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How inflation swindles the equity investor (1977)

121 points by mudil 9y ago

runeks 9y ago
From Buffet’s explanation, it doesn’t sound like it’s inflation in and of itself that swindles the equity investor, but rising or falling inflation. I.e. if inflation were constant, the market would easily adjust, but when it rises or falls slowly over decades, investors are bound to make decisions that will turn out to be wrong in the future. It seems to me that exactly the same is the case for interest rates: no rate is “right”, but falling or rising rates will force market participants to make wrong decisions: * In a rising interest rate environment, all bond purchases will prove unwise, since the investor could have earned a higher rate by waiting a bit longer. * In a falling interest rate environment, all bond selling (issuance) will prove unwise, because the issuer could have paid a lower rate by waiting a bit longer.
- blue1 9y ago
  Isn't really unexpected change that cause investors to make wrong decisions? Expected change should be already incorporated into prices.
- dantheman 9y ago
  Real interest rates - those set by banks based on demand for money, and not set by central banks are a price signal. What we have now is straight market manipulation which causes problems. Interest rates should be a signal about consumption vs investment.
  - YPCrumble 9y ago
    Does a "real interest rate" per your definition actually exist? Googling the term returns an inflation-adjusted interest rate. In theory if we didn't have central banks this might be possible. However, central banks "print" money to adjust short-term interest rates that are a lever for influencing demand for money. It seems unlikely that it is possible to decouple supply from demand in the real world.
    - Consultant32452 9y ago
      In this case I think "real" interest rate means a rate derived in the free market, rather than at the whim of central planners (fed).
      - YPCrumble 9y ago
        My point is that the notion of a "real" interest rate as defined doesn't exist. The idea of a currency that cannot be manipulated is a chimera. Here are two reasons: 1. Currencies are created by some government or government-equivalent (e.g., maintainers of bitcoin/bitcoin fork), and these governors set the supply of currency. Sometimes they use interest rates, sometimes they just print more currency, sometimes they set a schedule for mining digital currency, it doesn't matter. However, the "free market" is inherently manipulated by the "owner" or "creator" of the currency. 2. If you consider a "commodity-currency" like gold or diamonds (or probably bitcoins) whose supply is not determined by a central authority, these commodity-currencies can also be manipulated. In fact, without the check of a government, capitalism works in such a way that these commodities become centralized into a few large holders who are incentivized to manipulate the currency. This is why governments like to get off of the gold standard, so they can manipulate their currency without interference from other governments.
    - nine_k 9y ago
      > Does a "real interest rate" per your definition actually exist? Googling the term returns an inflation-adjusted interest rate. > In theory if we didn't have central banks this might be possible. However, central banks "print" money to adjust short-term interest rates that are a lever for influencing demand for money. It seems unlikely that it is possible to decouple supply from demand in the real world. With gold standard, central banks could not directly print money. It was abandoned by the US about 40 years ago, and by Europe, even earlier (because world wars).
      - YPCrumble 9y ago
        The gold standard gets abandoned because countries want to manipulate their currency independently of the impact of other countries' currency manipulation. This is sometimes because they want to pay for costly wars via currency manipulation, but that's not the only reason.
  - wbl 9y ago
    What problems has the fed caused since the 1980's? Prices are stable, employment is good.
    - tomrod 9y ago
      Prices are not stable, but increasing at 3 to 4% per year. Employment is okay, but more than a 10th of the population is in their working years but not working.
      - Godel_unicode 9y ago
        Since '81 it's actually exactly 3% per year, and since '90 it's 2.36% per year. The variance is around 1%, I'd call that pretty stable.
        tomrod 9y ago
        Fair point, and also depends on which measure you're looking at. https://fred.stlouisfed.org/graph/?g=iFuv https://fred.stlouisfed.org/graph/?g=iFuv
      - exHFguy2 9y ago
        Predictable increases == stable. "but more than a 10th of the population is in their working years but not working." Fed has very limited set of things they control. They don't do fiscal or policy.
    - dxhdr 9y ago
      > What problems has the fed caused since the 1980's? Prices are stable, employment is good. Which prices have been stable since the 1980s?
      - exHFguy2 9y ago
        Prices, in US Dollars, have more or less been stable. Some have risen a lot (e.g., medical, education). Some have gone down a lot (e.g., clothing). Overall though....stable-ish. Some of this the fed controls, some of this they don't. They are not all powerful. For example, the share oil revolution has done a lot to reduce prices. Has nothing to do the the fed. China coming online as manufacturing powerhouse has also reduced prices. Again, fed has nothing to do with that.
