With Inflation Who Wins And Who Loses

The first trick to understanding inflation is recognizing that every transaction has two sides.

The second trick is to pay no attention to the dollar amount but use purchasing power instead.

The third is to notice after-tax purchasing power instead of pretax.

Here’s how it works out

All economics is about trade-offs. When the government borrowed a billion dollars in 2012 in exchange for a 10-year bond, they received $1 billion worth of purchasing power. In 2022 the bond comes due, and they repay $1 billion, then worth only $800 million.

  1. The two sides are the government and the person who bought the bond.
  2. The government won $200 million of purchasing power, and the lender lost it.
  3. If the lender is in a 33.33% tax bracket, they must earn $300,000,000 somewhere else to reclaim their original purchasing power. The government wins the tax they collect, so another $100,000,000 for them.
  4. Don’t forget that sales tax on higher-priced items is more too. $300 million is their minimal gain

The government has a locked-in win by borrowing. The total win for the government is $300,000,000 per billion borrowed. That is a 2.66% return in their favour. The average rate on new issue 10-year bonds in 2012  was 1.80%.Easy calculation from there.

If you can profit without risk by borrowing, you would be foolish to not do it.

Governments are frequently inept and sometimes corrupt, but even someone as dumb as a bag of hammers would choose the inflation option.

How did the lender do? Not so well. This is a zero-sum game. The loser loses what the winner wins.

What to do?

Many people think buying physical assets that they too could win in the long run from inflation. That analysis is too superficial. Things you must also think about.

  1. How much income after tax will pay the interest during the loan’s term. 4% price will cost 6% before taxes.
  2. Cash flow support for the loan may disrupt your financial life, even if nothing like a job loss happens.
  3. The lender may require more cash investment at maturity. Maybe earlier if they can. Every loan is made based on some value to loan basis. Suppose you borrow $400,000 against a $500,000 asset. The bank will accept a loan at 80% of value. If mortgage rates are much higher because lenders demand higher rates, there will be fewer buyers, and the asset price will tend to fall. If rates are 6% at renewal, your payment will go from $1,893 at 3%, to $2,450.  Ouch, but maybe doable.  The problem comes up when you find people will want to buy the property for $375,000 instead of $500,000. You still owe $342,000, 91% of the value instead of 80%. The bank could easily ask you to repay $40,000 to get back inside the ratio rule. That is more than an ouch.

The bits to take away

Governments win with inflation to the point they would be stupid not to do it.

Governments win what others lose.

Borrowing during inflationary times works for the government but not reliably for the people.

Owning cash-denominated assets is likely to hurt you.

This is one of those cases where you will not catch on using intuition. That’s how the government gets away with it. Use a spreadsheet and work it out. Inflation makes the economy more fragile. Take no unnecessary risk.

If the short-run doesn’t work, the long-run won’t matter.

Help me, please. Please subscribe. If you have found this article helpful, forward it to others.

I build strategic, fact-based estate and income plans. The plans identify alternate ways to achieve spending and estate distribution goals. In the past, I have been a planner with a large insurance, employee benefits, and investment agency, a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business. I have appeared on more than 100 television shows on financial planning. I have presented to organizations as varied as the Canadian Bar Association, The Ontario Institute of Chartered Accountants, The Ontario Ministry of Agriculture and Food, and Banks – from CIBC to the Business Development Bank.

Be in touch at 705-927-4770 or by email at don.shaughnessy@gmail.com

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