exceptions.

Another argument given by the bill's main sponsor, Congressmen Brad Miller, is that, "We're not talking about continuing to build in overbuilt markets. We're talking about continuing to build in markets [where] there is a demand."

This is somewhat reasonable, but still flawed. Individual markets are more connected than that. To clean up the mess, you have to let low prices in overbuilt markets lure in buyers from tighter markets. A real-world example of this was the explosion in Sacramento's housing demand after San Francisco's market priced most people out.

Some will say the correct way to solve this imbalance is by building more houses in San Francisco (just using San Francisco as an example), which is what the bill's proponents are getting at. What's stopping builders from doing this already? They can't get a private construction loan to build in San Francisco. Why? Because banks fear these loans will rot as prices keep falling, and they're probably right. You need someone impervious to losses and blind to risk to provide financing. Like Congress.

Digging our way out
Bottom line, fixing housing means reducing the national oversupply of homes. How big is that oversupply? This chart provides a good start:

Supply

Source: Census Bureau.

Supply has come way down from its high, but this is largely because sales volumes have been juiced by a rush to beat the April expiration of the first-time buyers' credit. The number will almost certainly spike next month. You shouldn't be excited until supply falls below average for several months, showing vigorous demand on the part of buyers, and giving builders legitimate reason to build again.

More importantly, this chart doesn't factor in so-called "shadow inventory," which are primarily pseudo-bank-owned homes in the process of foreclosure that haven't been brought to market. Bank of America (NYSE: BAC), for example, just disclosed that the foreclosure process has been taking an average of 13 to 14 months to complete. That creates a big backlog of homes that should be for sale, but aren't.

Credible estimates on the size of shadow inventory are upwards of 1.7 million homes. Factor those into the supply figures, and the true months-of-supply number is probably north of 10 months. That's what is -- and will continue to -- dragging down housing prices.

In Buffett's perfect world, we'd blow up houses. In a rational world, we'd simply stop building more. Only in America do we build more houses and hope it'll drive up prices.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

Fool contributor Morgan Housel owns shares of Berkshire Hathaway. Berkshire Hathaway is a Motley Fool Inside Value recommendation and a Stock Advisor selection. The Fool owns shares of Berkshire Hathaway, and has a disclosure policy.