The Incomprehensibly Large Deficit and You

A little while back the Wall Street Journal ran a pair of articles about things we should do in preparation for the inevitable effects of the federal budget deficit. Brett Arends led off on February 4 with The Deficit: How to Protect Yourself and then on the 6th we got a round up of advice from most of the rest of the WSJ staff in Protecting Yourself from the Giant New Deficit: How to Keep the Scary U.S. Debt From Eating Up Your Assets.1981 treasury bond Crop

To a degree, items like these almost comically miss the big picture. They remind me of pieces popular a while back that said that in anticipation of global warming we should all buy land in the Canadian interior. If the government continues on its present course, and I for one am not ready to concede that that is a certainty, it will be an economic calamity that will make us all drastically worse off. The best thing a person can do about the deficit is to vote for leaders willing to do the ugly and unpopular things necessary to reduce it.

But if you can ignore the big picture and focus on only the near term effects of the current and upcoming deficits, it is possible to come up with some coherent advice. Not that the crew at the WSJ consistently do this.

There are basically only two predicted effects of the deficit, higher taxes and higher inflation. To a naive observer, higher taxes would seem to be an obvious certainty. Laura Saunders, who wrote the Journal’s bit on taxes, tells us that "It’s just a matter of how soon they rise and by how much."

If only government worked so reasonably. Even the Democrats don’t have the political will to increase taxes in a meaningful way. Obama’s budget only "raises" taxes on the "rich" by allowing existing legislation to run its course. The non-rich get tax cuts. And Congressional resolve will not be increased after November. Trust me.

Which leaves inflation. If you are my age, you can remember high inflation being a big deal when you were in school, but the details are hazy. If you are any younger, it is a strictly historical phenomenon you read about in books.

The WSJ gang seems to be firmly in the hazy history camp. The often erudite Jason Zweig tells us that the deficit "could set off a surge in inflation and push down the dollar" as if those were two different effects. And the rarely erudite Brett Arends gives us this gem, discussing long term Treasury bonds.

Embedded in the market is a long-term inflation forecast of about 2.5 percent. I call that a dangerous complacency. (I usually recommend inflation-protected government bonds, but right now they are looking a little pricey).

Regular longer term Treasuries currently yield around 4.5%. Their inflation-protected equivalents (TIPS) currently pay inflation plus about 2%, hence the embedded 2.5% inflation forecast. If you thought that 2.5% was dangerously complacent, i.e. way too low, and you understood algebra, you would have to believe that TIPS were a compelling bargain, not "too pricey."

The WSJ is also vague on how, exactly, the deficits will translate into inflation. Jane Kim explains that "Heavy government borrowing means more dollars sloshing around the economy, which is a key prerequisite for inflation."

First, possibly depending on how you define "sloshing," more dollars is not merely a prerequisite for inflation but is arguably the one and only cause of it.

Second, government borrowing does not increase the sloshing dollar count. In fact, taken literally, it decreases it, sucking up dollars that might otherwise be spent or invested. When we say that we expect huge deficits to lead to inflation (and I do say that, BTW) we do not mean that we fear that the government will borrow all that money. Quite the opposite. We fear that some of the deficit won’t be borrowed.

The worry is that, one way or another, Washington will "monetize" some of those deficits, that is, print more money. Printing money has two nice effects for the government. The immediate and obvious one is that another billion dollars in circulation is an extra billion the Treasury can spend.

The more significant effect is that when the increased money supply causes inflation, as it certainly will, that inflation will decrease the real value of outstanding government debt. In other words, although the government will owe the same number of dollars, those dollars will be worth less, so the government will owe less. There are some nasty long-term side effects of this trick, but the benefits are so compelling it seems implausible that it will be resisted.

So if you were expecting a multi-year round of inflation, at a level high enough to make a 2.5% prediction seem complacent, what would you do? The basic strategy is not complicated, although after reading the WSJ you might think so.

If you expect inflation, that is, if you expect the value of the dollar to drop, then you want to avoid owning dollars. More importantly, you particularly want to avoid being owed dollars. Giving somebody dollars today in exchange for being paid less valuable dollars in the future, that is, making a loan or buying a bond, is a bad idea. (TIPS, of course, being a special case exception.)

What you want to invest in is not bonds but real assets, the ownership of things that are not denominated in dollars. Real estate is a good example. So are stocks. Historically periods of high inflation have been bad times for stocks, but do not let that mislead you. When you own stocks you own shares in companies, and companies own things of value, factories, patents, inventory and the like, which will go up in value with inflation. Stocks tend to do badly in high inflation years because high inflation years tend also to be times of economic stress. And as bad as the 1970s were for stocks, that decade was much worse for bonds.

Of course, the flip side to it being a bad idea to lend money when you expect inflation is that it is a good idea to borrow it. Borrowing money at an interest rate below inflation means that you will actually make a profit in real terms, since you will pay back less real value than you borrowed. Borrowing now to buy a large real asset will turn out to be a smart move if inflation arrives. The value of the asset will go up with inflation but the size of the debt will not.

For many people, the obvious way to implement this strategy would be to buy a nice big house with as much borrowed money as the bank will allow. And this would seem like the perfect time for that maneuver: inflation is expected, house prices are down but stable, and interest rates are, for the moment, freakishly low.

There is a delicious irony here. Inflation is a worry because of huge government deficits, which are largely due to the economic crisis, which was largely due to too many people buying big houses with borrowed money. And the possibly smart move now? Buy a large house with borrowed money.

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