moneyFYI
Financial Freedom Is Merely Organized Common Sense
US Federal Debt Is Unchanged From 1970
Say What!!!???
The current US federal debt is somewhat north of 16.3 trillion dollars. In 1970, the debt was 370 billion dollars. That is hardly the same. It is 44 times greater.
If you look only at the number.
Upon examination of context, we find that in 1970 the price of gold was $37 per ounce so it took 10 billion ounces of gold to pay off the debt. On 11 December 2012, gold closed at $1,710.30 Now it would take only 9.53 billion ounces to pay the debt. Clearly the US is less indebted than it was 42 years ago.
A puzzled look may appear here.
In terms of gold, the dollar is worth a little over 2% of what it once was and we measure the debt in dollars. Does that matter to me? Yes. Absolutely YES!
Dollars are the measuring unit for wealth, just like inches for height, pounds for weight and degrees for temperature. If the unit value changes size, how can it make sense to use it? Inflation changes the value of the measuring unit. Inflation has not gone away and will be very apparent again before many years pass. That will matter to you when you do your planning.
Here’s how it matters. Keeping track of, or calculating anything in terms of a variable unit of measure is a fool’s game. Think fisherman’s ruler.
An example of the problem.
What is your estimate of the noon time temperature in Toronto on 15 July 2014? Probably 25 degrees Celsius is a good guess. But, if I tell you the size of a degree is unknown, how hard is the question? Impossible, right? Any number could be the answer. The interesting thing is that it will be exactly as warm that day whether the temperature is 25 big Celsius degrees or 50 little Celsius degrees or 10 huge Celsius degrees. Reality is reality.
When we talk about wealth, we talk about dollars. Pay attention, things are different this time and the difference is important. The absolute number attached to wealth is not useful, because the number, by itself, does not communicate useful information.
What will prices be in the future? That is the important, yet difficult question. You cannot know the number that will attach to your cost of living 20 years from now. Your future cost of living matters because you need income from savings to supply the cash to pay for it. The inflated unit size problem leads to the near impossible question, “How much capital do I need in 20 years?”
People already notice the problem but attribute its cause improperly. Older people say things like, “There is no way a Coke should cost a dollar. When I was kid, it was a dime.” What they are implying is that the Coke is no longer worth the money. Reality is that the Coke is worth the money, it is the money that is not worth the money.
If your doctor tells you that you are as sound as a dollar, you should immediately dial 911. This problem is not going away. You need to think about your strategic financial plans in a different way. Here are some thoughts that may be helpful:
It might not matter
- It does not matter much what inflation is, as long as investment returns are a couple of percent higher. It is just more computationally difficult and there are more variables. Example. Skip part 1) and 2) if numbers stress you.
- In 20 years with no inflation and 2% investment yield, $10,000 will be worth $14,859 (14,859 cans of Coke) Future income will be about $300 so, in retirement, you can buy about half a dozen cans of Coke per week. Forever.
- In a different world, inflation is 10% and investment income is 12%. 2% real yield. Now $10,000 becomes $96,463 and Cokes cost $6.73 each. You inventory is 14,206 Cokes. It looks like income is about 1,564 Cokes, but it is not all useable. You cannot spend all the income because you have to retain the real purchasing power of the investment. How much you should retain depends on how long you want to be able to do it. Forever will result in about the same 300 Cokes being consumed.
- Under inflation, you will notice that the duration of spending becomes important. You need to decide how much your consumption can be in future. That is easy if there is no inflation. With inflation you will need to work harder and guess more. Especially if the rates of inflation and yield change from year to year.
Taxes matter more under inflation.
- If 2% turns into 1% after taxes then $10,000 becomes $12,202 Cokes. 122 Cokes per year forever.
- If yield is 12% and inflation is 10% and taxes are still 50% then, real yield is -4%. Minus is never good when you are looking at investments. $10,000 will become only 4,765 Cokes. Not more than 25 per year to be used.
- Under inflation, income taxes matter huge. You must find ways to shelter income. TFSA, RRSP, Life insurance, tax sensitive funds, all may play a part. The design and mix is not work for amateurs.
- Structure matters more too. Things like income splitting, selective incorporation, multiple testamentary trusts, inter-generational transfers and loans, and other trusts will be important. You may need to start thinking in terms of three generations instead of one.
Price levels affect business decisions.
- Make business decisions that are influenced by price, either selling or buying, consciously. Just because prices are going up does not mean there is a scarcity. You might not need another factory to take advantage of the opportunity.
- Inventory management, accounts receivable and accounts payable all matter more as price levels change. You may need to get back in the habit of monitoring them.
- You should start pricing product based on the replacement cost of inventory rather than acquisition cost. If you bought it for a dollar and sold it for two dollars, it will look like you made a dollar; (to pay tax on) but if it costs $1.50 to put it back in inventory, how much did you really make?
Use your own metrics, not government CPI numbers.
- Like everything else, the CPI number is not what it used to be. In the United States, if you used 1980 CPI methods, the current inflation rate is triple what they say it is.
- Same thing more or less with unemployment and money supply.
- You can depress yourself as needed here. ShadowStatistics.
Flexibility, discipline and skill will be key values
- No plan that exists now will be the same under inflation. Some will be better others worse.
- Be alert and be willing to change.
- Pre-build choices. Set pieces in place that will give you new choices in the future. Convertible life insurance and no back end load mutual funds come to mind.
- Be curious. Read a lot, listen, watch, talk to others. It is hard to see reality from a single viewing point.
- Be skeptical. Things are not necessarily the way they seem. Remember intuition may not work.
- Be risk averse. Catching up is harder.
- Learn about tax planning. Structure your affairs to minimize the bite.
- Develop a network of advisers. If you lack know-how, you better have know-who.
Savings alone will no longer generate a good end game although saving a percentage of income has a chance. The world we face is extremely complex, even chaotic in the mathematical sense. Tiny differences in the starting points may have profound effects later.
I have no “guaranteed to work” advice. Be alert, be flexible, be networked, be proactive is the best I’ve got.
Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. don.s@protectorsgroup.com
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