The Inflation Tax

Guest Post by Daniel Wilson

The true and classical definition of inflation is an expansion of the supply of money in an economy relative to the total amount of goods and services, resulting in an increase in the general level of prices. Milton Friedman, a Nobel prize-winning economist, described inflation as a monetary phenomenon, noting that a rise in the average price level only occurs when central banks print too much money. In the United States, the central bank is the Federal Reserve, created in 1913 under Woodrow Wilson.

Since the inception of the Federal Reserve System, the U.S. dollar has lost over 90 percent of its value. The legacy of the Federal Reserve is an ever declining currency and perpetual inflation. Under the classical gold standard, from 1870-1914, a period without a central bank and a strong tie between the dollar and gold, prices actually fell while the economy boomed, proving to be the greatest growth period in American history. One of the many great aspects of a free market is to lower prices in the long run as production and productivity increase the supply of goods and services. However, central banks can increase the supply of money faster than the growth of the economy, substituting inflation for deflation.

Today, inflation is commonly measured through the consumer price index reported by the Bureau of Labor Statistics. Since World War II, the CPI has averaged around 3.5% a year. This means the average price of goods and services doubles every 20 years. The most infamous spouts of inflation occurred during the 1970s after Richard Nixon closed the gold window in 1971. As a result of ending the last linkage between the dollar and gold, the money supply, measured by M2, grew at a much faster rate than in previous decades. The CPI averaged more than 7 percent in the 1970s, reaching a high of 14 percent in 1980. The complete removal of the gold standard eliminated the only constraint on the Federal Reserve’s ability to print money.

Unfortunately, inflation is still alive and well. Misguided policies by the Federal Reserve in response to the recent economic downturn have dramatically increased inflationary pressures. In the name of economic stimulus or quantitative easing, the Federal Reserve has basically printed money out of thin air to buy U.S. treasury debt. Stated differently, the U.S. government is printing money to monetize the deficit, which currently stands at a whopping $1.3 trillion.

Inflation is essentially a tax, lowering the rate of return on work, savings and investments. The inflation tax has a particularly disparate impact on the middle class, which has seen their incomes fall over recent years. In spite of economic stimulus, household incomes have actually fallen more during the recovery then the actual recession. Intuitively so, households’ net worth will diminish with a continuation of higher prices on consumer items and falling incomes.

Luckily, there are several ways households can protect themselves from higher inflation. If you have any savings, look to make some investments. A great investment strategy is in real assets, such as gold. At $1700 an ounce, gold still offers a great buying opportunity. There is no ceiling on the price of gold because there’s no floor on the value of the dollar. The combination of trillion dollar deficits and loose monetary policy as far as the eye can see, provides impetus for upward movements in its price. Goldman Sachs projects an ounce of gold to rise by 20% for 2012, while Morgan Stanley forecasts 30%.

Another investment households should consider is buying stock in mortgage real estate investment trusts. As long as the Federal Reserve continues its commitment to keep short-term interest rates artificially low, MREIT’s offer a great buying opportunity. Many MREIT’s provide a very high dividend yield; American Capital Agency Corp. (AGNC) is currently paying a 20% dividend.

In short, considering inflation, you’re losing money by keeping it in a bank account that pays 0%. Provided you have the means, look to protect yourself from inflation by investing in real assets like gold and high dividend yielding stocks. If you can, buy the dips, and sell the rips.

Daniel Wilson is a senior who is majoring in economics at James Madison University. 

Leave a Reply

Your email address will not be published. Required fields are marked *