Why You Should Prepare for Inflation

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High inflation erodes the purchasing power of savings, pushes up interest rates and undermines future economic growth. Everyone agrees, in short, that it’s bad. Very bad. What experts can’t agree on is whether the risk of serious inflation demands immediate action, even if that means backing away from some of the current policies aimed at bolstering the economy.

Warren Buffett has been sounding the alarm about inflation for several years. On the other side, Nobel Laureate and New York Times columnist Paul Krugman keeps insisting that inflation is “just not something to get frantic about.” I agree with Buffett, and I’ll explain why.

To start, it’s important to understand where these two viewpoints actually differ. It’s not so much over theory. Instead, the debate is about priorities, time horizons, the likelihood of a relapse into recession, and the amount of maneuvering room still available to economic policymakers.
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It’s only natural that both sides believe clear and present dangers need to be dealt with first. Krugman argues that the most pressing concern is reviving the economy, not preempting possible inflation sometime in the future. He often sounds as though he fears a near-Depression.

Krugman may be right that the economy still needs help and that current levels of inflation are not especially dangerous. But Buffett is also correct, in my opinion, when he says that inflation which seems harmless in its early stages can suddenly turn deadly. Indeed, he compares it to jumping off the top of a 50-story building: It doesn’t hurt until you hit the ground.

Buffett’s folksy wisdom sometimes sounds a little simplistic, but there’s steely logic behind it. I’ll try to explain why I think he’s right, although I may sound a little simplistic myself. What’s essential to understand is the fundamental cause of inflation.

Prices are determined by the amount of money available for buying things divided by the number of things there are to buy. If there are six dollars in the world and three sandwiches, each sandwich will end up costing two dollars. When growth in the amount of money outpaces the number of things there are to buy, people tend to bid prices up – that’s what we mean by the term inflation.

The complication is the phrase “money available for buying things.” If one of the people who sells a sandwich for two dollars uses the money he receives to buy a beer, a total of eight dollars will have been spent, even though there are only six actual dollars you can point at. This is called the multiplier effect. And if the guy who receives money for the beer uses it to buy a magazine, that too will add to the amount of money in circulation, and so on.

Recessions curtail this money multiplication. In bad times, people spend less freely and may be forced to pay down debts. And since big-ticket purchases such as cars and homes require financing, when banks cut back lending, people can’t buy these things even if they can afford them. The Federal Reserve tries to offset all this by pumping additional money into the banking system. But the Fed can’t force people to spend or banks to lend, so it takes a lot of extra money to give the economy even a small boost.

The picture can change suddenly, however, once the economy begins recovering. Money can start changing hands much faster, revving up the multiplier effect and thereby creating sudden and powerful inflation pressures. Bang, 50 stories down.

And that’s not the only factor contributing to the long-term inflation threat today. Ideally, policymakers who boost government spending in a recession to bolster the economy would make plans to cut back spending once the economy recovers. But as we all know, Washington tends not to work that way. Meanwhile, the U.S. has already built up a huge national debt that will continue to grow as long as the government puts stimulus ahead of deficit reduction. Historically, when debt becomes larger than annual GDP, an urge develops to use inflation to reduce the burden in real terms, as occurred after World War II when the effective debt burden was cut by a third.

In theory, all these problems are manageable if economic policymakers are smart enough and the political system can respond quickly enough. Essentially, it’s necessary to flood the economy with money to beat the recession, then reverse course 180 degrees and suck money out of the system before inflation really gets rolling. Frankly, though, I’m skeptical that our government and political system are nimble enough to make that happen.

In short, it all sounds to me a lot like the Von Schlieffen Plan, Germany’s scheme to win World War I by launching a massive westward attack that would crush France, then spinning around and sending the army racing to the Eastern Front where slowly gathering Russian forces could be stopped in their tracks before they built up any momentum. Today’s economic version of this strategy can win a victory on the first front, the recession, but may well lose on the second, inflation.

It’s only prudent to get your portfolio ready for a Russian Winter. (I’ll discuss some specific investing strategies for such a climate in a future column.)

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