Toeing the Line with Inflation

Inflation is really a secondary form of taxation.  It is caused by government action and acts by eroding the purchasing power of dollar-denominated assets.  This effect happens when the government increases the amount of currency in circulation faster than the growth of real production.  The net effect is more dollars chasing after fewer goods and services.

The inevitable “next question” is to find out what inflation means to us as individuals, and how we can fight against it.

What Inflation Does

The best place to start determining how we can fight inflation is to examine what inflation does.  The primary effect created by inflation is to erode purchasing power.  This happens because the value of some things are increased by inflation while the value of other things are decreased by inflation.  For example, if you take out a loan on your home, the value of the loan is decreased by inflation if the face value of the loan (which you pay back) stays flat.  Meanwhile, the dollars you use to pay back the loan are going down in value.

Another effect that inflation frequently drives is to increase the nominal value of assets like stocks and real estate.  This effect happens because the quantity of dollars competing for these assets increases while the amount of these assets available to purchase stays relatively flat.  In this way, some people can be “tricked” by inflation since it pushes up the nominal value of their investments and property while the real value may be holding flat.

Even worse is that tax policy does not control for the impact of inflation, so these nominal increases in asset value are treated as though they are real gains for the purpose of determining tax liability.  In effect, this means that you may be obligated to pay taxes on a gain that simply maintained the value of your investments and didn’t result in any real gains.

Inflation Transfers Wealth

The way that inflation transfers wealth is by the interplay between assets that are bolstered by inflation and those that are decimated by it.  By and large, investments in fixed-return securities such as CD’s and bonds are especially weak against inflation since their returns/value are fixed in dollars.  Conversely, people who use fixed-rate debt to invest in assets that increase in value from inflation, produce a cash flow that increases in value from inflation, or both are in an especially advantageous position since the value of their investments/cash flow are increasing while the value of their liabilities stays fixed.

Another effect that emerges from inflation is a net transfer of wealth from retirees to workers.  This happens because the wages of workers frequently increases with inflation, but the pension payments and bond interest and other “safe” investments recommended for retirees rarely keep pace.  The transfer of wealth happens because the interest rate for these “safe” instruments gets eroded by inflation as the net purchasing power of the retiree’s nest egg declines.  Conversely, workers wages tend to increase with inflation as competition between employers for skilled labor drives up wages to the new rate of equilibrium.

What to Do About It?

So how do we fight against inflation?  The unfortunate answer to this question is to work against the advice that many of us have received throughout the majority of our lives.  Many people operate under the belief that the way to long-term wealth is to save, invest, and eliminate all debt.  While it is true that this plan will definitely make you better off than not saving or investing, it will still leave you very vulnerable to the impacts of inflation.  (Especially when the unfunded Social Security & Medicare obligations come due)  The best way to fight back vs. inflation is to make investments in appreciating assets that produce income by borrowing money for a long time at a fixed rate.  The reason for this is because the income from the assets will help to pay the interest expense.  Over time the impact of inflation will cause the value and income of the asset to appreciate, and will also allow you to repay the fixed-rate loans in devalued dollars.

The future is rapidly changing and requires that our strategies change as well.  The strategies that worked in the past may not be appropriate for the financial world of the future.  Each person must analyze and assess the decisions that they want to make in order for their own future to be shaped by factors of their own making instead of factors beyond their control.

What decisions are you making to shape your personal financial future?

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