How to live with inflation

by Philip Brewer on 18 January 2008 14 comments
Photo: earth_photos

Of the various ills the economy can face, inflation is simultaneously the worst for society as a whole, and yet the easiest for individuals to deal with successfully. The strategies for dealing with inflation are pretty straightforward.

In theory, inflation shouldn't matter at all, as long as it is predictable. If you know that inflation is going to be 10% next year, you demand a 10% raise (and your boss gives it to you, because he knows that 10% inflation means that the raise doesn't cost him anything). Everybody else does the same and prices, wages, interest rates, stock market returns, etc. are all 10% higher, even though in real terms everyone is standing still.

In practice, of course, it isn't so simple:

  • Just because you demand a raise that matches inflation doesn't mean you'll get it.
  • When inflation is bad, prices go up every month (maybe every week), but wages and salaries generally only go up once a year. People are always feeling like they're playing catch up.
  • Inflation is never really predictable. Everybody has their own guess about what inflation will be, and most of them will be wrong. Whether your estimate is high or low, you'll have problems to the extent that you're wrong. Even if you're wrong in a good way, such as having negotiated a 10% raise when inflation turned out to only be 8%, you're still in trouble (maybe your company has to lay you off).
  • Taxes are imposed on nominal returns, so you can find yourself in the perverse situation of losing money in real terms, and yet still paying taxes on supposed profits.

For individuals, the strategies for dealing with inflation are:

  1. Be careful about holding cash. This is a big change for people who have come of age since 1981 or so--since then, holding cash has been a perfectly reasonable thing to do. People whose saving and investing experience includes the 1970s, though, remember having a bank account that was earning 5% interest rates that was nevertheless worth 5% less at the end of the year.
  2. Don't make long-term, fixed rate loans. Until the inflationary period is over, don't buy bonds. High inflation rates completely destroy the value of long-term bonds. The flip side of this is that borrowing money on a long-term, fixed rate basis (such as a mortgage) can make good sense, if you can get good rate. There are a lot of people who bought a house with a 30-year mortgage at a fixed 6% or 7% and held as rates went up to 14% or higher. They made out like bandits.
  3. Invest in "stuff" rather than in money. This can be gold (although I'd hesitate to establish a position at these prices). Even better is stuff that you're going to use anyway. If you're going to use it anyway, and you can get it at a good price now, it makes a great deal of sense to buy stuff now, rather than save cash and then buy it later.
  4. Invest for long-term capital gains. Inflation tends to produce illusory profits: you look like you're making a profit even when you're just keeping up with (or even failing to keep up with) inflation--and you have to pay taxes on those profits. This makes investing for income (where a large fraction of the income is really just keeping you even with inflation) a bad deal. It also makes short-term capital gains a bad deal for much the same reason--you have a big (taxable) gain, even if in reality you're just breaking even. Investing for long-term capital gains helps with these issues.
  5. Use barter and the informal economy. If your neighbor hires you to help him create a website and you hire him to help you cut down a diseased tree next to your driveway, you both owe income taxes on whatever you're paid. If you instead swap these services informally, you still owe the taxes, but you're expected to declare the income at its fair market value. It's perfectly reasonable, though, to declare the income at what the service would have been worth the previous year.

For businesses, the strategies are similar, except that it's possible to greatly expand on that last point--use barter and the informal economy--by vertically integrating the company so that the steps of producing your product are all internal transfers rather than cash transactions with another company.

If company A produces raw materials, company B refines them, company C builds sub-assemblies, company D makes consumer goods, company E ships them, company F wholesales them, and company G sells them to consumers at retail, imagine what happens as inflation forces prices up at each step along the way--producing illusory profits that each company has to pay taxes on. On the other hand, if one company handles the entire production chain, the only cash transactions are things like salaries and rents--that can be fixed for a year at a time. All the other transactions can be dealt with as an internal accounting matter, with no taxes due.

In addition to vertically integrating, it also makes sense for businesses to reverse the trend toward outsourcing--instead of paying someone else to haul the trash away (a taxable transaction), haul your own trash away (an internal transfer that doesn't incur any taxes). Likewise, in-source anything you can--accounting, legal, maintenance, facilities, etc.

Damage to the economy

Inflation works its harm on the economy in several different ways. None of them are really due to the inflation itself, which is why economists always insist on pointing out that mere inflation does little harm. The harm is done, though. It's just one step removed.

