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April 04, 2007

Inflation Pickpocket: How Scott Used Inflation To Separate Peter From His Net Worth
by Daniel Amerman

Inflation is not an even game, it is not a fair game, and we are not all in this boat together. For inflation is not about destroying everyone's wealth - it is about redistributing that wealth, and if you don't understand this, then it will likely be your wealth that will be getting redistributed.

ACT ONE: Smooth Economic Sailing

To illustrate how inflation redistributes wealth, we will use a simple morality play with two investors, in three acts. Peter is our virtuous hero, for he understands that a penny saved is a penny earned. Peter has been diligently saving for retirement, and that saving has taken two forms. The first was paying down all his debts, and the second was building up retirement assets. So Peter contributed to society through his work, was paid for his contributions, controlled his spending, responsibly deferred his gratification, and built up $100,000 in hard-earned savings.

Scott is our irresponsible villain. Scott is not the kind of guy who appreciates the wisdom of being debt-free, indeed, Scott doesn't assign any moral implications to how he manages his money at all. Scott has a use for $100,000, he sees that Peter has the money ready for investment, so Scott borrows $100,000 from Peter.

So, in the smooth economic waters of the present, virtuous Peter has a $100,000 asset with no debt, and irresponsible Scott has a $100,000 debt.

(Both hero and villain happen to be Baby Boomers, for there are aspects of this play that are particularly appropriate for investors of the Boomer generation. However, the lessons apply to all investors, and indeed, some aspects are even more applicable for many investors outside the United States than they are for American investors.)

ACT TWO: Picking The Pocket

The Boomers start to retire, and begin simultaneously trying to convert their bountiful paper wealth supply of dollar denominated investments into a quite limited supply of real goods and services, even as government deficits reach all new levels in attempting to pay for Social Security and Medicare. The Chinese and Japanese stop buying US treasury bonds (and thereby stop supporting the dollar), and instead directly buy oil, which is in much tighter supply than it used to be. The US scrambles to simultaneously find buyers for the Boomer's securities, buyers for the bonds needed to pay for Boomer retirement promises, and hard currency to buy oil from exporters that will no longer accept dollars. (A concise description of some complex issues, but this is a short play and illustration, not an econometric model.)

The dollar drops 90%.

The former dollar is now only worth ten cents. What you used to be able to buy for $1 now costs $10. Whichever way you care to look at it, 90% of the former value of the dollar is gone. And so is 90% of the value of the debt which Scott owes Peter.

In real (inflation-adjusted) terms, the $100,000 investment that constituted Peter's loan to Scott is now only worth $10,000. So Peter has lost $90,000 of his investment, in purchasing power terms. Scott, on the other hand, no longer owes $100,000 in real terms. He only owes $10,000 in inflation-adjusted terms, meaning he his personal purchasing power is $90,000 ahead in real terms of where he started (or $900,000 ahead of where he was in nominal terms, keeping in mind that it now takes a dollar to buy what ten cents used to).

By borrowing $100,000 in pre-inflationary dollars, and paying back (in full) $100,000 in post-inflationary dollars, Scott has used inflation to redistribute $90,000 in real wealth out of Peter's net worth, and into his own net worth. By better understanding that inflation destroys debts even as it destroys dollar assets, Scott has used inflation to take $90,000 directly from the virtuous and cautious Peter, just as effectively as if he had picked Peter's pocket.

ACT THREE: Real Assets & Pieces of the Pie

To more fully understand what happened and how Peter was separated from his net worth, let's take a closer look our "villain", Scott, and the chart below. Like everyone else who knows how to read a newspaper, Scott was aware that there were huge economic issues associated with paying for the retirement of the Baby Boom. As a regular reader of contrarian financial education websites, Scott was further aware that the easiest way of reneging on debts was to inflate the currency. If the politicians of this generation make easy promises will be too expensive to possibly pay in the future - the politicians of the next generation merely inflate the currency (while "managing" the official indexes). So that a nation (or individual) legally pays in full in contractual terms what has been promised, but those payments are only worth a small fraction of what the original debt was.

