The Investor’s Dilemma[1]
Fiat currency forces even risk-averse investors to become speculators to one degree or another.
“Never sell Consols”, was the admonition of Mr. Forsyte in John Galsworthy’s novel The Forsyte Saga. Consols, short for Consolidated Stock, are bonds of the British government that were initially issued in 1751 to consolidate various debt issues of the British government. Consols were especially important in financing the Napoleonic Wars. “Perpetual annuities” with no maturity date, they were long considered the safest and soundest of all investments and, along with similar high-grade long-term bonds, were a foundation of the prosperity and comfort of propertied families (derisively called “coupon clippers”, because removing the interest coupons from their bonds was presumed to be their closest approximation to work) such as the fictional Forsytes.
Mr. Forsyte’s dictum worked through the end of World War II. Since then, his warning has been a prescription for penury. The reason, of course, has been the rejection of sound currency by the governments of the world in favor of officially sponsored inflating.
Inflating Forces Investors to Become Speculators
Investing was a relatively simple matter when the British pound, the U.S. dollar, and other currencies were defined as redeemable on demand in specific amounts of gold. Indeed, such currencies were generally believed to be “as good as gold”. High-grade bonds and similar instruments thus were even “better than gold”—they paid interest. The cost of living might go up or down with cycles of trade or of war and peace, but the longterm stability of prices seemed assured. Under a fully functional gold standard, long-term interest rates were quite stable through business cycles—interest rate fluctuations were far more pronounced in short-term rates—and high-grade bond prices fluctuated in a relatively narrow range. In this environment, all an investor needed to do was save up some money and lend it out at interest to borrowers who were likely to pay it back.
This has changed completely during the past half century. The record of the British Consols (yes, you can still buy them) illuminates how much. The 4-percent Consols traded above par as recently as 1945, when the wholesale price level in Great Britain was (believe it or not) nearly the same as it was when Wellington defeated Napoleon at Waterloo. Since then, the British pound (and that perpetual stream of interest income from Consols) has lost more than 95 percent of its purchasing power, and the 4-percent Consols were recently trading at about 75 percent of par.
This is an extreme example. Relatively few perpetual annuities such as British Consols have ever been issued—most high-grade bonds eventually mature and return 100 percent of par in terms of nominal currency, but the loss in purchasing power for these long-term investments over the past half century has rivaled that of Consols.
Chart 1 shows the long-term trend of the purchasing power of the dollar, which has decreased more than 90 percent since 1933. AIER has estimated that, through 2000, inflating cost savers in the United States more than half of the real wealth they had set aside and held in fixed-dollar claims. In 2001 dollars, these losses totaled more than $13 trillion.
Fixed-dollar claims, other than currency itself, earn interest income for their holders and interest rates on high-grade dollar instruments have for some time included an “inflation premium” over the 3-4 percent that was usual in the days of the unquestioned gold standard. However, that premium has often been less than adequate to compensate investors in fixed dollar claims for their losses in terms of purchasing power.
This is evident in Chart 2, which shows the cumulative value of $1.00 invested in 91-day U.S. Treasury bills from the end of 1950 through the end of the year 2000. Treasury bills are considered to be “riskless” in the sense that few doubt that the Treasury will redeem them (with dollars created out of “thin air” if need be) and because they are very short term there is little risk their market value will decrease. It is very unusual for the market value of Treasury bills to be less that what holders paid for them (and if it happens it is only by a very small amount and for a very short time). The rates on Treasury bills are usually comparable to what is available on savings accounts or money market funds, and similar risk-free holdings.
Also shown in Chart 2 are the cumulative values of that $1.00 adjusted for the cost of living as measured by the Consumer Price Index; the cumulative values after deducting income taxes each year (at an assumed tax rate of 35 percent); and the cumulative values after taxes and adjustment for the cost of living. The 50-year average rates of return on each cumulative value series are also shown in the chart. The $1.00 grew to almost $13.00 over the 50 year period, an average return of 5.2 percent. But inflation averaging 4 percent per year reduced that amount to less than $2.00 (in terms of 1950 purchasing power) and the annual return to 1.2 percent.
If the interest earned each year had been taxed as it was earned (at an assumed rate of 35 percent) then the holder would have had a little less than $6.00 in the year 2000, the purchasing power of which would have been only about $0.75 in terms of 1950 purchasing power. The double whammy of inflating and taxes means that anyone who continuously rolled over T-bills for the 50 years actually paid the Treasury twenty-five cents (1950 dollars) for the privilege of lending it one dollar!
Principal and Income
A corollary of the traditional notion that sound investing meant buying and holding high-grade, fixed-currency claims was that only the interest income from such holdings should be used to meet living expenses. The story is told of a female member of a “Proper Bostonian” family who was picked up by the police for street-walking. At the urgent family conference that followed, the head of the family asked:
“Emily, how could you do such a thing?”
