Valued Clients and Friends,
We are in the midst of a standoff in Congress about raising the debt ceiling. Most of the standoff is political posturing and trying to escape blame for the poor fiscal position of the U.S. Government. The standoff is a distraction from the underlying magnitude of issues that impact you, and it should be considered in your financial lives. I believe the eventual impact can be summed up in one word: Inflation.
Inflation is the expected symptom of larger forces and underlying problems which any negotiation and new law between Congress and the White House will never repair, not in any real sense that is. Regarding the U.S. National Debt, here are a few numbers that summarize the problem:
- The U. S. Government is currently $31 trillion in debt.
- The Fed’s balance sheet (what they have financed of the national debt) is roughly $8.5 trillion.
- The U.S. Government spent $6.25 trillion in 2022.
- The U.S. Government collected $4.9 trillion in tax receipts in 2022.
- The deficit was $1.35 trillion in 2022 alone.
Think about this: U.S. taxes would have to either go up by 30% or government spending would have to go down by 30% immediately and permanently just to hold the line on our current national debt balance. Imagine if your household budget had to change by 30%. If either taxes increased immediately or spending decreased immediately, categorizing the shock to the economy as “immense” would be a substantial understatement.
It’s not a Democrat or Republican issue (although politicians would like to frame it as such); neither political party is willing to touch entitlements, defense spending, or other sacred cows. As soon as one party does, the other party will immediately appeal to the affected voter and scream “look at what those bad guys are doing to you!” The problem cannot be easily fixed because the underlying issues are not being addressed. Regardless of how this political fiasco gets resolved, the large and ever-growing national debt remains. But why is it a problem to live beyond your means when you can create your own money? Because currency creation leads to price inflation, and that impacts the value of your wallet. Inflation is not a new concept, but its growth has been novel to the last half century.
Why Inflation is Harmful to Most
Later in this letter, I get to why inflation has picked up since the early 1970’s. Let’s take the assertion of a rise in inflation as a fact right now, and please read on page 4 for the history of why inflation has picked up if you’d like to understand more. How and why does inflation impact you?
- Inflation steals your time & purchasing power
Illustrated below are the years of income needed to buy an average American home and some examples of living and food expenses in 1971:
Sources: Mark Moss & thepeopleshistory.com
In 1950, it took 2.3 years of your life and labor to save for the cost of an average home; by 2020, it took shy of seven years of earnings. It could be construed that a debt-based monetary system has stolen that time from you via inflation.
The cost of living and food chart is equally fascinating—it’s not so surprising that households could typically live off one income 50+ years ago.
- Wage Stagnation
The chart below illustrates the difference between productivity and compensation since 1948.
Source: Economic Policy Institute
The divergence between compensation and productivity is immediately apparent. From 1948 (after WWII) to 1971, both wages and productivity increased at nearly identical rates. From 1971 to today, many workers have barely received a pay raise (in purchasing power terms) commensurate with their productivity increases. The only reason those workers are still somewhat ahead today is the deflationary forces of technology and the abundance of cheaper consumer goods from labor abroad.
- Economic Distortions and Financialization
Over the last 100 years, the economy has shifted from a very bottom-up structure to a very top-down structure. Money now trickles down from the Federal Reserve going to the commercial banks first, then big businesses, then retail and small businesses following the path downward. Along this path, the group higher in the chain buys up financial assets pushing prices higher. When money reaches the little guy, they are paying the highest interest rate and have the highest price to pay for assets as they have been previously bought up by the bigger guy. This drives up the wealth divide and speculation of asset prices for a simple reason: time value of money. It is encapsulated by the idea “I better buy this house/asset/consumer good now as it will cost more later.” Dollars are losing value, therefore “I need to buy something that retains value.”
A currency which does not store wealth de facto causes a rise in asset (non-currency) prices by the need to retain purchasing power and speculate on assets rather than hold currency (e.g., the benefit of holding real estate rather than cash in a low-interest savings account). I am not one to indulge in arguments on class warfare, but the idea that the top 1% who have access to capital from the spigot have outpaced main street is undeniable.
What You Need to Consider in An Inflationary Environment
It is important to take steps to protect your finances and preserve your purchasing power in a higher-than-normal inflationary environment. Here are some steps we will continue evaluating for you.
