The Inflation Crisis, and How to Resolve It

21

Can You Beat Inflation?

In nearly every country in the world today the outlook is for continued inflation. The arguments of the sound money champions and limited-government advocates have proved futile against the sophistries of the inflationists and the vested interests of the politicians. The politicians have concluded that they can continue to hold office only as long as they spend more than they tax, as long as they redistribute income, as long as they “soak the rich,” as long as they hand out subsidies to a score of pressure groups under the plea of “relieving poverty” and showing “compassion.”

For years thoughtful and responsible men have hoped that, when the situation in a given country got bad enough, the inflating “welfare” government would be turned out, or would itself reverse its policies. But the expected time of realizing this hope keeps receding into a more distant future. Where, in this country or that, the inflating socialist government has at last been thrown out, the “conservatives” elected in their place have feared to make any but trivial changes. Millions of people have got used to their food subsidies, or their controlled rents, or their high and prolonged unemployment insurance, or their government-provided jobs, or their escalating “social security” benefits. They have come to accept all these subsidies as rights. The existing government fears that any attempt to remove or reduce them will set off riots. The attitude of the politicians in power becomes increasingly one of “Après nous, le déluge.”

In this climate, more and more individuals abandon hope of ending inflation by political argument or action, and decide to devote all their energies to trying to save themselves from being ruined by inflation. Some even hope to make a profit out of it. Certainly each of us has a duty to himself and his family to try to minimize the harm that inflation threatens to inflict on his own fortunes.

So let us consider what the most appropriate actions are for one who attempts this.

The first piece of advice is negative. It is to tell him what he should not hold. He should hold only enough cash for his more immediate needs. He should sell bonds and other securities that yield only a fixed return. He should not put his money into mortgages or annuities. He should reduce his savings-bank deposits to a minimum.

This advice is especially important if he expects a hyperinflation. In the German inflation of 1919–23, prices went up hundreds of billions of times. The value of cash and savings-bank deposits was wiped out. But if he expects only a moderate inflation, our negative advice may not strictly apply. For example, if an inflation (in the sense of an average price-increase) is expected to run at a rate of only 5 percent a year, a savings-bank deposit will at least retain the value of its principal.

At this point it is perhaps necessary to define our terms. By a “moderate” inflation I mean one that brings an average price rise of less than 10 percent a year. By a “double-digit” inflation, I shall mean one, as the adjective implies, that brings an annual price rise of anything between 10 and 99 percent. And by a “hyperinflation” I shall mean one that brings an annual price rise even higher than that.

This division is arbitrary, but it is not my own. It follows roughly what have lately become common newspaper designations. To call any inflationary rise of less than 10 percent a year a “moderate” one would until very recently have astonished any conservative economist. Even an “inflation rate” of as low as 5 percent a year would wipe out half the purchasing power of the dollar every fifteen years, and even an inflation rate of only 2 percent a year would mean an erosion of the purchasing power of the dollar by about one-half in each generation.

The Risks of Holding Common Stocks

Let us return to our inflation-hedging problem. If the investments to get out of are savings-bank deposits and all fixed-return securities, then it would seem to follow that the investments to get into are “equity” securities, or common stocks. But most past results of this have been very disappointing. In the German hyperinflation of 1919—23, it is true, the average price of stocks increased billions of times, but average wholesale prices increased many more billions of times. The net result was that, at the end of the inflation in December 1923, the average price of stocks was equivalent to only one-fourth their gold value in 1913.

The causes of these disappointing results have been somewhat complex. Let us recall once more that in any inflation, individual prices and costs never go up at a uniform rate but at widely different relative rates and times. Cost-price relationships become discoordinated. Individual firms find it increasingly difficult to know or guess what their own future costs or future selling prices are going to be, and what will be the ratio between them. During an inflation demand shifts quickly from one product to another. This makes it increasingly difficult to plan production ahead, or to estimate future profit margins. In the later stages of an inflation, wage rates are more certain to go up than individual prices. Even if aggregate profits increase in monetary terms, the range of deviation and dispersion is much greater as between different firms. The investor faces increasing uncertainty. This always tends to lower stock prices.