“I needed the money,” she calmly replied.
“But your father took care of you in his will, why didn’t you use that money?”
“Why, that would be spending out of capital!”
The notion that spending principal is wrong, or at least shameful, would have been heartily endorsed by Mr. Forsyte. It was okay to spend the interest but “Never sell Consols.” Chronic, officially sponsored inflating has changed this ancient principle of investing too, although it continues to be enshrined in trust indentures, and (most outrageously) in the tax code, which taxes as income the portion of interest received and realized capital gains that do no more than offset the losses in purchasing power from depreciation of the currency in which they are measured.
As mentioned above, interest rates nowadays incorporate an inflation premium to compensate for the loss of the purchasing power of the principal. Similarly, higher asset prices may simply reflect general increases in the cost of living rather than genuine capital gains. From the individual investor’s point of view, looking only at the nominal values of principal and interest can result in what can only be described as irrational, if not self-destructive, behavior.
Consider, for example, a retired couple who bought gold coins 30 years ago (when the price of gold was less than $50 per ounce) as a hedge against inflation. They may now find themselves strapped for cash as price inflation has eroded the purchasing power of their sources of retirement income. Because they view the coins as capital, they may be reluctant to sell any to supplement their cash income, even though that is precisely what they should be doing and the very reason that the coins were purchased in the first place.
On the other hand, some investors apparently view all interest receipts as spendable income. When price inflation abated from its most recent peaks, interest rates did too. The decrease in interest rates prompted many investors to seek higher yields by switching to riskier investments (such as junk bonds) even though the abatement of price inflation meant that their “real” incomes (after-tax income less the loss in the purchasing power of the principal) had changed little.
The point is not so much that such investors were ill-advised to hold fixed-dollar investments (their real income from these investment was in fact very little, if anything, both before and after interest rates and price inflation decreased). The point is that lower nominal rates accompanied by lower price inflation is not a sound reason to accept more risk.
Some Things Don’t Change
Chronic inflating has not changed the fundamental importance of living within one’s means as the key to becoming a successful investor. What is different is the accounting—determining what your means really are. In the first example given above, the retired couple failed to understand that gains on their gold coins had offset decreases in the purchasing power of their retirement income. Oppositely, spending all nominal interest as income is a sure-fire prescription for a progressive decrease in the real value of one’s holdings.
More generally, there is no reason to believe that a regime of fiat currency has served to increase the long-term returns that can be expected from investment capital to more than their historic levels (four percent or less). Indeed, there is much reason to believe that even that level may be difficult to obtain if inflating continues.
As the foregoing discussion of holding Treasury bills illustrates, the real returns from holding risk-free dollar claims are likely to be very low, even negative. The fundamental dilemma facing investors during an age of fiat currencies and chronic inflating is that in order to receive an acceptable rate of return, one has to accept the possibility of losses. As the late Arthur Okun of the Brookings Institution, who served as the Chairman of President Kennedy’s Council of Economic Advisors, put it:
The opportunity of safe saving is lost in a period of sizable and unpredictable price increases. Some assets offer a degree of protection against inflation in the sense that their values are likely to move up as consumer prices rise. But no asset shows a good year-by-year correlation with prices; even corporate equities and real estate are not good anti-inflationary hedges by this test. They may actually tend to outpace the price level on the average in the long run, but only with wide swings and great uncertainty.
Our financial system ought to serve both investors who want to earn maximum returns (and are willing to take substantial risks) and holders of reasonably safe assets who view their saving largely as deferred consumption. The latter are not accommodated during inflation… the unsophisticated saver who is merely preparing for the proverbial rainy day becomes a sucker.
This perhaps is the greatest single affliction of fiat currency: it forces risk-averse investors to become speculators to one degree or another. The speculative elements become 1) what will the dollar be worth when my investment is sold or matures, 2) what will my investment be worth when it is sold or matures, and 3) how much of the nominal income from an investment will be taxed away?
Accepting Risk
Money has served three traditional functions: as medium of exchange, as standard of value, and as store of value. All governments of the world have embraced fiat currency and inflating, with results similar to that of the dollar evident in Chart 1. This means that, while their currencies can continue to serve the first function of money in transactions, their usefulness as standards of value are subject to the distortions of fluctuating foreign exchange rates, and most of all, currencies have become unreliable stores of value, especially over the long term.
Resolving the investor’s dilemma means that, in order to achieve an acceptable real return in terms of purchasing power, today’s investor must rely to a greater or lesser extent on holdings that can fluctuate markedly in price.
It is only by accepting the possibility of losses in terms of currency (as well as purchasing power) that investors can expect to mitigate the “double whammy” of price inflation and taxes.
1AIER, RESEARCH REPORTS Vol. LXVIII No. 24 December 24, 2001