Scott was in fact just as responsible a saver as Peter, which is how he built his own $100,000 in savings. Because he saw inflation coming, unlike Peter, Scott put his savings into solid, real assets of the sort that withstand inflation (such as precious metals, cash flow producing properties and other contrarian assets). Because Scott understood economics, he was happy to take Peter's loan as well, particularly at an interest rate that was only slightly above the then low rate of inflation. Scott took that money, and purchased another $100,000 of hard assets. Scott's pre-inflation combined position was $200,000 in real assets, and $100,000 in dollar debts, for a net worth of $100,000.

Scott further understood that, ultimately, dollars are symbols and resources are reality. That what he needed in retirement wasn't actually electronic symbols in a brokerage statement -- but the right to convert his savings into goods and services so that he would be able to enjoy a comfortable lifestyle. So Scott prepared the chart below:

As can be seen above,Peter and Scott each started with an equal net worth, and an equal claim on goods and services, meaning that each has an equal right to goods and services in retirement. The ending bottom line, however, is Scott owns 95% of the rights to the goods and services, and Peter only owns 5%. So Peter spends his 70s cleaning tables at a fast food restaurant, while Scott enjoys a verandah suite on frequent cruises.

And the most nefarious part of this little confidence scheme? The mark never realized what happened to him. Because Scott repaid Peter in full, as contractually promised. While sweeping floors, Peter frequently shook his head about the irony of his investing well in an investment that paid him back, and yet losing the purchasing power of his net worth to the same inflation that claimed the retirement assets of nearly all of his friends. Never realizing that Scott had quite deliberately used inflation to take $90,000 of that net worth.

A Deliberately Offensive Story

What a horrible ending to a perfectly lousy story! The virtuous and debt-free hero makes a good investment that is repaid in full, but still must spend his golden years cleaning up after teenagers. Meanwhile the villain is cruising around the world as a reward for his fiscal irresponsibility. If you are feeling a bit outraged and perhaps even offended by the way the story is presented and how it turns out - good! For that means you are learning a crucial but little understood lesson about inflation right now by reading an article, instead of learning it by losing much of your net worth in the future.

For good reason, there is an enormously powerful paradigm right now, this morality play that many of us were raised with, that says savings are good and debt is bad. These are heartland values, the kind I was raised with as well, and there is powerful truth to them in ordinary circumstances. However, there is an unspoken assumption underlying this view of savings and debt. It assumes the currency is stable, that assets and debts each maintain their value, and that a dollar is a dollar. The problem is - it isn't. With powerful inflation, what a dollar is changes every year (and every month), and that turns our morality play upside down.

The problem is that most of us want to be the "mark" in the little three act play above. We want to be debt-free, particularly coming into retirement. We want to have substantial portfolios of stocks and bonds, just like the financial columnists all preach. We want to be responsible, to pay as little money as possible in debt service - so that our financial assets are working for us, instead of us working for our creditors. Good, solid truths - all of which add up to being like Peter and having the maximum possible exposure to losing the value our dollar denominated savings if major inflation does occur, with no hedge or portfolio insurance to protect us, with no ability to even partially offset those losses through profiting from the inflation driven destruction of the value of our debts. We have a burning desire to walk down dark alleyways with 20 dollar bills hanging from every pocket. If that is, if major inflation returns, and there are powerful reasons to believe that it will.

Changing The Names

"Peter" and "Scott" were used to make the play personal, and hopefully something the reader can more easily relate to than abstract economics principles. The story could happen just the way shown, with one individual making a loan to another. However, it is far more likely in today's world that the financial "system" will be standing between Peter and Scott. For instance, Peter could be investing in bonds, and Scott could be borrowing with a home mortgage (the historical way in which millions of "Scotts" made a great deal of money the last time inflation rampaged in the 1970s, as discussed below, at the same time that the stock and bond investing "Peters" of the world were getting badly burned). Taken together however, the picking of the pockets will work the same basic way for the Peters and Scotts of the world, even if their transactions are not directly with each other.

When we remove the direct personal component then, does this change your view of the comparative morality? Is Scott being somehow a bit shady when he accepts the terms of a loan that is freely offered from a large and sophisticated financial institution that is in the business of lending? If Scott accepts the loan because he has a five or ten year horizon while the executives at that financial institution are only looking to the next quarter or year - is that indicative of a shortcoming on Scott's part? Or does that merely mean that Scott is intelligently looking after his own self-interests?