Because the future of the business is increasingly uncertain, corporations become more reluctant to pay out dividends. If, as in many cases, profits are particularly high in money terms, if inventories and plant and equipment are constantly rising in price, more and more plant managers conclude that the best use of their current profits is to plow them back immediately into expansion of the business. This seems especially the most profitable thing to do in a hyperinflation. It then seems foolish to declare dividends when, by the time the stockholders receive them, they may be worth much less than they were when declared.

But all this tends to have a demoralizing effect on the stockholders. They cannot afford to hold many investments that yield them little or nothing. They need current income to live on, and more and more of it in monetary terms. No matter how much the theoretical book value of the shares, few can afford to buy or to hold them.

Gold

The next inflation hedge we have to consider is the purchase of gold. This seems to many the best hedge of all. They remember that in the great German inflation those Germans who consistently bought gold whenever and to the extent they could, and held it until the inflation ended, came out with at least their principal intact. From a strictly economic point of view, buying gold in a major inflation and holding it probably presents the least risk of capital loss of any investment or speculation.

But it also has serious drawbacks. Hoarded gold yields no interest. Either the holder must have some other source of current income to meet his day-to-day living expenses in the depreciating paper currency, or he must sell a certain amount of his gold every week out of his hoard. Otherwise he must sit with his gold till the end of his life or until the inflation is over, whichever comes first.

(And how can he know when the inflation is “over”? If he were a Frenchman he should have bought gold in early July 1914. But now, sixty-four years later, inflation in France is still going on. Technically, of course, it is not the same inflation: there have been any number of “stabilizations” and “currency reforms” in between. Catching every stabilization and every resumption of inflation would not have been easy.)

In addition to not yielding any income return, holding gold is subject to heavy political risks. For a whole generation the U.S. government made private possession of gold illegal. When it was once more permitted, Treasury authorities seemed for a while to take a malicious satisfaction in dumping gold on the international market to depress its price. This was called part of the process of “phasing gold out of the monetary system.”

There is no reason to think that the political animus against “gold hoarders” and “goldbugs” is permanently over. The possibility of a discriminatory capital-gains tax on gold “profits,” or even of outright confiscation, cannot be wholly dismissed. We must remember that in 1933, when private citizens began to exercize their clear legal right to convert their Federal Reserve notes and gold certificates into gold, President Franklin D. Roosevelt suspended the conversion, ordered the citizens to exchange their gold for paper money, and made it illegal for private citizens to hold or own gold. In other words, the government not only broke its solemn and explicit pledge to convert its notes into gold on demand, but treated the holder (and dupe) who had taken the pledge seriously as the real culprit. And the Supreme Court later upheld the president’s act and the new law.

Trading in Commodities

Let us turn now to the advisability of speculating in other precious metals, such as silver and platinum, and, still more broadly, in any of the commodities that are traded on the great speculative exchanges: copper, cattle, cotton, lumber, coffee, cocoa, sugar, hogs, pork bellies, wheat, corn, oats, soybeans, and so on.

Trading in silver has some of the advantages of trading in gold, but also shares some of the political risks. In nearly all the other commodities, however, we are getting into an area better left to the professional speculator. It is not only necessary for the trader to know a great deal about the special supply-and-demand situation of the particular commodity he is trading in, but he has to take into account all the costs and risks of trading in and out—the costs and risks of buying on margin, paying interest on borrowed money, paying commissions, and losing because of the constant gap between bid and asked prices. For even if the general trend of the market for the commodity he trades in is upward, there are sure to be violent price fluctuations both ways; and he may find himself being “whipsawed.”

Finally, he must take into account the heavy toll of the capital-gains tax. We will return to this last problem later.

We come now to a miscellaneous group of objects frequently resorted to as inflation hedges. One of these is diamonds. These, like gold, have the advantage of a negligible storage charge. But the “investor” in these will need expert advice and appraisal, which involve a cost, and if he is not in the business he must either buy at the retail price and sell at the wholesale, or pay high commissions. In addition, he must keep in mind that his diamonds, being each in some degree unique, will not be as “liquid,” or as readily salable, as gold, stocks, or commodities on the exchanges.