  - JumpCrisscross 9y ago
    Real interest rates are a monetary measure, to be contrasted with nominal interest rates [1]. I believe you are referring to the rate of interest absent a central bank. [1] https://www.imf.org/en/Publications/WP/Issues/2016/12/30/The-Determinants-of-U-S-994 https://www.imf.org/en/Publications/WP/Issues/2016/12/30/The...
    - dantheman 9y ago
      correct - I used the wrong term.
- OscarCunningham 9y ago
  One could equally say that its bad for someone whenever a stock price moves. I think it's okay for interest rates to vary, that's just the normal reponse of the market to changing conditions. It's not contraversial that inflation should be steady. That's literally the point of a central bank.
- simo7 9y ago
  Actually according to Buffet even _constant_ inflation can be very bad if the business is capital intensive with high fixed-costs. See my point here: https://news.ycombinator.com/item?id=16458373 https://news.ycombinator.com/item?id=16458373
- dheelus 9y ago
  Bear in mind that most bonds are callable so the seller really has little choice in a falling rate environment.
- exHFguy2 9y ago
  "* In a rising interest rate environment, all bond purchases will prove unwise, since the investor could have earned a higher rate by waiting a bit longer. * In a falling interest rate environment, all bond selling (issuance) will prove unwise, because the issuer could have paid a lower rate by waiting a bit longer." Not quite. Bond prices incorporate future expectations of real rates and inflation rates and then also associated risk premiums. Thus, a bond purchase will lose money only if realized rates come in higher than what is already discounted. That is, it is possible for short term rates to rise, and yet a bond increases in value (i.e., because the ST rates came in lower than what was already assumed in the bond).
  - runeks 9y ago
    > Bond prices incorporate future expectations of real rates and inflation rates and then also associated risk premiums. Thus, a bond purchase will lose money only if realized rates come in higher than what is already discounted. Isn’t the fact that bond interest rates falling for the past ~35 years — on a 5-year average — then a testament to the market being unable to predict future interest and inflation rates? If the market were able to correctly predict future interest and inflation rates, the rate of interest wouldn’t change. So, as far as I can see, the fact that it has been dropping, on average, for the past three decades seems to indicate that the market fails at this prediction under our current monetary system. Or, perhaps a better question: if the rate of inflation were to slowly increase by one percentage point per year, for the next 30 years, what would be the right real rate of interest right now — assuming we knew this were going to happen? In other words: how do you discount a rate that’s slowly but steadily changing (even if it’s in a known direction)? With regards to short term rates, I should have explicitly written “the long/bond rate of interest” since the two indeed are fairly independent.
    - tensor_rank_0 9y ago
      > if the rate of inflation were to slowly increase by one percentage point per year, for the next 30 years, what would be the right real rate of interest right now — assuming we knew this were going to happen? the rate would increase exponentially according to the number of days between the present and the maturity date. the rate for securities that could be redeemed on demand would steadily increase, but represent the lowest rate (because you would always have the option to decide to claim your money). whereas a 30 year cd would have the highest rate in the market.
pjc50 9y ago
A very different time when equity returns were 12% and inflation was in the 5-10% region.
- outside1234 9y ago
  we are probably on the verge of at least the inflation part of this - there is no way we are going to be able to do $1T deficits for long.
  - pjc50 9y ago
    Why not? Not just snark, that's a key question. 30-year yields are currently at just over 3%.
