Posted on January 1, 2019
For decades now we have seen standards of living decline for the average American household. With constantly rising cost of living and stagnant wages it can seem the system is rigged against the common citizen. Make no mistake about it, the economy is indeed rigged and it is rigged on purpose.
The economy is designed to use inflation to slowly erode financial wealth and transfer that erosion to the government. In fact there is an official term for this wealth transfer that is called seigniorage, or alternatively referred to as an inflation tax. The basic concept is that the government increases its coffers with newly created currency in lieu of taxes on existing currency, which equates to decreases in purchasing power. We are even told that a little bit of inflation is a good thing.
At the same time the government is slowing sucking your wealth it is also reducing its liabilities with inflation. Bonds issued in nominal currency are not adjusted for inflation, meaning a $1,000 bond issued today will be repaid in the future with $1,000, regardless if inflation is 0% or 5,000%.
To make matters even worse there is the concept of taxation. It is not enough that the government stealthily transfers your wealth through inflation but the government also wants to tax you on the wealth transfer through various taxation rules. Have a bond that pays interest or a stock that pays dividends? You’re taxed on the full amount received, not just the amount in excess of inflation. Did you make any capital gains on an asset sale? You’re taxed the full amount here too.
Let’s illustrate this concept through a hypothetical purchase bond. Say you bought a bond for $1,000 and later sold it for $1,025. It yielded $25 in year for a 2.5% yield and the annual inflation rate was 5%.
You managed to make $50 in total by combining the capital gain and interest received. This is your nominal return. However, since inflation eroded away your entire nominal return you might expect your real return to be zero. Not so. Your real return is actually negative because you are taxed on the $50 nominal return through capital gains and interest income taxation.
Unfortunately there is not much that will make a drastic impact but there are a serious of things that can be done to limit the effects.
1. Knowledge - The most important step is to acknowledge the economy is rigged. Knowing this will help the investor make better investment decisions. Are you looking at a bond fund that yields less than inflation with exposure to duration and default risk? That’s probably a bad investment choice knowing you are guaranteed to lose real purchasing power in addition to taking on risk. Are all your investments in paper assets subject to inflation? Perhaps you should reconsider your portfolio.
2. Tangible Assets - Investing in tangible assets can help limit the effects of a rigged economy. We know inflation is being used to slowly erode your financial assets by transferring value to the government. Therefore it is advisable to consider assets that are more or less protected from inflationary effects. Real estate and gold are good examples of tangible assets that tend to be isolated from inflation, although capital gain taxes may still apply. Gold is particularly good in that one can procure it and keep it off the books if desired.
3. Floating Rate Bonds and Preferred Stocks – Floating rate bonds and floating rate preferred stock periodically change their interest payments typically based on a benchmark such as the 3 month LIBOR. These type of investments can be a bit tricky to find individually. Finra.org has a good bond searching tool and Quantumonline.com is a great source to find floating preferred stock. ETFs also exist in these categories such as Vaneck’s FLTR, iShares’s FLOT and Invesco’s VRP. As with any ETF be aware of the fees involved.
4. International Assets – International assets, such as international stock funds or property, derive their underlying value in foreign currency rather than domestic currency. Note that you are trading one rigged economy for another. However, with diversified international assets the overall risk may be significantly reduced.
5. Vote – Vote the politicians that support the status quote out office.
Government Bonds – Avoid government bonds of any type. Loaning money to the government only feeds the beast and further encourages the system to operate as designed. Don’t be tempted by treasury inflation protected securities (TIPS), especially long duration TIPS, as they don’t provide enough protection against inflation. TIPS yields are tied to the Consumer Price Index (CPI) which is not actually an inflation index but rather a behavioral index.
Long Term Corporate Bonds – Avoid longer duration bonds of any kind, whether it’s a government bond, cooperate bond or preferred stock, as increasing inflation can quickly destroy wealth.
Savings Accounts and CDs – Savings vehicles such as certificates of deposits and savings accounts are guaranteed to lose value since a majority of them pay out interest that is less than inflation.