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We've already talked about the damage done when taxes are owed on the illusory profits on transactions that were break-even or worse. This drains money out of the economy at every transaction. The government can mitigate this harm in several different ways (cutting tax rates being the easiest, but also through any of a large variety of tax indexing or tax rebate schemes, special allowances, deductions, credits, etc.), but the capricious nature of where the harm lands (on transactions between parties, rather than on the economic activity itself) produces perverse incentives to agglomerate businesses together. This is not invariably bad, but it is often bad--you generally get maximum efficiency when each entity specializes, but you don't get enough efficiency to outweigh the tax disadvantages when inflation rates are high.

Another way that inflation hurts the economy is that governments are highly prone to try to attack the symptom of inflation (rising prices) rather than the cause (money becoming less valuable). The usual tactics are price controls, wage controls, and various kinds of tax policies designed to punish wage and price increases (or reward companies that "hold the line" on prices and wages). These all harm the economy, because the price changes are just symptoms. All price ceilings do is produce shortages, because the market doesn't stop functioning just because the government creates a rule.

The third big way that inflation harms the economy is that it creates uncertainty. The "positive" effects of inflation (increasing business activity) only come when inflation is higher than expected, so inflation rates tend to keep rising until they get so high that the negative effects become unbearable, at which point inflation gets ground out of the economy through a recession. Since no one knows just when that recession is coming or how bad it will be, people tend to be more cautious. The result is slower growth, less long-term thinking, and less long-term investment.

Ending inflation

Governments (through the central bank) cause inflation, and governments can end it anytime they want, by ensuring that the money supply doesn't grow faster than the economy. But, of course, it's not that easy.

First, nobody knows how big either the money supply or the economy actually is, and the tools for controlling it are blunt instruments. There are statistics that give people a clue about how big each was as of a few months ago, but that's only a partial indication and it's already out of date. Back in the 1970s economists liked to use the analogy of driving a car while looking in the rear-view mirror by alternately stomping on the accelerator and then on the brake.

Second, if the money supply has already outstripped the growth in the economy (which it has, for many years now), then the effects will inevitably work their way through the economy, producing however much inflation is necessary to bring things back into balance, no matter what the central bank does now.

Still, all periods of higher inflation end. Some end with the inflation rate coming back down to the rate where it doesn't do much harm to the economy (basically, to where it's small enough that things like changes in relative prices and changes in standards of living are more important than inflation, and the inflation component just vanishes in the noise of the economy). Others end with hyperinflation making the money worthless, at which point it is replaced with something else.

Based on the experience in the US so far and the current situation, I don't think the hyperinflation scenario is likely. So that means that your strategies for living with inflation need to handle the situation where money supply growth slows and the inflation rate drops--a scenario that usually involves a recession.

Once the central bank moves to stop inflation in a serious way you need to turn around the strategies you used for surviving it and instead prepare for a recession.

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Guest's picture

I wouldn't exactly say the centrals banks way of controlling inflation are blunt. Inflation can be controlled through fiscal and monetary policy through things like: changing interest rates, changing taxes, manipulating the supply of money.

There is absolutely no need to worry about hyper inflation in the united states, if anything deflation will take place

Philip Brewer's picture

Changes to taxes and government spending won't affect inflation (which is the money becoming less valuable), but they will affect prices--which makes it pretty hard to tell the difference, at least until long after the fact.

But there are two big problems with the instruments for increasing and reducing inflation (the instruments that change interest rates and the money supply):

First, they do other things, too. Raising interest rates doesn't just reduce the inflation rate. It also raises the value of the dollar (hurting exporters) and it generally reduces economic activity (hurting all businesses). Further, it hurts people who owe money with a variable interest rate, especially those who are owed money with a fixed interest rate.

Second, the economy isn't static. I's full of actors who respond to central bank activity by doing things--often things that magnify or minimize the effects of central bank activity. So, when the central bank is raising rates, there will be borrowers out there trying to get long-term, fixed-rate loans fighting it out with lenders trying to only make short-term or variable-rate loans. To the extent that either influence prevails over what would happen if things were stable, the economy suffers.

However unlikely hyperinflation is (and I think it's pretty unlikely), I don't think you can ever dismiss it as a possibility, especially when inflation is rising at the same time recession already threatens.

