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“Inflation is as violent as a mugger, as frightening as an armed robber, and as deadly as a hit man”. But it works

You don’t have to be Greek to understand that something very wrong has happened. Public and private sector over leverage has led to the certainty that it cannot continue in its current form. A problem that has been brought to the fore by markets who either won’t lend more or want a much higher return for the perceived risks.

But help is at hand there are three ways out:

1.  Orderly default. Lenders take a haircut. Borrowers get a level of debt that they can manage. The well known example is Latin America. It would take the banking system down again and recapitalization would be necessary. A forced transfer from taxpayers in surplus countries to those in deficit ones would ensue. It’s politically difficult.  But it works.

2. Inflation. Borrowers pay back with money that is worth less or should that be worthless? It misallocates resources, affects those on fixed incomes and easily gets out of hand. But it works

3. Repayment. Raising taxes and cutting government spending leads to surpluses. The cost is unemployment and social unrest. But it works.

So what are we doing?

In the UK the choice was made over two years ago. But you weren’t told.

Pledging to repay was intended to buy time. It’s what markets want to hear, it keeps borrowing rates low and is good for Gilts. But can we do it? The budget deficit continues to rise and discontent is manifest before the main cuts are made.

That’s why inflation is doing the heavy lifting. The 2% target has been continually missed by the Bank. Excuses have included:

  • The wrong type of inflation because its imported. (Hasn’t accommodative monetary weakened the pound?)
  • It’s the future inflation rate that matters, not the one today. (Incredible! Just how far forward are they looking?)

No wonder the government changes indexation from RPI to CPI. Do they know something you don’t?

So here’s the good news……

If you have on an interest only mortgage of £100,000 and inflation continues at 5%, then in real terms after 10 years you have just over £61,000 of debt.

the bad……

If the difference between after tax interest and inflation rates is 4% then £10,000 of savings will be worth little more than £6,700 after 10 years in real terms.

The value of your money is almost halved in value for a 7% difference. The chances are that with such extreme monetary policy being used bigger policy errors will creep in and will be very hard to contain.

and the ugly……..

If  Bank of England independence only lasted a short period of time the following statistics are salutary.

  • RPI peaked in 1975 at 24.2%
  • The low was in 2009 at -1.6%
  • £1 in 1987 was only worth 43p in 2011
  • From 1752 to 2001 the pound lost 99% of its purchasing power

Ronnie Reagan was right “Inflation is as violent as a mugger, as frightening as an armed robber, and as deadly as a hit man.”

Not that this bothers borrowers. The UK government just happens to be one of the largest.

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