    - adventured 9y ago
      $30 trillion * 3% = saying goodbye to Social Security, Medicare or the entire US military, pick one. That's assuming the market complies with 3% rates. And that the dollar doesn't do a nose dive (as it did when Bush & Co. went wild with spending), debasing the US standard of living, setting off a nasty chain reaction of consequences. Who is going to buy $1 trillion of new US debt every year? Sooner rather than later, nobody. That's nearly equivalent to the sum that Japan and China are each holding. There's nobody left on earth that can absorb another $10 trillion in US debt in the next ten years, while continuing to maintain the existing $21 trillion pile. What will happen, is perpetual QE, debt monetization. The Federal Reserve fiscal death spiral begins and they have to forcibly maintain hyper low rates forever. Already the $15 trillion those clowns have added to our national debt over just ~16 years, is going to steal the money we need annually for infrastructure spending. The interest cost on $15 trillion at just 2% is enough to not only rebuild all US infrastructure over ten years, it'd build us bullet trains out the wazoo. All because they couldn't maintain basic fiscal discipline after 9/11. Or, alternatively, taxes have to go up a lot. The US has spare taxing capacity that most developed nations do not, however the rich are likely to be inclined to absorbing inflation rather than seeing their taxes go up a lot, they'll fight that. They can adjust assets, to a reasonable degree, to respond to inflation. After Japan's savings rate hit near zero, and the people of Japan could no longer finance their government's reckless spending, they had to turn to Yen debasement to manage their debt interest problems (attempt to inflate the problem away by destroying the currency), the consequences of that are extremely ugly over time unless you slash spending, growing a lot faster, or massively raise taxes (or a combination). Today their debt interest cost is over 1/3 of tax revenue. At those levels, you stop being able to maintain things you need to maintain, and the debt robs you of being able to make large investments for the future. That's where the US is heading over the next 10 or 15 years, and it already can't afford to deal with its existing spending needs.
simo7 9y ago
There is an important aspect which is not well remarked in the article: high fixed-costs businesses are the ones that really suffer inflation. If every time you want to expand you need to make significant investments (and there will always be a delay before it starts making money), inflation will affect your costs way before it will affect your revenue. Even worse, because fixed assets need to be replaced due to obsolescence every once in a while, you'll end up increasing your costs way more than you're increasing your revenue just to maintain the current production level. TL;DR: The more the delay between investment and revenue generation and the more capital intensive it is, the worst.
- tomjohnneill 9y ago
  Depends how you fund the investments. If you fund them by taking on more debt, then higher inflation is a benefit - it reduces the value of your debt compared to your product.
  - simo7 9y ago
    In a context of _constant_ high inflation that's not true: the interest rates will already be discounting the future inflation. You have a positive gain of that type in case inflation grows more than expected. Enough to offset the negative impact given by the delay costs-revenue? Probably not in most cases. In fact the positive effect applies to debt made in the past which precisely because of inflation is likely to be lower than the new debt you need to take on (on which the negative effect applies). Of course also the opposite could happen: inflation grows less than expected after you took on a lot of debt. So for a capital intensive business it'd just be better to operate in a context of constant low inflation.
    - BenoitEssiambre 9y ago
      Economists usually say that with constant predictable inflation money is "neutral" meaning that the interest rates adjust to offset any higher cost so that businesses shouldn't be affected by inflation (except for a bit of "menu cost", that is the overhead cost of having to update price lists more often. Low inflation has huge potential downsides in that fiat money can't have negative nominal return while it is quite normal for private investment returns to go negative sometimes (thermodynamics says that things, including stores of value, tend to degrade with time unless you put work and energy into them). This is the famous zero lower bound problem. It means that when private market rates go negative, people transfer their savings to cash, the world switches from producing real stuff and building real businesses to people hoarding intrinsically worthless pieces of paper (pieces of paper that might not be able to buy that much in the future because production will have gone down. On top of this, if you keep interest rates above market rates and inflation too low for a long enough time, that is if you keep rates high at 0% when they should be at -3%, market pressure will build for an uncontrolled inflation rebound when all the cash hoarded on the sidelines start flowing in an economy with lowered production. It is much easier to keep inflation stable if you keep it high enough so that the investment market can always clear and never hits the zero lower bound.
CPLX 9y ago
He certainly has a fair point. The problem, however, these days, is the way a monetary policy hyper-focused on eliminating inflation swindles the wage-earner.
- ergothus 9y ago
  I'm by no means well-educated on finance. However, it seems like inflation has been the boogeyman of every major policy decision in the US for the decades I've been watching. So far, the dire predictions haven't come true, but we've faced growing wage inequality for 30 years. I've read that the Fed has a dual mission - keep inflation/deflation in check and unemployment at healthy levels, but I only ever hear their concern for inflation risks. As a result I tend to discount concerns over inflation, assuming that the major problem will be the issue we aren't addressing...is my reaction reasonable?
  - sidibe 9y ago
    All central banks have been focused on the other issue since 2008. No one has been very worried about inflation until very recently.