Similar and even more emphatic warnings must be given about the speculative buying of paintings and other art objects. The layman reads of huge profits made by the early acquisition and later sale of, say, the French Impressionists, and fancies he can duplicate the achievement. But fortunes can be lost as well as made in paintings. The trick for the person who wants to speculate in them is either to have impeccable taste or a shrewd market sense of the next swing of an art fashion or vogue and of how long it will last. Failing this, he needs expert advice—which may also go wrong. Again, whoever is not himself in the business must pay a substantial dealer’s commission when he wants to buy and face the problem of finding a buyer to unload on when he wants to sell.

This leads us to the question of the advisability of buying tangible luxuries of all kinds—antique or expensive modern furniture, vases and similar art objects, personal jewelry, a new car, a yacht, a private plane—anything to get out of depreciating cash and into “real goods.”

This is what nearly everybody tries to do when he becomes aware that he is in a hyperinflation. It is hard to offer any general advice about it; too much depends on the advisability of each purchase. It is often a final act of desperation rather than a shrewd provision for the future. One of its ironic consequences is that some economists point to this desperation-buying as a sign of an “expanding economy.”

Real Estate

I have left to nearly last the discussion of a very important hedge: the acquisition of real estate. The problem is not a simple one. We must consider at least four different options: (1) the purchase of a home, or perhaps of a bigger and more expensive home, (2) the purchase of raw land, (3) the purchase of residential property—apartments or detached houses—for the purpose of renting, and (4) the purchase of commercial property for one’s own business or for rental.

Each of these choices involves its own risks and its own comparative advantages and disadvantages. The advantage of purchasing one’s own home or a much better home during an inflationary period is the most obvious. You do not get an immediate monetary return, but you do get an immediate return in added enjoyment. And you have the satisfaction of knowing, if you have bought wisely, that the monetary value of your property is rising as long as the inflation lasts. Even if you buy or build late in an inflation, and pay a much higher price than you would have had to pay a year or ten years previously, you can still expect a further rise in the monetary value of your investment. You may have to pay a high interest rate for a mortgage, but you may more than compensate by paying it off in depreciating dollars. Your main real problems will be a rising cost of maintenance, repairs, and taxes. True, the neighborhood you have chosen may deteriorate, but it may also improve.

With the speculative purchase of raw land, you face a quite different problem. You seldom have to worry about upkeep, and not at all about repairs. Raw land has the advantage that its selling price tends to capitalize not only past and existing inflation, but the average expectations about future inflation. On the other hand, the owner usually gets no enjoyment or other use value out of raw land, and it yields him no monetary return. Instead, he is out of pocket year by year for taxes, which tend to increase with the inflation. And land is illiquid; he cannot sell a particular parcel easily and quickly. In the German hyperinflation of 1919—23 there were men sitting with large tracts of land of high nominal monetary value, but lacking the cash to meet their current living expenses.

The purchase of residential property for rental will normally yield a net income over taxes and maintenance charges, but the owner often faces the danger of a sudden imposition of rent control. The more severe the inflation becomes, the more likely rent controls become. The owner can be trapped in compulsory losses.

The purchase of commercial property tends to avoid the danger of rent control, but it also involves greater risks in finding and keeping a tenant. If the owner puts up an office building or a factory on speculation, he may find that he has built the wrong size or kind of office building or factory.

Foreign Investments

I have left till last a form of inflation hedge that might logically have been mentioned much earlier. But I have postponed its discussion because, until the later and worst stages of an inflation, it is a form of hedge usually resorted to only by a comparatively small and sophisticated group of bankers and businessmen. This is the acquisition of foreign currencies and investment in foreign securities, businesses or property. It should be obvious that this is a form of hedge that should be undertaken only by somebody who knows what he is doing, who has an intimate knowledge of the foreign country in which he is investing, or who knows where to get expert and disinterested advice. Many foreigners in the past have invested in dollars and in American securities; it is a little awkward for Americans now to be trying to do the reverse.

The risks of this type of hedge are great. It is extremely difficult to “watch” one’s foreign investments. No foreign country is today on a gold basis, or exempt from a possible spurt of internal inflation. When a small country, like Switzerland, begins to find itself such an “inflation-refuge” country, it becomes embarrassed by excessive refuge deposits and tries to discourage or penalize them. And Americans who try to invest their capital abroad are also liable to find themselves increasingly discouraged by domestic legislation. There are apt to be laws and penalties against capital outflow. No matter how discriminatory or unfair these are, they are likely to win popular approval. The assumption will be that only the rich and unpatriotic are able or likely to resort to such a “flight of capital.”

