The subject of taxes is typically highly charged with political animosity.  During every election cycle, there tends to be quite a bit of discussion how what the ‘right’ amount and structure of taxation should be.  However, there are actually two types of taxes that people pay.  The first is the taxes that the IRS or state revenue agency assesses on your earned income during the year.  (This is what most people think of when you say the word taxes)  The second and much stealthier tax is inflation.

At this point, I’m sure that many of you are wondering what inflation has to do with taxes.  Most people think of inflation as being the result of increases in the price of commodities such as oil or concrete.  However, let’s step back from the details for a moment and think about the big picture.  If the total amount of products & services in the economy stays the same, and the total amount of money in circulation (both hard currency & electronic records) stays the same, any time one product goes up in price something else would have to go down in price.  The only way that you can possibly experience an across-the-board increase in prices is for economic output to go down or for the amount of money in circulation to increase.  (Please note that this isn’t an original observation.  Milton Friedman won the Nobel Prize in 1976 for his work on the relation between monetary policy and inflation)

So how does this relate to taxes?  Since the government has the power to increase or decrease the money supply, they have the ability to spend money without increasing taxes by increasing the money supply.  Because of this fact, the primary danger of the national debt is not that the government will not be able to pay its obligations.  (The federal reserve could literally ‘wipe-out’ the national debt by purchasing all of the outstanding government bonds with treasury notes and tremendously increase the money supply, thus causing widespread inflation)  The primary danger of the national debt and unfunded social security / medicare obligations is that the government will have to massively inflate the currency to meet its previously committed obligations.  Ultimately, this amounts to a tax that is never passed by congress.

 

One of the peculiar things about the human condition is that we tend to look backward while we are attempting to move forward.  When the problem shifts from individuals to organizations and government, the problem becomes much greater in severity and much larger in scale.  The fundamental reason why human beings look backward so often when seeking wisdom, is that past experience is something that feels concrete while the future is always murky and unknown.

The inherent danger in this tendency to grasp what we know and scorn what unknowable is that we constantly endeavor to solve yesterday’s problems.  This phenomenon plays itself out with government entities that attempt to solve the problems of their last generation while a new crisis begins brewing for the next.  It manifests itself in companies that cling to antiquated business models, small businesses run by owners that insist on the ‘old way’ of doing things, and individuals who invest based on what prospered during the last economic expansion while avoiding the assets that were most troubled.

In an era of burgeoning unfunded government entitlement liabilities and looming inflation, the national authorities are currently attempting to generate a health care entitlement while the systematic destruction of the dollar’s purchasing power from monetary expansion and price inflation looms over the national economy like a snowdrift perched in position to unleash a devastating avalanche.

In a market environment where real estate values have collapsed, many people are seeking the security of treasury notes for fear of volatility in values that were experienced in both the stock market and real estate during the last few years.  This fear has left many people blind to the risk of severe inflation from monetary expansion by the government.  In this attempt to preserve what assets they still have, many people are placing themselves in severe danger of losing the purchasing power of their assets to inflation.

True vision requires that people see the problems and challenges of tomorrow so that they can be solved today.  We cannot expect our elected officials to exhibit this level of foresight in the midst of their terminal pandering for electoral support from people who are focused on the problems of yesterday.  While we can draw inspiration from the rare person who exhibits this insight in the public arena, it is our responsibility to find our personal path.  Each person must develop their own vision and find their own solutions.

 

One of the concepts that can emerge from irresponsible fiscal and monetary policy on the part of the government is what Dan Amerman refers to as the financial “reset” button.  Practically speaking, this is the phenomenon that occurs when a government floats away its debt by inflating the currency and reducing the purchasing power of the dollars already in circulation.

The danger posed by this “reset” button is that it will destroy the purchasing power of all people who have dollar-denominated assets, and dollar-denominated payments from annuities, pensions, or government programs.  In addition to this, inflation will increase the nominal value of an asset without increasing its underlying purchasing power.  However, the government will recognize this increase in nominal value as a taxable gain and the investor will be left with less purchasing power than he or she had before the inflation occurred in the first place.

The reason why governments use the “reset” button is to clear out excessive amounts of debt by diminishing its value through inflation.  This seems all but inevitable, given the current government debt of $13.7 Trillion, and the unfunded entitlement Liability of $76.4 Trillion in 2010 dollars.  When this eventually happens, it will result in many people of low to moderate income being ‘pushed off the edge’ into desperate poverty.  This is likely to be accelerated by the relatively large pool of people who have become dependent on government subsidies and have not developed marketable skills that can be used to earn income at inflating rates.

The other group of people who will be adversely affected is senior citizens that are dependent on social security and pension payments.  As the purchasing power of these payments is destroyed through inflation, it will push many of the retired population to lower levels of prosperity and possibly into poverty.

This “reset” button will need to be invoked because of the spending liabilities that have been undertaken by government agencies in an attempt to buy votes with government policy and taxpayer money.  The hitch is that taxes can no longer be raised high enough to fund the spending, so the only answer left is to destroy the purchasing power of the currency.  In this case, the people who will be damaged the most are the ones who have become dependent on government entitlements . . . meaning that the policy of spending to win elections will inevitably impoverish the people whose votes are being purchased with the spending.  Not quite the warm and fuzzy compassion that you see in political campaigns.

