Sunday, March 23, 2014

Inflation, the Biggest Sin Tax

Highlights: Sin Taxes, Lessons from the Cosmos, The Political Crutch,
The Enemy, How an Award Winning 401-K Invests During Inflation,
Other Currencies

Sin taxes

Governments have many problems but all have two in common. The first is that certain crimes appear to be endemic to their societies and don’t appear to be susceptible to inexpensive eradication. For example we know there are enormous social costs due to chronic losses from gambling, and there are others as well. Many governments take the attitude that they can not stamp out these sins; however they can hurt them by imposing taxes on them. There is a na├»ve belief that if they raise the cost to participate that eventually the public will not indulge. This brings us to the governments’ second need which is a source of growing tax revenue, not to pay for the social costs of the crime, but to meet general government expenditures. Just look at the incredibly sharp increase in taxes on cigarettes and alcohol in our lifetime. The victims of these sins are often labeled addicts. Strange, we do not label governments as addicts, though they are addicted to sin tax revenues. By the way I believe by far the largest sin tax in terms of impacts on our societies is inflation.

Lessons from the cosmos

We may believe that inflation is a relatively new phenomenon from the time of the birth of coins and currencies. Evidence just revealed this week proves that Albert Einstein* was correct in suggesting that it was present in the original Big Bang Theory* at the creation of our universe. This week according to James Bock, a Caltech* physicist along with others using a telescope from the South Pole, found evidence of gravity (waves that Dr. Einstein, a century ago predicted would be found that were the direct result of the Big Bang that created our universe.) I will leave to others, more learned than me to explain the theory. For those of us that live in the world of numbers and taxes, the key to the discovery was the term used for the exponential growth of particles that became planets and other objects. That term was ‘inflation.’ Thus the term from the physical world describes a power that keeps growing.

* When he came to the US Albert Einstein spent some time at the California Institute of Technology (Caltech). I have stayed in the room/suite that was prepared for him to stay in the faculty club on campus. Princeton lured him away to teach in New Jersey, where we now live. His Big Bang Theory is used as a title for a current television comedy about very bright scientists adjusting to functioning in the everyday world. I will admit my good wife is addicted to watching both the original and re-runs of these hilarious shows. Many believe that Caltech graduates are the models for these characters. There is much amusement about the success of the program at Caltech board meetings that I attend.

The political crutch

I have read a number of constitutions from around the world, and in none of them have I found that the sacred duty of the government is to create jobs for the governed. Yet any government that wants to stay in power, whether elected or not, is at risk when people are out of work and there is general lack of sufficient food. The leaders of the government, rather than to solely rely on the underlying economy to produce sufficient income and jobs, believe that they must do it. In general, governments have two sets of financial tools, fiscal and monetary policies. Fiscal policies are those that set the level of taxes raised from the population. As most people do not want to give up some of their hard earned money to the government, raising net effective tax rates is generally not favored.

The second set of policies is monetary policies. These deal with the levels of loans made by the financial community and in its essence the value of money. There is a long history of the latter. A monetarist would point out the Roman Empire, like all great empires, did not fall to the hordes of barbarians. Rome fell because for many years the government was literally shaving some of the metal from its coinage money. In effect it was devaluing. The public was not dumb and realized that the value of the money declined and so they raised the prices for their goods, services, and labor. Rome fell because it could no longer be protected by the best, most expensive, military in the world. In the Middle Ages shaving coins was punishable by death. A government which is not popular, and few are, can either publicly raise taxes or more quietly devalue which creates inflation. All too many of today’s leaders are unwilling to pay for current and future government services through tax revenues and so resort to forms of inflation that the public does not fully comprehend.

Central Banks which are titularly responsible for monetary matters and in theory independent of political forces are in fact beholden to them. Because the political leaders can not obtain sufficient taxes they have the central banks induce inflation into the economy that they hope will stimulate individual and corporate savers to spend and invest that will create new jobs and incidentally lower the value of their debt repayments.

The enemy

In a closed society that is not expanding, the need for increased spending and investment is high. By definition the people that have the necessary money are the savers. These people are those that are choosing not to spend in order to provide for the future spending needs of themselves, their families, and worthwhile charities. By lowering the value of their savings by inflation, central banks are in effect stealing from these savers. Thus, the savers become the target to generate the future growth. If they don’t readily provide the necessary funds they become the enemy. 

The current policies of many central banks including those in US, UK, Europe, and Japan is to raise inflation to 2% or more to drive their economies. The theft comes in by understanding the long-term effects of inflation. The collapse of the Weimar Republic in Germany brought Hitler into power when their money was practically worthless. Many would say that can’t happen here. If successive central banks meet their goals of 2% or more inflation in one or two generations the entire wealth of the savers can be wiped out. (The rule of 72 shows the number of years it takes to double your money by dividing the current or expected interest rate into 72. The same calculation can be used in reverse to see how long it would take to lose half. Two divided into 72 suggests 36 years. For those of us responsible for long-term investing for endowments or multiple generations of families, 36 years is a short term when century-100 year bonds are being eagerly sought.) 

How an award winning 401(k) invests during inflation

There is no complete answer to creating an investment portfolio that can meet the needs for reasonable returns that is aware of the risks of inflation. We have addressed these needs in a 401(k) that BrightScope labeled as the best in the country in terms of many attributes including low costs  As the participants can not withdraw their money from this plan for ten years, the ten year performance numbers are relevant as a guide for long-term oriented accounts. Below is the annualized performance for ten years through the end of February of the nine options offered to the participants and their rank within the nine alternatives:
Rank/Category=Total Reinvested Return
1.    Small-Cap Core=9.23%
2.    Small-Cap Value=8.23%
3.    Index fund=7.89%
4.    Growth=7.76%
5.    Value=7.07%
6.    Balanced=6.71%
7.    International=6.27%
8.    Bond=4.73%
9.    Stable Value=3.10%

Do not fixate on the actual numbers which were influenced by numerous special circumstances. During this last ten years I have been very concerned that after-inflation returns were going to be important for all of our accounts to meet their spending needs beyond the financial world. To me the best overall way to do this was to assume more volatility and liquidity concerns by investing in smaller companies. In any given ten year period the actual returns will almost certainly be different as will probably those ranked between 3rd and 7th. As the end of this period was February the ranking of International was hurt by currency movements.

Believing that the US will not adequately address its inflation issue, which should be zero based, I believe on a relative basis the long-term value of the dollar will decline upon the leaders. Thus, at this point in time for long-term accounts I would be increasing exposure overseas even with the economic and credit risks in China. The Bond return of 4.73% includes significant investments in TIPS to provide some real return benefits from owning bonds. Because I expect interest rates to rise the total reinvested return in bond funds in a cash flow account will enjoy higher rates that can offset some lower bond prices. Stable value returns over time should equate to the inflation rate.

Are there other long-term oriented 401(k)s with which we should be speaking?

Other currencies

The way we invest into non-US dollar currencies is through funds that have equity and debt positions in selected currencies. With the US dollar being the temporary safe currency it has appreciated against other currencies. This means that the other currencies have lost value relative to the greenback.  Liking to buy when things are down, I am attracted to investments in sound Canadian companies. The relatively newly appointed head of the Indian Reserve bank appears to me he could be making India’s securities more attractive by raising interest rates as some investors may want to diversify out of some of their direct holdings in China. Along the same line of thinking, the Taiwanese dollar could be of interest.

My question for all of us is: How are we going to hedge our inflation risk ahead of inflation manipulation replacing interest rate manipulation?

Please share your thoughts.  
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