William Cate

Five Myths About Inflation

A classic definition of inflation is any increase in the money supply. Understanding inflation is vital to anyone seeking investment profits or attempting to build a successful company. As with most basic issues of the global economy, inflation is surrounded by myths and misinformation.

Myth #1 Inflation is bad for everyone.

Inflation is bad for lenders. It's good for borrowers. To break even on a loan, a lender must charge sufficient interest to offset inflation and taxes on the resulting interest income. For the past decade, inflation has hovered around 6%/year in the USA. If you assume that State and Federal taxes on interest income are 40%, the lender needs a 10% interest rate to breakeven. There haven't been any relatively safe U.S. Investments paying anything near 10%/year, for over two decades.
If you have a 30-year fixed mortgage at less than 6%, you are benefiting from inflation. Assuming the inflation rate remains at 6%, (which is very optimistic) you are making more money on the borrowed mortgage money than you would earn having deposited the same amount of money into a bank savings account. America's biggest borrower is the U.S. Government. The Government's plan has always been to ensure that the inflation rate offsets the Government's interest payments. Follow Washington's lead and be a borrower in the United States. However, borrow to create income and assets, not to live the good life.
When people no longer accept their currency, lenders usually go bankrupt and the borrowers will pay their debts with worthless paper. There are two examples in American history of the loss of confidence in the U.S. Dollar. After the Revolutionary War, the Continental Dollar was no longer accepted as currency. After the Civil War, the Greenback Dollar was no longer accepted as currency. Both were printed by the Government to pay for a war. In both cases, the dollars where bought by speculators and the Government eventually redeemed them at face value. The reason that the U.S. Constitution has a provision limiting currency to gold and silver is directly related to the failure of the Continental Dollar.
The strategy that benefits from this inflation paradox is to be an American borrower of dollars to buy hard assets and a foreign investor (lender) of your investment funds.

Myth #2 A gold standard would end inflation and result in a better life for all.

You can't eat gold. You can't wear gold. It takes too much gold to build a house. As Art Hoppe suggested twenty years ago, chicken eggs would make a better hard currency than gold. At least you could eat your nestegg when the Government scrambled the economy.
Western Europe had eight centuries of the gold standard. From roughly the 4th Century to the 12th Century, everyone was on the gold standard. Usury was outlawed everywhere, It was against the teachings of the Catholic Church. It's still against the teachings of Islam. Money was limited to gold, silver and land. This period in Western History is called "the Dark Ages" for good reason. After WWI, Winston Churchill tried to move Great Britain back onto a modified gold standard. Not only did his effort fail; it was among the secondary causes of the Great Depression in England.
Fiat money is intrinsically worthless. Gold is intrinsically worthless. The advantage to paper currency and credit is that it can be expanded at any rate and thus create perceived wealth. This perceived wealth could be used to create products that create more jobs and more perceived wealth. The goal is to ensure that those hurt by the expanding money supply aren't aware of their lending mistakes. As long as everyone agrees that paper money has value, the system works better than people agreeing that gold has value.

Myth #3 Governments are the sole source of inflation.

Governments inflate their currencies. However, they aren't the sole source of inflation. In fact, they aren't the primary source of inflation. Credit is a more potent factor in supplying cash to consumers to buy products, thereby adding to demand and this price appreciation. Beyond credit, there are assorted financial instruments that add worthless paper to the economic system. The most dangerous of these paper instruments are derivatives.
The economic force that overcame the Dark Ages was lending. The lenders increased the money supply and allowed city entrepreneurs to go into business and sell more products and services. The Renaissance resulted and evolved into the Industrial Revolution. By the 19th Century, we saw the rise of Western Technological Society.
After WWII, the Bank of America introduced plastic money. By the way, plastic has no more intrinsic value than paper or gold, but the public readily accepted it. Visa's success meant the introduction of Mastercard and the American Express card. Today, we have as much plastic money as paper money in the world.
Also, inflation is the result of supply and demand. The reason that oil is $60/barrel relates to the fact that demand for oil has radically increased in the past decade in places like the People's Republic of China and India. Meanwhile, known reserves appear relatively fixed and are expected to decline in the next decade. The result is higher gas prices. Prior to being caught in the supply/demand vise, oil prices moved up more slowly than the overall U.S. inflation rate.

#4 Inflation will destroy the World Economy.

Inflation will eventually lead to a financial crisis. There is always the risk that the public will lose confidence in the U.S. Dollar. An inflationary financial crisis is unlikely to lead to an economic crisis. The Government is well aware of the risks of continue inflation and would quickly move to avert a Depression. The Underground Economy is growing and a collapse of the Dollar would send millions of Americans into it. In fact, the Underground Economy is a greater risk to Washington than the potential that the public will realize the dollar is intrinsically worthless. As with the Continental and Greenback dollars, the Government would issue a new currency. Since it's in the public interest to not ask too many questions about the new currency's intrinsic value, this currency would be quickly accepted and the inflationary game could be started again.

#5 Invest Conservatively During Inflationary Periods.

You can't beat the system by accepting the financial illusion that more dollars that buy less are a safe investment. You need to find relatively low risk investments that pay well enough to offset inflation and give you a net gain in buying power. I'm aware of one and I'm sure there are many more. Take the time to get past the hype and find these investments.

If you can pay your debts until there is an inflationary crisis, you will be a winner in the inflationary game. The winners of the Weimar Republic hyperinflation after WWI were those who borrowed Marks and repaid them when the mark was worth nothing. The problem is maintaining your debt load until everyone agrees that the paper dollar is worthless. Borrowing is financially beneficial. Too much borrowing can be fatal to your short-term future.

In our world, nothing is as it seems. Look beyond the puppet show and find reality. If you fail to do so, you could find yourself and your family dinning in a soup kitchen in a few years.

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