Private Advisory Group

Inflation–The Real Monster

Posted by Christopher

The United States is running up record high levels of debt. In fiscal 2009, we will increase the debt by more than we did during the last five years combined. We have essentially four ways to service the debt:

1. Spend less
2. Tax more
3. Default on the debt
4. Encourage inflation

In recent memory, there has not been an administration that has even remotely come close to reducing annual operating budgets. Despite the empty promises we hear ever four years, even the most conservative Republicans find ways to spend more and more of our money. So, we can cross the first option off the list, there is no way we are going to pay down the debt by spending less than we currently spend.

Most readily agree increased taxation in one form or another will be in the future. There still is some debate as to what type and how much increase will exist but it certainly seems inevitable. Unfortunately, even with higher taxes it does not look like that will be enough to pay off the increasing debt load.

Defaulting on our debt is not really a viable option. Not only would the US’ defaulting on our debt completely destroy modern banking, finance, and trade on a global scale, it would also likely lead to a war between China and the US.

Inflation makes servicing debt easier because future dollars are not worth as much as today’s dollars. Additionally, in inflationary environments, people need more money to buy goods and services. Salaries typically rise to meet this demand, creating increased tax revenue for the government. So, not only will the government be paying back debt with lower-valued US dollars, but they will have more of them to do it with.

Due to our current national debt, our future will include some combination of increased taxes and inflation, neither of which is ideal, but both of which are inevitable. While it may not seem like it, taxes are somewhat controlable. Inflation, however, is not.

When policy makers want some inflation, like they do now, they use powerful but crude tools to create it. The problem is they are not always able to control how much inflation they get and often overshoot–meaning prices prise higher than they intended. Not bad for our national debt, but it will dramatically impact your quality of living unless you plan accordingly.

Most conservative financial pundits plan on an average of 3% annual inflation. This translates to prices doubling on average every 25 years. Recall the price of a stamp 25 years ago ($0.20) versus the price of a stamp today ($0.44), and you’ll see that on average the 3% inflation rate has held. However, during the United State’s worst inflationary periods prices have doubled every five years. A far cry from countries like Zimbabwe where last year prices doubled, at times, each day, however even a five year 100% increase in prices could have a heart-stopping affect on retirement plans beacuse a 100% increase in prices is equal to a 50% reduction in your investments.

In 2008, we learned that projections of acceptable long-term market risk and return include some painfully difficult years. Many have now redefined long-term from 10-20 years to 3-5 years. As noted in a separate posting, we need to learn from 2008 by reevaluating our allocation of investment approaches and asset classes, our perspective of long versus short-term, and our willingness to accept appropriate levels of market risk. However, we cannot drive forward by looking in the rear-view mirror. If we do, we risk hitting inflation potholes that can wreak even further havoc to retirement plans.

In this post, we outlined the inevitable inflationary push that will occur at sometime in the future. The questions of how should this eventuality be addressed, what asset types are inflation resistant, and which ones are to be avoided will be posted shortly.