The Historical Precedent -- One of the Largest Transfers of Wealth From Institutions To Individuals In History

Let's change the date and the names. Let's make the date 1972, let's rename "Peter" the Savings & Loan industry, and "Scott" the average American homeowner, who took out a mortgage to buy his house. Over the next ten years the dollar lost 57% of its value. Taking into account the value of having a 7% mortgage in a 16% market, the average mortgage lost 75% of its value over those ten years to inflation. Which effectively bankrupted the Savings & Loan industry. Over those same years, inflation slashed the real cost of mortgages leading to a double-barreled benefit for millions of American households. Every year, real home equity soared as the value of the mortgage owed was destroyed by inflation (house values didn't quite keep up with inflation). Every year, the after-inflation costs of mortgage payments declined substantially, freeing up badly needed real purchasing power in a time of economic turmoil.

By 1982, the average homeowner who had been in their home for ten years, had increased the ratio of their home equity to mortgage debt value from 25% to 500%. Economically speaking, the average American picked the pocket of the financial industry (albeit accidentally for the most part). This isn't some arcane financial theory. It was what actually happened (see links below) the last time inflation raged out of control in the United States. Which directly benefited tens of millions of American households, indeed for many it was the single largest real profit they would make in their lives, and still forms the core of their net-worth. At the very same time that almost all financial assets were taking a pounding, it was being in the right kind of debt was coining net worth for millions of households - as counterintuitive as this may seem, when viewed from the perspectives we gain after a couple decades of much lower inflation. A counterintuitive lesson illustrated with the dastardly "pickpocket" above.

Playing The Great Game At Different Levels

Deliberately using debt and inflation to redistribute wealth is advanced finance compared to most of what passes for "financial education" as presented to individual investors through conventional channels - but it's not all that advanced. That inflation systematically redistributes wealth from retirees to current workers, and from creditors to debtors, are both well understood principles of economics, routinely taught in undergraduate courses for many decades. The financial world contains quite a few wolves who got straight "A's" in economics when they were in college, and as discussed in the previous article in this series, "The Great Game, Gold Arbitrage and The Three Little Pigs", for the smartest of the smart money, the judicious application of these principles means that a collapse of the dollar will increase their real wealth, not decrease it. A deeply unfair outcome, given that it is the games being played with our financial system by many of these same people that is jeopardizing the value of the dollar - but as discussed in the first paragraph, this is not a fair game.

The "wealthy" are certainly not all in this game together, indeed, there is a case to be made that much of what will happen will be the billionaires picking off the millionaires, as well as the pension, IRA and Keogh assets of most of us (because that is where the money is). There are approximately nine million American households with net worths in excess of $1 million, not including the value of their primary residence. Most of these people are self-made millionaires, and unless they are well advised, those holding their newfound wealth in conventional investments may find it to be fleeting (in inflation-adjusted terms). This class of investors does have powerful tools available for preserving their net worth and even thriving in a time of inflation, playing the Great Game on a smaller scale than the billionaires - but these tools must be deliberately selected, on both the asset and debt sides.

Ironically, many (though not all) of the middle class will survive a powerful bout of inflation surprisingly well, perhaps even better (on a percentage basis) than the average person with a $2 or $5 million net worth, because they will have the same natural hedge strategy as their parents did in the 70s. With not all that many financial assets to lose, and a large, long-term, relatively low cost and tax-advantage debt just waiting to be destroyed by inflation - their home mortgages. Some people will luck through this by just happening to have the right mortgage and natural hedge. Other people will try to be like Peter in the example above, and do their level best to lose as much possible from inflation, while gaining nothing. Many others will be heavily in debt, but it will be the wrong level or type of debt, and they will be financially destroyed by soaring interest rates. A much smaller group of people will quite deliberately choose an intelligent strategy of optimized debts and optimized assets (like Scott above, or Jim with his gold arbitrage in the "Great Game" article previously referenced). It is these people who will find that the widely anticipated costs associated with the retirement of the Baby Boom will not devastate their retirement funding - but will instead increase their real assets.