Guest's picture
Debbie M

Another thing about folks who weren't cognizant in the 1970s is electronics have helped make inflation less important than it used to be. While housing, gas, postage stamps, and wages have gone up, food really hasn't (until recently) and electronics have plummeted. Buying electronics now before they get more expensive, just doesn't make sense. And nowadays that applies to more and more aspects of life: TV, videos, music, phones, typewriters (computers). And the expensive part (phone service, monthly cable and internet fees) can't be bought ahead of time.

Philip Brewer's picture

Not all increases in price are inflation. Inflation is when the money becomes less valuable. That tends to show up as higher prices, but it isn't the only thing that shows up as higher prices--prices can change for a lot of different reasons.

For the same reason, it's a mistake to say, "Well, prices aren't going up so inflation must be under control." That the thinking that got the Fed into its current predicament. The inflation that we're seeing now is largely a result of increases in the money supply a year or two ago. But applying the necessary correction now would turn a possible mild recession into a certain and severe one--the Fed is never going to do that on purpose. But the Fed missed it when it might have been possible to avert the problem, because prices were held down by globalization (among other things).

Guest's picture
John Krumm

If you look at periods of inflation historically, often it results in the lower and middle classes playing a little income catch-up with the wealthy, so it can be a good thing for a lot of people. Why do you think Wall Street hates it so much? They don't want wages rising. However, with inflation triggered by high energy prices you can get stagflation, stagnant wages and rising prices, a very bad situation and what we are likely seeing now.

Guest's picture
Kelja

The public is ignorant when it comes to economics. So are the pundits & politicians. INFLATION is increasing MONEY SUPPLY! As more dollars chase the same or fewer services and products, price will naturally increase. An easy example of this is the price of a college education. Easy to get loans & grants caused the price of tuition to spiral ever higher. Along with tuition, wages paid to college presidents and administrators have skyrocketed to obscene levels. Now think just a moment what tuition would be or could be if everyone had to pay out of pocket.

And what do you think our fine central bank officials are doing right now. They are attempting to inject more cash into the economy than has ever been attempted before - before its over, trillions. They are doing this because systemic problems threaten to bring the economy, the world economy, to its knees. The massive injection of paper money into the economy will cause - is causing inflation that will be much worse than most anticipate. Hyperinflation is a possibility, although slim. (My wife complained yesterday about the prices at the Grocery store. Said the cheapest apples were priced at $2.75 lb.)

Some, although few, politicians recognize some of this. For instance, Julianni proposes changing the capital gains tax to something indexed to inflation. If you invested $100 10 years ago and now that investment is worth $200 - NO ITS NOT. Inflation, even at the low levels we've enjoyed over that time has made the dollar worth half as much. That $200 buys you what $100 bought 10 years ago - or less.

Unfortunately, like I said, our politicians by and large, cannot wrap their minds around the inflation problem. Perhaps too busy running for office. In any event, we elect those most like us.

There is one guy who understands, and he doesn't stand a ghost of a chance because people don't think. It's Ron Paul (and before you shut down, read what he said):

“Inflation is immoral,” said Congressman Ron Paul when we sat down with him a few months ago.

“It’s immoral in the sense because it steals, it steals value. If you double the money supply and your prices go up twice as much, it’s an invisible hidden tax. But the real immorality here is that some people pay higher prices than others. So if you’re in a middle class or especially in low middle income, your prices might be going up 15% a year...and somebody on Wall Street might be working leverage buyouts and making billions of dollars and they don’t have to worry about the rising costs of living.

“This to me is an immoral act that is prohibited by the constitution and the outcome is always tragic.”

As far as gold, it's protection, it's insurance, it's real money for the last 6000 years, and it will never go to zero. I've been investing in and talking about gold since 2001. Back then it was $250 an oz.. It recently went over $900. That's a 260% increase in the investment. Not bad and better than anything else.

Sorry about my 2 cents running so long.

Guest's picture
Guest

One way to avoid increasing the money supply, but still maintain consumer confidence and demand, is to cut taxes at the lower income brackets, and raise them at the upper income brackets. (Delaying that AMT tax relief for a couple years, and let inflation push more people into that bracket.) Cut sales taxes, and apply a property tax temporarily on assets over some fairly large amount. Help people to pay down long-term debt - institutions will have more cash for investment. Working and middle class people will catch up to the rich and ultra-rich.

Philip Brewer's picture

@Kelja: I think you'd find that our views on what inflation is are very much the same. That doesn't mean, though, that gold is always a good buy. (Like anything, whether it's a good buy depends entirely on the price you can buy it at.) It was a great buy when it was under $300. (I bought some.) Whether it will turn out to be a good buy at $900 is something that we'll only know after the fact. (I wrote a bit about Gold as an investment a while back.)