- Diversification can help mitigate the impact of inflation. Consider including assets like stocks, real estate, commodities, and inflation-protected securities in a portfolio. All these assets have the potential to provide returns that keep up with (or outpace) inflation.
- Build a robust emergency fund and manage liquidity. Inflationary times are volatile times. It is important to have liquidity available to not have to sell assets when markets have a downward volatility.
- Review and adjust your budget with inflation in mind. Identify areas where you can cut costs or find alternatives to mitigate price increases of goods and services. Be mindful of discretionary spending and focus on the essentials.
In regard to #1, when Foundation Wealth’s portfolio managers invest in individual companies and exchange traded funds (ETFs), they look to sectors that can pass on higher costs to consumers and weather the storm. I always enjoy my discussions with the portfolio managers as they talk about looking for companies that can (and do) increase their top line revenue and have a historic pattern of doing so.
Other assets that perform well to hedge inflation are limited or fixed supply assets with less counterparty risk. Historically that is gold, silver, or commodities, such as oil. It’s tough to own an oilfield though, so you typically need to stick with a security that invests in that sector.
Bonds are the epitome of high counterparty risk as you are 100% dependent on another party to make payment on the bond returning your principal. I am increasingly directing our portfolio managers to use bonds for short-term cash flow needs and disregarding them for decades-long time horizons.
Gold and Bitcoin are two assets that have the potential to keep up with or outpace inflation. I personally own both. The downside with both assets is that they are hard to own. Bitcoin is difficult to buy through an IRA or brokerage account, and the fees are high. I look for opportunities to own outright instead. Gold is a little easier to buy in a portfolio, but fees remain high and often you are buying “paper gold” meaning the company issuing the securities may not have the gold they claim to sell you. I would be happy to discuss with you in our summer meetings about owning some of these hedges if you do not already.
In brief, inflation is likely here to stay (more on this below if you would like to learn more). I will end this main section of my letter similarly to how I ended my January letter… There are two ways to process higher than normal inflation: We can be victims, or we can be fighters. I choose the latter, and I will continue to guide you to fight back with good financial planning and risk management.
If you would like to learn more of the history and economics of how we got here and where I think we are going, please continue below.
1971 And The Breaking of The Gold Standard
Up until 1971, the U.S. Dollar operated under a gold standard and was convertible to gold (to some degree). This helped the U.S. dollar maintain an inherent value. During WWII, the U.S. accumulated gold via economic activity and held gold for the European countries at risk of German invasion. In return for storing this gold, the U.S. spun up the military and financing machine we know now, and, by the end of WWII, the U.S. Dollar was the world’s reserve currency. After the war, those countries began requesting their gold back. The U.S. sold them dollars instead that were backed by the gold, with the ability to still convert those dollars into gold if needed. Eventually, the U.S. sold too many dollars relative to the gold supply, and the Nixon administration “temporarily” suspended the convertibility of the U.S. dollar to gold in 1971. From that moment on, the U.S. transitioned from a commodity money system to a fiat money system; the U.S. Federal Reserve and U.S. Treasury had the collective power to create money at will, which is backed by the “full faith and credit” of the U.S. Government.
The early 1970s saw a glaring revaluation of currencies relative to gold as dollar printing was unleashed. But, what does that mean? Gold was very stable for the prior 300 years relative to the reserve currencies (mostly the Pound Sterling). Economic growth and the discovery of new gold were fairly synchronized yielding relatively consistent prices in the marketplace. The shock of de-pegging the dollar to gold was a chief catalyst for the stagflation (low growth and high inflation) of the 1970s.
To understand this further, we must realize that currency creation now equals debt creation. New dollars are introduced into the monetary system by the creation of bank loans. The Federal Reserve creates money in the form of a loan/bank reserves to the U.S. Government and member banks. Banks then loan money into existence from these underlying reserves. Because the dollars used to make loans are “new” and are not pulling from the existing pool of currency, every new dollar created reduces value from the other dollars in existence. In the fiat currency world, debt = currency. Since 1971, federal debt has exploded, and thus so has the supply of dollars.
Sources: 2020 Peter G. Peterson Foundation
Gross Domestic Product (“GDP”) is the measure of the total productive output (goods and services) in a country. Entire volumes are written about these concepts, but in a dramatic oversimplification: a rise in GDP can be thought to increase the purchasing power of the dollar. So, if inflation reduces the value (purchasing power) of the dollar, GDP (productivity and the market desire for the dollar) increases it. However, there has not been an underlying growth in national production commensurate with the debt created.