Escaping the Inflation Trap

Once people fully understand the specter of inflation, and its likely impact on their financial wellbeing, the natural reaction is frequently to despair.  This does not have to be you, since there is a historically proven way to escape the inflation trap.  This trick is accomplished by understanding that inflation destroys all dollar-denominated paper assets . . . including debt.

Thus, if you have a real asset such as an income property that is financed with fixed rate debt, the inevitable inflation will increase the dollar-value of your property, but your loan balance and payment will remain flat.  Furthermore, your rents are likely to increase with the inflation, as the cost of new housing increases in nominal dollars.  By building a portfolio of income producing assets that are financed with long-term, fixed-rate debt you can actually benefit from inflation.  The advantage of this strategy is that you can leverage the expertise of local market specialists to select high quality properties in strategic micro-markets with excellent property management.

 

One of the most pervasive intellectual fallacies that people at large fall into is a heuristic known as “money illusion” or the tendency to view money in ‘nominal’ instead of ‘real’ terms.  The impact of this is that people seem to ignore the purchasing power of money and simply anchor on the nominal values.  This can have a catastrophic effect on your financial wellbeing if it is allowed to influence your actions and decisions.  The root of this fallacy comes from the modern fiat currencies that lack a fundamental value and are frequently manipulated by government entities.

The way that this danger comes most often is through inflation.  Inflation occurs when the supply of available money increases and the purchasing power of money already in circulation decreases.  In this scenario, wages and investment values will both need to increase for your purchasing power to remain fixed.  However, government policy does not dynamically recognize inflation in its tax tables, so increases in your wages or investments that simply keep your purchasing power flat will be taxed as profits, resulting in a net reduction of real purchasing power.

The impact of money illusions leads to a phenomenon that economists call ‘price stickiness’ or a general tendency for prices to stay relatively flat, even when inflation causes costs to increase.  Sometimes this is because of contracts that have fixed prices and in other cases it is because of a perception that business will be lost if prices are increased.  For example, most people would consider a 3% cut in their salary in a price-stable environment to be unfair.  However, most people would not object as much against a 3% raise in an environment of 6% inflation.  The rational impact of both events is the same, but perceptions are clearly tilted toward interpreting reality in nominal instead of real terms.

Another way that price stickiness comes about is in segments where prices are decreasing such as real estate after the financial crisis of 2008.  The market value of homes has in many markets have dropped considerably, but people are hesitant to sell because they are ‘upside down’ in their loan (meaning that they owe more than the home is worth) and are either unwilling or unable to bring enough cash to the table so that they can get out of their loan.  Banks are also reluctant to recognize losses on their loans by approving ‘short’ sales and the result is a drastic reduction in market transaction volume.

As astute businesspeople and investors, it is important that we understand the impact of money illusions so that they do not blindside you at the worst possible moment.  The pervasiveness of money illusions is the primary reason why government has developed a propensity to finance its spending with monetary expansion (aka ‘printing money’) instead for direct taxation.  Since most people perceive money in nominal terms, the impacts of inflation slip by partially to completely unnoticed.  Astute people will recognize the impact of money illusions and structure their finances so that they are insulated from the impacts of inflation.

One way that this can be accomplished is to select investments in vehicles that use the power of inflation to generate real profits.  The most frequent way to accomplish this feat is through income property.  By purchasing a property that is rented to tenants with fixed-rate financing, you will have two layers of protection against inflation.  The first layer is rent revenues, since increases in the cost of living tend to flow through to increases in market rents.  This results in a positive correlation between rents and inflation.  The second layer of protection is your fixed-rate mortgage.  By locking-in your cost of capital for three decades, you will be able to make flat nominal payments while the real value of your payments is eroded by inflation.  All of this is capped by the section 1031 tax-deferred exchange where capital gains from investment properties can be deferred indefinitely, so long as the appropriate conditions are met.

In the end, success in our current economy will require that we internalize the impact of money illusions and take action to counteract their effects.  There are tremendous opportunities available for people who are astute enough to recognize the alignment of events and take action in a prudent fashion so that those events work to their advantage.  The structure of your future will be the sum total of decisions and actions that you make.  Becoming educated about concepts like money illusions is one of the ways to ensure that those decisions are made wisely and that your actions produce good fruits.

 

Those who have read our previous newsletters know that inflation is actually a second form of taxation that is caused by government action, and acts by eroding the purchasing power of dollar-denominated assets.  The inevitable ‘next question’ is to find out what inflation means to us, and how we can fight against it.

The best place to start answering this question is to explain what inflation does.  Since inflation erodes purchasing power, it effectively transfers wealth.  Inflation transfers wealth from lenders to borrowers because the lenders are contractually obligated to an interest rate that becomes less and less relevant as the currency devalues.  On the other side, the borrowers are paying their loans back in dollars that have declined in value.

Inflation also transfers wealth from retirees to workers.  The reason for this is because retirees typically have their ‘nest egg’ invested in ‘safe’ assets such as Certificates of Deposit, government bonds, and other financial instruments whose principal value is guaranteed by the government.  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.

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.