    - ergothus 9y ago
      Banks, perhaps. Everyone else (conservative pundits, fiscal pundits) seem to be declaring imminent crippling inflation on a regular basis, yet it never seems to happen, even when the banks/govt take the action (or don't take the remedy) to this threat. Qe1 and Qe2 in the US were both accompanied by much hand wringing and doomsaying (for example), but the logic of the fear never made sense to me.
  - Godel_unicode 9y ago
    The Fed has used both lack of employment growth and lack of wage growth multiple times to explain holding off on raising rates.
    - ergothus 9y ago
zimbatm 9y ago
Is it still common to get 12% return on the market? My layman impression is that with ETFs, ~6% is the current average return.
- spacehome 9y ago
  I think the more commonly cited number is 7% as an inflation-adjusted total return.
- adamt 9y ago
  It’s not been hard to get more than those returns in recent history. The Nasdaq-100 total returns have been 32% last year and 155% over the past five years. This is a average of just over 20% a year. Source: https://www.nasdaq.com/markets/indices/nasdaq-total-returns.aspx https://www.nasdaq.com/markets/indices/nasdaq-total-returns....
  - gdubs 9y ago
    I imagine if you looked at the 5 years leading up to 2000, the nasdaq would have some astronomical annualized returns. However, it’s too specific an index and too narrow a time range to draw any meaningful conclusions about the kind of total market returns an investor can expect over the next several decades.
- gdubs 9y ago
  Important to remember that they’re averaging over a decade to get that annual return figure. I still hear 10% thrown around as a rough estimate (if you believe anyone is capable of making such a prediction) — though Jack Boggle has been cautioning that we should expect much lower returns over the next twenty years (more like 3-4%).
  - mancerayder 9y ago
    But if that's true, isn't that just keeping, just barely, with inflationary predictions? Especially given the new tax bill increases the deficit wildly, which will lead to a bond glut / money printing exercise? If so, what's the market going to do, if not reallocate capital from the stock market to a less risky asset?
zaroth 9y ago
Inflation is one of the primary justifications for a lower capital gains rate, because getting taxed on inflation is quite the slap in the face.
- vslira 9y ago
  While I agree that being taxed on inflation is unfair, it would not be that hard to discount inflation when assessing taxes. Surely a tax system could accommodate that.
  - matte_black 9y ago
    But the fact is, it doesn’t and that’s the world we live in. We need to lower capital gains taxes sometime in these next few years.
    - randomdata 9y ago
      The fact also remains that the world we live in doesn’t have a lower capital gains tax rate. If we’re going to propose tax changes for the future, all proposals are as good as any other.
      - skybrian 9y ago
        I didn't know what part of the world you mean, but in the US the capital gains rate maxes out at 20% for people earning over $425,000 a year and that's pretty darn low. The question to ask is why capital gains tax should be lower than taxes on wages? If encouraging work is the priority, it should be the other way round.
        hanklazard 9y ago
        Not exactly. Long-term capital gains in the US max out at 20%. Short-term capital gains (those investments held < 1 yr) are taxed at your marginal tax rate, which can be significantly higher than 20%. https://www.nerdwallet.com/blog/taxes/capital-gains-tax-rates/ https://www.nerdwallet.com/blog/taxes/capital-gains-tax-rate...
ikeboy 9y ago
>Virtually every corporate treasurer in America would recoil at the idea of issuing a “cost-of-living” bond — a noncallable obligation with coupons tied to a price index. But through the private pension system, corporate America has in fact taken on a fantastic amount of debt that is the equivalent of such a bond. https://www.treasurydirect.gov/indiv/products/prod_tips_glance.htm https://www.treasurydirect.gov/indiv/products/prod_tips_glan... So do any companies use tips to fund their pension obligations?
- misnamed 9y ago
  I assume so these days, but TIPS didn't exist when this article was written. And probably not exclusively TIPS in any case (but perhaps combined with equities, etc.).
csdreamer7 9y ago
The main takeaway for me is that is Buffett encourages investors to invest in companies that reinvest all earnings in resource saving capital investments. He argues that is the proper way to increase standards of living, and not with distributions of earnings to investors or redistribution to the government in printing money. That is, stocks that don't pay dividends, and require the government to have a balanced budget. My argument against this, and is one he has made in later years, is the greed of modern management discourages investors from long term investments in a company. Specifically, outrageous salaries for subpar results, golden parachutes, or acquisitions of questionable value. Wells Fargo's management either lied or was not doing their job, and yet their CEO was paid compensation of $20 million in 2014 (did a quick google search for a figure). Meyer's spent Yahoo's money on acquisitions that people she knew owned, enriching many friends in her network. I really don't feel like subsidizing a connected person's cash grab. Dividend stocks are a way to get some control over management that tries to pocket the earnings for themselves. Investors flee a stock that even looks like it could cut it's dividend which avoids some of the wasteful acquisitions and compensation (management is forced to buy in as an investor to get the dividends). If the stock goes down you can reinvest the dividends. If it goes up you can sell the stock and reinvest in one that has a better yield.