Our review of possible inflation hedges has not been on the whole encouraging. We have seen that each attempted hedge has its particular attractions, risks, and shortcomings. Our survey of the major possibilities may also lead us to suspect that there is no one single type of hedge or purchase to be at all times preferred to any of the others. On the contrary, your success will depend much less on what you buy than on when you buy it, at what price, how long you hold it, and at what price you sell it.

No one thing, in an inflation, goes up steadily and dependably and faster than everything else. In a major inflation, even a commodity that makes a spectacular long-run advance often takes sudden downward plunges in the midst of that advance. Ruinous losses have been suffered by some speculators in gold who were unable to hold on.

At any one time—for a week or a month, say—one commodity will be going up faster than any other. But it is in the nature of speculative markets that the particular front-runner will be constantly changing. An omniscient speculator, foreseeing what the next front-runner was going to be, would sell even a rising commodity to buy this faster-rising one. He would know just when to buy and when to sell each particular thing, and would be constantly changing his “investment.”

But not only is no one omniscient; no one is smart enough, or consistently lucky enough, to afford to act this way. The cumulative risks and costs would be prohibitive. First of all would be the cost in study and time. A speculator of the type described would have to devote his full day to his speculation; he could not engage in any other business or profession. He would suffer the repeated costs of getting in and out of his incessant swaps—from the inevitable gap between the bid and asked prices, and from the constant commissions.

Capital-Gains Taxes

And under present laws any successful inflation-hedger would pay ruinous capital-gains taxes. He would pay a capital-gains tax even on nonexistent capital gains, which would happen whenever his monetary gain, for example, was smaller in percentage than that of the average rise in prices in the period. And present laws would allow him, on the average, only a grossly inadequate offset for real losses. The average federal capital-gains tax comes to 25 percent, and the state capital-gains tax—in New York, for example—comes to another 5 percent. It has been frequently pointed out that, even when the “take” of a gambling casino averages only 2 or 3 percent, those who gamble long enough against it must all eventually lose. What must be the result when the take of the “house” is 30 percent?

It should be obvious that the whole present American tax system not only discourages effort and enterprise, but makes it all but impossible for a law-abiding citizen to protect himself against the ravages of the inflation that the government’s own policies impose upon him.

A period of inflation is almost inevitably also a period when demagogy and an antibusiness mentality are rampant. If implacable enemies of the country had deliberately set out to undermine and destroy the incentives of the middle classes to work and save, they could hardly have contrived a more effective set of weapons than the present combination of inflation, subsidies, handouts, and confiscatory taxes that our own politicians have imposed upon us.

Tipsters, advertising their services, often lead the unsuspecting citizen to believe that inflation offers him exceptional opportunities to make a fortune. So far as the overwhelming majority of us are concerned, this is exactly the opposite of what it does. In addition to all the special factors we have just been discussing, there are two overriding considerations. One is that, in hedging against inflation, each of us can protect himself only at the expense of someone else. Every time we buy some commodity as a hedge, we tend to raise the price for the next buyer. It is possible successfully to practice inflation hedging individually, but never generally.

At best, inflation can benefit one group only at the expense of other groups. The price of what you have to sell can go up more or faster than the average price of what you have to buy only if the price of what other people have to sell to you goes up less or slower than the price of what they have to buy from you. The net amount of any real gain from inflation must be offset by at least an equivalent amount of real loss. The political appeal of inflation comes from fostering the illusion in the great majority of voters that they will somehow get the better of the swindle, and profit at the expense of a few unidentified victims.

But the overall situation should be clear. Inflation is a form of tax, a tax that we all collectively must pay. If the government spends, say, $70 billion more in a given year than it imposes in taxes, and pays out the difference by issuing $70 billion more in paper money, all those of us who are not paid part of that deficit money from the government must collectively forego the equivalent of $70 billion in goods, services, or savings.

For every outstanding profiteer from a major and prolonged inflation there are crowds of losers. Those who spread the false belief that the individual, by a few simple hedges open to all, can easily save himself from inflation, or that one is even presented with a special opportunity to make a fortune from it, reduce the opposition to it and encourage its continuance. There is no safe hedge against inflation except to stop it.