About This Simple Illustration & Its Limitations

This article is intended to be an educational illustration, not a comprehensive investment model. By isolating changes in the inflation-adjusted value of the principal amount of a single monetary asset from the perspectives of both a creditor and debtor, it is intended to help readers understand the potential personal implications of a fundamental economics concept that has benefited many millions of people in the past, even while it has hurt many millions of other people. That's it, that's the scope, and numerous other variables have been left out of this model, each of which could materially change the results for "Peter" and Scott". Many of the most important of these left-out factors revolve around the interim cash flows for creditor and debtor, which are not considered in this illustration. Of course, the illustration only works if Scott intelligently and prudently uses a level and type of debt which he can make the interim payments upon, the wrong kind and levels of debt can be quite financially dangerous. Please carefully read the disclaimer at the base of this page as well.

Two Suggestions

Let's close with two suggestions. The first is to save the chart "Inflation Pickpocket", or perhaps even print it out. Then look at it again tomorrow, again next week, and again next month. Watch repeatedly as the "mark", the virtuous Peter, gets cleanly and effectively relieved of the burden of his net worth and retirement assets, by following the conventional wisdom in a time of major inflation. Without his ever realizing how it happened, while he maintains the mistaken beliefs that inflation is a fair game, and that we are all in this together. Ask yourself if you believe the chances of substantial inflation are real over the next decade or two. Then ask yourself if you would rather be Scott than Peter - and what changes you can make to both your assets and debts, in order to make yourself less of a mark if that inflation does occur?

As a second suggestion, if you know anyone else whose retirement plans consist of walking down a dark alley with twenties hanging out of their pockets, please feel free to send them a link to this quite offensive morality play. Once they get over their initial offense - you just might end up saving their net worth.

Discover why MortgageSecretPower.com jumped from zero to a Number One Ranking at Google (out of almost a million web pages) within two weeks of opening to the general public. Read the free sample chapter, and using historical statistics, learn precisely how millions of households accidentally turned the greatest bout of inflation in recent American history into substantial personal wealth. However, only the first three chapters of "The Secret Power Within Your Mortgage" are about history - the next 12 chapters are all about your future, the practical application of these principles for homeowners and investors, and how to deliberately and safely optimize this powerful net worth protection tool for your personal financial situation.

Daniel R. Amerman, CFA
The-Great-Retirement-Experiment.com

Daniel R. Amerman is a financial futurist, author, speaker, and consultant with over 20 years of financial industry experience. He is a Chartered Financial Analyst (CFA), and holds MBA and BSBA degrees in Finance from the University of Missouri. He has spent seven years developing a large, unique and intertwined body of work, that is devoted to using the foundation principles of economics and finance to try to understand the retirement of the Baby Boom from the perspective of the people who will be paying for it.

Since 1990, Mr. Amerman has provided specialized quantitative consulting services to financial institutions, with a particular emphasis on structured finance. Previously, Mr. Amerman was vice president of an institutional investment bank, with responsibilities including research, synthetic securities, and capital market originations.

Two of Mr. Amerman's previous books on finance were published by major business publishers. "COLLATERALIZED MORTGAGE OBLIGATIONS, Unlock The Secrets Of Mortgage Derivatives", was published by McGraw-Hill in 1995. Mr. Amerman is also the author of "MORTGAGE SECURITIES: The High-Yield Alternative To CDs, The Low-Risk Alternative To Stocks", which was published by Probus Publishing (now a McGraw-Hill subsidiary) in 1993. Advertised by the publisher as a professional "bestseller" for four quarters, an Asian edition was sold as well.

Mr. Amerman has spoken at numerous professional seminars and conferences nationwide, for a variety of sponsors including New York University, the Institute for International Research, and many others. After the publication of his prior books, he acted as keynote speaker at a number of banking related conferences over the next several years.

This article contains the ideas and opinions of the author. It is a conceptual exploration of general economic principles, and how people may - or may not - interact in the future. As with any discussion of the future, there cannot be any absolute certainty. What this article does not contain is specific investment, legal or any other form of professional advice. If specific advice is needed, it should be sought from an appropriate professional. Any liability, responsibility or warranty for the results of the application of principles contained in the website, pamphlets, videos, books and other products, either directly or indirectly, are expressly disclaimed by the author.

Copyright © 2006-2008 Daniel R. Amerman, CFA

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