The growth in debt and the monetary base has led to a rise in inflation. The charts below represent the consumer price index with various cumulative percentages on the left-hand chart and over various historical dates on the right-hand chart. It is ultimate intuitive: an increase in debt via an increase in the money supply correlates to increased prices in the economy because each dollar is worth less than it was before.
Sources: Bureau of Labor Statistics, Historical Statistics of the United States, and Reinhart & Rogoff (2009)
What Likely Comes Next
When the dollar lost its gold convertibility in 1971 and transitioned to a fiat currency, all holders of dollars and dollar-denominated debt were harmed (soft default vs. hard default). Nobody can know what will happen in the decades to come, but I can follow the logic chain and see potential secondary effects and outcomes better than most.
We are inching closer to a debt spiral. A debt spiral, also known as a debt trap, refers to a situation in which an individual, organization, or government becomes trapped in a cycle of increasing debt to pay the interest and service costs of the existing debt. The debtor is unable to meet their debt payment obligations and must borrow further to cover the existing debt, and so on. Eventually, the cost of holding debt will crowd out all other budget items. Rising interest rates (as the Fed is doing today) exacerbate and accelerate this problem. With the U.S. Government in mind, the most likely options to address spiraling debt are:
- Let the debt/bonds hard default or restructure.
- A debt jubilee or forgiveness.
- Print more money and cheapen the “cost” of the existing debt by weakening the purchasing power of the currency the debt is denominated in (soft default).
In Option #1, a hard default, bondholders lose money on a nominal basis and it’s easy to blame a culprit-- The Government only paid me 75 cents on the dollar on my maturing bond! In this case, wealth is lost on a nominal basis.
With Option #2, a debt jubilee, debts are canceled. Borrowers are relieved of their obligation to repay part of the outstanding amounts. The concept of a debt jubilee has historical roots and has been practiced in different forms throughout history. It is often seen as the most progressive solution in that it harms the wealthy the most and the poor the least. Typically, the wealthiest own large amounts of bonds and it is thought that they can afford the loss of not being paid back. As the wealthy and Washington go hand-in-hand, I find this solution unlikely, but it is from someone I highly respect: Ray Dalio. Ray Dalio, the billionaire investor and founder of Bridgewater Associates, has written and discussed his perspective on how a big debt cycle works. According to Dalio, debt cycles typically go through three phases: the boom, the deleveraging, and the depression. To bring about the end of a big debt cycle, Dalio suggests that a combination of restructuring, debt write-offs (Jubilee), and significant policy interventions are in store. This could be highly deflationary and highlights the joy of economic choice.
Option #3 requires more money creation to permit the government to pay all lenders, but the price of goods rise as well. You may not lose wealth on a nominal basis, but do so on a real basis. I believe Option #3, printing more money, and driving further inflation will be the chosen path; it’s the easier choice for those in power as the source of the inflation can be obfuscated when it’s the shadow tax of inflation and blamed on everyone else.
Luke Gromen of FFTT did an excellent job connecting the dots of the next steps the U.S. Government and Federal Reserve will likely take in an attempt to stabilize government debt (i.e., Option #3). To start, the last time the national debt was as high as it is today was in the immediate aftermath of WWII. The Federal Reserve (through interest rate policy) capped nominal rates (without regards to inflation) in the low single digits and allowed real rates (post-inflation) to reach negative 10-13%. From 1945-1951, the U.S. national debt went down from 110% of GDP to about 55% as post-war price inflation pushed through the economy. After six years, the Treasury-Fed Accord of 1951 was implemented where the Federal Reserve and U.S. Treasury agreed to go back to operating as separate entities. The Fed was again “independent” and returned to monetary policy that was best for the currency (i.e., consumers) and not what was best for the government. We can use the same logic now and assume the Fed will take similar measures in the years ahead. It worked out well then, why not do it again? When that time comes, they will be reversing course from their current hawkish activity and allow inflation to run hot for some time until the debt to GDP ratio is more manageable.
It is always possible to outgrow your debt problem by having economic growth outpace the accumulation of debt, but I don’t think that is likely. I believe the easiest medicine to prescribe and take will be inflation rather than a default or jubilee. If not already evident, I am passionate about these related topics and would always love to discuss further.