How to live with inflation
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:
- 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.
- 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.
- 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.
- 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.
- 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.
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.
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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