Can high inflation save the economy?

An article in Forbes magazine tries to make the case for devaluing the dollar by 40% to help out the economy:

Why not attack the situation in a manner that will benefit most everyone, an approach that has been successful before and, when compared to the current course, has little downside? Here it is. Stand back. World currencies should be devalued overnight.

The Forbes article is riddled with errors about inflation and the gold standard that I won’t address in this post. The short of it is that devaluing the dollar by 40% won’t do anything at all except force the prices of everything else in the market up by 40% overnight as businesses move to protect themselves. It would also drive interest rates on loans through the roof, put many companies into bankruptcy, wipe out huge portions of savings of the average American and make a bad economy much, much worse. 

So what if? After all, this is Forbes Magazine discussing the idea so someone thinks it’s good. How would you want to position your finances if the threat of a massive inflation to solve our problems came to pass? 

For severe inflation you want to be in gold, commodities, and other tangible assets. Real estate may also be another option, but is not a very liquid investment which causes its own problems. 

You want to be out of long and intermediate term bonds and cash which will rapidly lose value. In the long-run stocks should beat inflation. However, in the short-run stocks will do poorly during high inflation as businesses have a hard time adjusting to rapidly increasing prices. Short term government bonds and money market funds may tread water OK but won’t be profitable. Treasury Inflation Protected Securities (TIPS) may also tread water again without much profit. Then again, risks could show up in this situation that would even effect these bond holders dramatically. 

The true worst-case inflation scenarios includes things like price, wage, capital and exchange controls which always are tried when governments are scrambling to prop up their currencies. These actions are all tremendously bad news for an economy. If you ever hear high-ranking politicians openly talking about doing such things you should be prepared to move quickly to protect your money by shifting it into tangible goods, hard assets, or moving it into another currency (preferably in a foreign bank) if possible. Even this is not foolproof as governments would likely put up blockades to trap as many people as possible before a serious devaluation would occur. 

But this is all worst-case scenario. Does it happen in real life? 

Well, in Argentina before they devalued the peso in 2001 they implemented capital and exchange controls. These controls forced citizens to repatriate foreign funds, froze all bank accounts, limited how much money could be removed at any one time, and converted all domestically held accounts in Euros and Dollars into the Peso before they did the devaluation. The Argentinean peso lost about 80% of its value shortly thereafter, decimating the life savings of their citizens. Nice huh? 

Just because the US Dollar is the reserve currency doesn’t rule out the use of high inflation to try to solve economic problems either. The question is, can it happen here? Well, it almost did. The decade of the 1970’s wasn’t bad just because of Disco. It also saw double digit inflation with the prime rate over 20% by 1980. It also saw price and wage controls, shortages of oil and other staples due to these controls, and a destruction in the standard of living for working and retired Americans on fixed income as the value of the dollar sank by 50%. So this type of scenario has happened even in the US and was only averted after a very painful recession that capped off 15 years of flat stock market returns. The next time it occurs we may not be so lucky.

This is all an extreme situation, but it’s always a good idea to consider how to deal with problems you think are unlikely right now. For this reason, I think all investment portfolios should hold some percentage of their allocation in hard assets as insurance in case a bad inflationary situation unfolds. More on that in the future.

Craig Rowland

I own the place.