Warren Buffett’s latest op-ed article in the New York Times warns about a surge in “greenback emissions” which could result in high inflation over the next several years. This is not Mr. Buffett’s first warning about inflation. In his latest annual letter to Berkshire Hathaway shareholders (discussed on The Rational Walk in February) , Mr. Buffett warned about a potential “onslaught on inflation”. How should investors react?
The Butterfly Effect
The “butterfly effect” is often used to refer to the idea that a small initial event such as a butterfly’s wings flapping could impact atmospheric conditions in a manner that causes a chain of events ultimately resulting in a large scale event. As applied to monetary policy, Mr. Buffett believes that “greenback emissions” could result in dangerous inflation conditions in the future in an economic version of the butterfly effect:
The United States economy is now out of the emergency room and appears to be on a slow path to recovery. But enormous dosages of monetary medicine continue to be administered and, before long, we will need to deal with their side effects. For now, most of those effects are invisible and could indeed remain latent for a long time. Still, their threat may be as ominous as that posed by the financial crisis itself.
Of course, in prior comments, Mr. Buffett has been supportive of both the monetary and fiscal policies put in place in response to the economic downturn. However, he appears to be saying that the worst of the recession has passed and now is the time to think about strategies to remove the extra “monetary medicine” that was used as shock therapy during the worst of the crisis.
The Path of Least Resistance
The massive debt that has been accumulated over the past year has left the government facing a number of key choices regarding how to address the situation. As Mr. Buffett correctly notes in his article, politicians dislike making difficult decisions related to taxes and spending. Every spending program has a constituency even in cases where the program in question seems entirely wasteful and trivial. Because such programs often provide concentrated benefits for certain groups but the costs are spread widely, government programs often are very hard to cut or eliminate. Other than new taxes for the very top of the income distribution, few politicians are willing to advocate higher revenues.
This leaves inflation as a potential “solution” for lowering the real value of the national debt because no hard votes are taken and there is no one clearly to blame for the situation:
Legislators will correctly perceive that either raising taxes or cutting expenditures will threaten their re-election. To avoid this fate, they can opt for high rates of inflation, which never require a recorded vote and cannot be attributed to a specific action that any elected official takes. In fact, John Maynard Keynes long ago laid out a road map for political survival amid an economic disaster of just this sort: “By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens…. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”
It is interesting that Mr. Buffett also states that “the dollar’s destiny lies with Congress” when it is supposedly the Federal Reserve which controls monetary policy. Obviously, the article shows a degree of skepticism regarding the independence of the Federal Reserve and the ability of the Fed Chairman to resist demands for looser monetary policy even as the economy recovers. I personally have never believed that the Fed will dare to tighten policy until unemployment levels return to the 7 or 8 percent range, but by then the inflation genie will be out of the bottle.
Fool Me Once …
Inflation creates the phenomenon known as “money illusion” because most people tend to think of prices in nominal terms rather than real terms. For example, most people will be happier with a 2 percent wage increase in a time of 4 percent inflation compared to a wage cut of 2 percent at a time of flat prices even though both outcomes are identical with the individual suffering a 2 percent decline in real purchasing power. Money illusion can temporarily fool people into thinking that they are better off, but this does not last long. Inflation expectations eventually increase and anticipated future inflation enters into calculations of wage and price increases, thereby creating momentum for an inflationary spiral.
Other problems associated with inflation include erosion of the real value of cash and many bank deposits which pay low or negative real rates, the erosion of the value of fixed income investments for corporations and individuals (including retirees), and unexpected economic effects of inflation on contracts that are not indexed for inflation.
Many years of relatively low inflation have resulted in a population that is highly likely to suffer from money illusion in the coming years even if inflation accelerates. Only after a sustained period of inflation will people figure out what is really happening to their real economic well being. Of course, there will be disproportionate winners and losers. Homeowners who have large fixed rate mortgages will be winners while retirees with large fixed income investments will be major losers. Inflation tends to result in capricious and unintended outcomes.
Coping With Inflation
Current long term interest rates, particularly for treasury notes and bonds, remain priced in anticipation of benign inflationary conditions for the foreseeable future and yields on cash equivalents are near historic lows. Many investors tend to look at commodities and real estate for inflation protection, but it is not clear that such strategies have worked in the past.
Warren Buffett and many other investors have suggested that the best way to protect against inflation from an investment standpoint is to purchase interests in businesses with large “economic moats” that will allow for price increases and where large capital expenditures will not be required to sustain the economic moat over time. Such businesses are few and far between but still represent the best strategy for coping with an “onslaught of inflation” over the coming years.
Of course, one could also bet on the wisdom of politicians in Washington to opt for a fiscal policy that corrects the imbalance rather than resorting to inflation, but to say that this would be similar to believing in the Tooth Fairy or Santa Claus may be too charitable.