The Unrepentant Individual

...just hanging around until Dec 21, 2012


January 5, 2007


Is Inflation Helping Me (in a Relative Sense)?

I’ve never claimed to be an economics whiz, but I know a few of my readers are. So I was hoping someone would be able to tell me whether I’m right or wrong.

My understanding is that in the long run, inflation is pretty much a bad thing for everyone. However, in the short run, it can be beneficial to some people and detrimental to others. The conventional wisdom is that the first people to get their hands on that “new money” get the most benefit, because they get the buying power before the currency has weakened. This would seem to me to benefit [fixed-interest] borrowers, because borrowing money before interest rates have raised with inflation means that your soon-to-be-inflated wages will make it easier to pay off that dollar amount.

Conversely, the people who would be most hurt by inflation would be fixed-interest lenders and investors. Lenders lend money at a low interest rate, then find the inflation rate to quickly start approaching that interest rate, making their real rate of return flat or negative. The same occurs to investors. As inflation increases, you need to get higher and higher rates of return to keep your real rate of return high enough to make it worth investing.

So here’s where I sit. I bought my house with 0% down just under 2 years ago, when interest rates were low. By my understanding of fractional reserve lending, the “new money” is created in the lending process by banks, which means that I got the new money. A little bit of inflation will inflate my wages as well as the value of my house, but given the low interest rate, may actually reduce how heavy the home ownership burden rests on my shoulders. Since I’m young, I have started investing, but the amount I’m earning in interest isn’t really that much of an issue right now, so I’m not getting behind on investments. In fact, though, liquidating some investments to pay down variable rate (i.e. credit card debt) may actually be a very good decision in the long run.

By my understanding, it seems to me that I’m actually the beneficiary of some inflation right now. After a good 5 years or so, I’d love to see it come to a halt, but it seems like right now it actually helps me. Am I right?

Posted By: Brad Warbiany @ 10:25 pm || Permalink || Comments (4) || Trackback URL || Categories: Economics, Ponderings

4 Comments

  1. Yes, you are right.

    Assume you borrow $100 to buy a microwave oven. After one year (ignore wear & tear), inflation has driven up the price of a microwave to $105. So you paid $100 for a $105 microwave. It’s that simple.

    The investment question is a bit different. If you have, say, a 6% mortgage, then paying it down gives you a 6% return (ignore taxes). So you should buy an investment only if you expect to earn more than 6% on that investment. Otherwise you should simply pay down your debt.

    Note also that the “debt paydown” return of 6% is zero-risk: you know with absolute certainly that you are earning 6%. So a risky investment, such as a stock, would actually have to earn an expected return of greater than 6% to compensate you for the risk of not returning what you expect it to return.

    Comment by KipEsquire — January 5, 2007 @ 10:33 pm
  2. One note; only relative inflation is very bad.

    Balanced absolute inflation; where wages, interest rates, and inflation are balanced against each other, is mostly fine; because relative cost, reward, and buying power are maintained.

    The only people hurt in the case of balanced inflation; are those who do not participate in the economy (keeping their money under the mattress).

    Comment by Chris Byrne — January 6, 2007 @ 4:55 am
  3. Chris,

    Is there ever an instance where inflation is balanced? Over time, inflation balances out, but the increase in the money supply never gets passed out equally, helping some people in the short term, hurting others in the short term, and balancing out over the long term.

    Comment by Brad Warbiany — January 6, 2007 @ 10:57 am
  4. “Balanced inflation” sounds like an unattainable utopia. Why should the mattress-stuffer be penalized for keeping cash if that is his desire? He could still be participating in our economy through some means of production (a job, for instance), but is perhaps hoping to use that saved cash at a later date. If all investments are deemed risky by the mattress-stuffer, his risk-free rate of return would be zero in a constant dollar environment. But given that inflation is unavoidable, in order to keep up with inflation he is required to take on more risk than desired just to keep up with those who either create the inflation or profit from it by knowledgeable use of leverage.

    With the Federal Government issuing new debt (creating money out of thin air) to the tune of 7.5%/yr, the saver loses out and the debtor wins, as long as everything is inflating in your hoped-for balanced manner. Guess wrong in any one area, and you could suffer from deflation when the balance goes out of balance, housing deflation for instance. The real killer in that scenario is the amount of debt being created with everyone chasing inflated assets in attempt to beat out inflation or at least keep up with it. If the inflation music ever stops for any reason, all assets will go down in price (pick any asset) and the debt remains behind, fully intact.

    The mattress-stuffer looks like a real idiot for not “participating” during the inflation period, but if the music stops he wins. Cash is king when the music stops.

    essential reading:

    http://www.jackstevison.com/weblog/index.php/2006/09/14/holy-cow-an-epiphany/

    Comment by Uncle Jack — January 6, 2007 @ 6:48 pm

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