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Using Debt to Fight Inflation: If You Can’t Beat Them…

So last week we covered TIPS, a way to protect yourself against inflation in a no-risk, no-reward, but-at-least-not-sinking fashion, which is perfect for those who are getting close to retirement.

This week, we cover a totally different approach.  The way to not just keep up with inflation, but to turn it into something that works for you, not against you.

First, let’s ask ourselves again, why does inflation occur in the first place?

Governments spending more than they take in, creating debts which require the additional printing of money to pay back.  When they print more USD without adding value to the assets that USD holds, it reduces the value of USD that was already in existence.  They are intentionally using inflation to “pay” (shrink) their debts by removing value from the assets you and I own. 

So what does this mean for the gov’t?  They borrow $1000 in 2018 with a promise to pay $1,020 in 2019, but pay it back with currency that is only worth $980 by 2018 standards.  And they’re doing it in a way that the average joe does not understand, and thus, won’t get any negative feedback in the way that raising taxes would.    Why would they ever stop?

So not only do we know how inflation works, we also know that people in power have a very vested interest in keeping the little shell game up.  It’s not going to be changing anytime soon.  Unless gov’ts all of a sudden decide that they’d rather run balanced budgets.  I’m not holding my breath on that one, are you?

But wait… if it shrinks their debt… doesn’t that work for us, too?

You bet your ass it does.

That is the one single reason most baby boomers will manage to have a healthy retirement.  Not because of the value of their retirement savings, but because of the value of their debts like their house loans literally melted away in the early 80′s.   Say you bought a house in 1977, with an 8% interest rate.  But in 1980, inflation hit 16%!  That means that as the value of the money someone was making their mortgage payment with shrunk by 16% in one year.  In fact, within a six year stretch, the real-world value of their debt had shrunk by half before we even took the payments themselves into account!  

A $300 mortgage payment was a hell of a lot bigger in ’77 than it was in ’83.    And during that period, the value of the house itself increased along with inflation as well.  Not as high as the rate of inflation… real estate prices didn’t increase by 16% in 1980, but it was 8-10%.  Add that on to the debt shrinkage, and you have some serious damn value creation!  So much so that many smaller savings and loans either required bailouts in the early 80′s or went under entirely.  That money went somewhere alright… right into baby boomer mortgageholder’s pockets!

But there’s still one problem.  We have to pay more interest to borrow money than a government does.  While real interest rates (interest minus inflation) is negative for governments, it’s still positive for us, which means we’re losing value on the debt.   ex.   3% inflation a year isn’t going to do much against a 23% credit card interest rate. 

But, if we buy something that appreciates faster than inflation, we can add that onto the total, giving us a net profit!    Think of it like this.  Let’s (in our dreams), buy a Picasso.  Say we get a loan for $1,000,000 and put down $250,000 to do it.   (Cheap Picasso… was it a sketch on a bar napkin or something?)   And unlike the gov’t, which is getting it’s loans for 2% (or less!) We have to pay 3% or more based on the length of the loan.  Let’s say we’re paying 4%.

But, the value of the painting is going up an average of 4% in nominal dollar terms every year as well.  So we’re breaking even.

But if, for some, strange reason, inflation spikes because, say some gov’t debt goes through the roof and goes above 4%, we actually start making money because the value of the dollars the debt is in is shrinking!  And our 4% apprecation?  Well, the reason that painting’s dollar value is going up is not just because fine art becomes rarer over time… it’s also going up because the value of the dollar is shrinking.  And if that value starts to shrink faster, the “appreciation” goes right along with it!   

Let’s say that the time of inflation reckoning is year one (it won’t be, but for the sake of easy math) of 10% inflation.  You paid 4% interest, but the value of your debt shrunk 10%, and the value of the painting went up 8%!  We mostly kept up with inflation in our re-sale value, but we actually lost 2% of it’s value.  But our debt lost 10% of it’s value!  In inflation-adjusted terms, we made (-4% of $1m, -2% of $1.25m, +10% of $1m) $35,000 of post inflation value ($60,000 pre-inflation) on an investment of $250,000!  That’s 24% pre or 14% post inflation cash on cash!

Of course, don’t run out and buy a painting.  There’s all sorts of transaction and maintenence costs we’ve neglected, and how do you sell a painting, anyways?   And the value of art will go up and down independant of inflation due to other market pressures, the same as any other asset does.  (ask American homeowners about their houses)

But the principle remains.   Find something that you are very sure will appreciate at least as fast as your interest rate.     Get a rate of interest if not below inflation (damn near impossible),  as close to it as possible.   As long as the appreciation plus debt shrinkage is high enough above the interest rate to offset the risks and expenses of being in that asset, you are making value!


One Comment

  1. sustainability says:

    fantastic post, very informative. I wonder why the other
    experts of this sector don’t notice this. You must continue your writing. I’m confident,
    you’ve a huge readers’ base already!

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