@Guest: Tax policies like the one you suggest might reduce the risk of a recession, giving the Fed more room to rein in money supply growth. (Of course, changes in tax policy don't affect the money supply, so they won't have an effect on inflation all by themselves. They might have an effect on prices, though, making the whole thing rather fraught.)

Guest's picture
Guest

I think redistributing money to the bottom will cause prices for basic things like food to rise, but, that's ok if this doesn't cause a rise in more expensive things like health care and housing.

Guest's picture
jess

"#5 Use barter and the informal economy. If your neighbor hires you to help him create a website and you hire him to help you cut down a diseased tree next to your driveway, you both owe income taxes on whatever you're paid. If you instead swap these services informally, you still owe the taxes, but you're expected to declare the income at its fair market value. It's perfectly reasonable, though, to declare the income at what the service would have been worth the previous year."

you still have to pay taxes if no money was exchanged? what happened to doing each other favors?

Philip Brewer's picture

As I understand the law, if you do a favor for someone with no expectation of return, and then they do a favor for you with no expectation of return, then no taxes are owed.

Of course, the IRS can't read your mind, and neither can the tax court. If your usual business is selling radio ads and his usual business is driving a snowplow, I doubt if the IRS would question it. But, if your usual business is setting up websites and his usual business is cutting down trees, the IRS might look askance.

In practice, as long as the exchanges are informal, I don't think the IRS is going to care. In the past, though, they have gotten involved when people set up bartering networks that let people keep track of how much they're owed. (There are bartering networks where you get 10 points for feeding my cat while I'm out of town, then spend them getting a babysitter in for your kids, after which the babysitter can spend them at the local video store. The IRS has gone after people involved in such things saying that each point was worth $1 or some such.)

Legally, though, if you exchange services with someone, you both owe taxes of the value of the service performed. If each service is done as a gift, with no expecation of a favor in return, then it's tax-free.

Guest's picture
Mike m

Too bad we're in a inflationary reccession. Unfortunately, we're probably going to solve it with hyper inflation. The fed cut WAY too much too fast, and its' effects aren't usually fully felt to a minimum of 6 months (about June)
Silver is a MUCH MUCH MUCH better investment than gold right now. Unlike gold, silver is used in all sorts of different productions, and it's incredibly undervalued compared to the median price of homes and where it usually is when you compare to history. When 40 ounces of gold is worth the median price of homes, sell gold and buy real estate... But it's not until 500 ounces of silver are worth the median price of homes when you sell gold and buy real estate.
There's a BIG silver boom coming... get ready.
Other commodities will go up huge as well, as will the companies that ship them.

Guest's picture

I believe the bubble has only max 10 years left. That said everyone should be looking into alternative sources to secure their financial futures like Gold and Silver. I understand not everyone has the ability to get Gold at its current price but Silver is very affordable (as of right now) because Silver is just starting a new long-term bull market. Based on facts and simple calculations *no guesswork involved* silver will rise to $208+ per ounce over the next few years.

There is a video from Rober Kiyosaki as he and his colleagues predict that silver will continue to rise against the declining U.S dollar on my website. (link below)

Over the course of the present bull market in silver and gold, probably another 10 years, silver should rise about four times as fast as gold. That forecast arises from silver’s historic performance, especially during the 20th century, as well as its present fundamentals.

The best way to profit from that trend is to swap back and forth from silver to gold with the rise and fall in the gold/silver ratio. That strategy will convert a sterile investment into one that pays dividends, and possibly double the ounces you own over the life of the bull market.

The fastest and easiest way I have seen to date to get into buying silver if don't have the capital or want to deal with financial advisers is The Silver Snowball and best thing if you want to market it you can accumulate silver eagle coins for free. Check out my website for all the details and Rober Kiyosaki predictions for 2008.

- Vincent Cameron
Silver Eagle Coins

Guest's picture
concern mom

I just read the following news:

BCBS raises premium in San Francisco by 30%( SAn Fran Chron.)

Venezuela current inflation is at 30 %((CEPAL)

Greece has a current inflation of 34%(Kathemerini news)

Property taxes will go up in Florida(Tampa News)

Dollars are being printed like there is no tomorrow.

Outcome: INFLATION and big one. Am I wrong?

What is your suggestion?