Daniel Amerman describes the how deflation and inflation combine to reduce the purchasing power of the dollar. Devaluing the dollar bails out governments and companies who have underfunded pension plans. Unfortunately, it transfers money from savers to debtors in the process. Excerpts below.
Link: “Surviving The Cure For Asset Deflation” by Daniel R. Amerman, FSU Editorial 12/03/2009
Many people would say that the true lesson of the early 2000s in the United States is the demonstration what an extraordinarily loose credit policy can do in terms of asset prices. Low cost and easily obtainable mortgages led to a real estate bubble, even as easy and loose corporate bond markets led to a booming private equity market, with leveraged buyouts being an important factor in maintaining an overvalued stock market.
The problem is that Wall Street, the government, and much of America has effectively bet everything they have on these asset bubbles not only staying inflated, but continuing to expand. Pensions long ago became “the tail that wags the dog”, for state governments, local governments and most major corporations. Almost every state and local government in the US that has full time employees has entered into promises for future benefits, which it anticipates being unable to cover from ongoing tax revenues. Some of these promises are unfunded, others are fully “funded” (meaning they have adequate current portfolios given the investment return assumptions), but the mechanism all comes down to the same thing. Via the mechanism of the markets, vast sums of money and resources will flow from the outside economy into the local economies for all the states and cities, and will pay for the legally binding promises that would otherwise be unaffordable from current revenues. In other words – the asset bubbles have to not only be maintained, but must continue to inflate, or else the pension obligations bankrupt every level of state and local government.
Governments aren’t the only ones relying on asset bubbles, so are most of the major corporations. Oh, the defined benefit plans are disappearing fast in terms of the ability of workers today to participate, but there are still tens of millions of workers covered, and many trillions of dollars of pension and health care benefits that will have to be paid. Future benefits that would destroy corporate profitability, and drive many corporations into bankruptcy.
The government doesn’t control the value of assets, but it does control the value of the dollar. It can do something that actually fools almost all of the people almost all of the time. The government can devalue the dollar. It can create inflation. What the government can do is it can take that hundred thousand dollar asset, that wants to fall to $20,000 in real terms, and let it fall, but still make it worth $200,000 in nominal terms simply by devaluing what each of those dollars are worth. Which means the homeowners are no longer underwater, and the banks are no longer insolvent.
… so long as the purchasing power of money is destroyed faster than the purchasing power of assets, an illusion of asset inflation is created.
An illusion that is potentially deadly for your investments and standard of living for the next several decades – but which is impossible to see through if you take the most common approach to looking at inflation or deflation, which is that it must be one or the other.
…consider the dilemma of the pension funds. It could be the State of California, or your local city government, or just about any major corporation that has been around for several decades. Legally binding promises have been made based on the belief that markets always rise and reliably compound wealth. (I wrote my first book pointing out what an exceptionally bad and historically unsupported idea that was, back in 1993.) So for example’s sake, if the market value of a portfolio doesn’t rise from $35 billion to $50 billion, then the pension sponsor is in serious trouble. Enter asset deflation, and the portfolio goes down to $25 billion, and refuses to go back up. An event that leads to systemic bankruptcy of every level of state and local government and corporation in the United States with major pension obligations.
Unless, as illustrated above, a dollar becomes worth 50 cents. Asset deflation is entirely covered by monetary inflation. Rephrased, the destruction of half of the value of the pension fund (and your) assets is entirely hidden by the destruction of half of the value of your money. Everybody is legally solvent again.
…if you are unwilling to be fooled again, and you are willing to roll up your sleeves and learn, then an unfair world transforms into a world of opportunity. Because here is the real essence of inflation and deflation: they are both REDISTRIBUTIONS of wealth. In each case, and particularly when the two occur together as illustrated in this article – there is a fundamental redistribution of wealth within society. With some people doing much better and others doing much worse.
This fundamental redistribution is more dangerous for some than others. Generally speaking, the higher the degree of monetary inflation and asset deflation, the more the older segment of the population is disproportionately devastated. For the reason that older savers have the savings & portfolios to lose, but lack the decades of peak personal career earnings needed to replace the assets. Which is deeply, totally unfair, but it is the way of the world.
With knowledge, the redistributions can flow to you, rather than away from you. The greater the degree of inflation – the more wealth that fundamental economic forces will redistribute to you. Understand how the redistributions work – and a potentially catastrophic degree of inflation can become the single most financially lucrative event of your lifetime.
But for this to happen, two uncommon steps have to be taken, which will separate you from most of your peers. You have to fully accept personal responsibility for your own future, and say “I won’t be fooled again”. Then you have to make the choice to learn how to turn societal deceptions into personal opportunity.
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