- pjc50 9y ago
  "Looting" of companies by their management is starting to look like an increasing problem. Usually in failing companies, but one day it will turn a success into a conspicuous failure. UK examples: Jaguar Land Rover, BHS, Carillion.
  - csdreamer7 9y ago
    > "Looting" of companies by their management is starting to look like an increasing problem. I think it's been a problem since the 80's. When I look at management pay issues and corporate raiding that was the era Buffett began talking about it if I remember correctly. Futurama even made fun of it indirectly in an episode.
    - 9y ago
deleted 9y ago
[deleted]

121 points by mudil 9y ago

From Buffet’s explanation, it doesn’t sound like it’s inflation in and of itself that swindles the equity investor, but rising or falling inflation. I.e. if inflation were constant, the market would easily adjust, but when it rises or falls slowly over decades, investors are bound to make decisions that will turn out to be wrong in the future. It seems to me that exactly the same is the case for interest rates: no rate is “right”, but falling or rising rates will force market participants to make wrong decisions: * In a rising interest rate environment, all bond purchases will prove unwise, since the investor could have earned a higher rate by waiting a bit longer. * In a falling interest rate environment, all bond selling (issuance) will prove unwise, because the issuer could have paid a lower rate by waiting a bit longer.

blue1 9y ago
Isn't really unexpected change that cause investors to make wrong decisions? Expected change should be already incorporated into prices.
dantheman 9y ago
Real interest rates - those set by banks based on demand for money, and not set by central banks are a price signal. What we have now is straight market manipulation which causes problems. Interest rates should be a signal about consumption vs investment.
- YPCrumble 9y ago
  Does a "real interest rate" per your definition actually exist? Googling the term returns an inflation-adjusted interest rate. In theory if we didn't have central banks this might be possible. However, central banks "print" money to adjust short-term interest rates that are a lever for influencing demand for money. It seems unlikely that it is possible to decouple supply from demand in the real world.
  - Consultant32452 9y ago
    In this case I think "real" interest rate means a rate derived in the free market, rather than at the whim of central planners (fed).
    - YPCrumble 9y ago
      My point is that the notion of a "real" interest rate as defined doesn't exist. The idea of a currency that cannot be manipulated is a chimera. Here are two reasons: 1. Currencies are created by some government or government-equivalent (e.g., maintainers of bitcoin/bitcoin fork), and these governors set the supply of currency. Sometimes they use interest rates, sometimes they just print more currency, sometimes they set a schedule for mining digital currency, it doesn't matter. However, the "free market" is inherently manipulated by the "owner" or "creator" of the currency. 2. If you consider a "commodity-currency" like gold or diamonds (or probably bitcoins) whose supply is not determined by a central authority, these commodity-currencies can also be manipulated. In fact, without the check of a government, capitalism works in such a way that these commodities become centralized into a few large holders who are incentivized to manipulate the currency. This is why governments like to get off of the gold standard, so they can manipulate their currency without interference from other governments.
  - nine_k 9y ago
    > Does a "real interest rate" per your definition actually exist? Googling the term returns an inflation-adjusted interest rate. > In theory if we didn't have central banks this might be possible. However, central banks "print" money to adjust short-term interest rates that are a lever for influencing demand for money. It seems unlikely that it is possible to decouple supply from demand in the real world. With gold standard, central banks could not directly print money. It was abandoned by the US about 40 years ago, and by Europe, even earlier (because world wars).
    - YPCrumble 9y ago
      The gold standard gets abandoned because countries want to manipulate their currency independently of the impact of other countries' currency manipulation. This is sometimes because they want to pay for costly wars via currency manipulation, but that's not the only reason.
- wbl 9y ago
  What problems has the fed caused since the 1980's? Prices are stable, employment is good.
  - tomrod 9y ago
    Prices are not stable, but increasing at 3 to 4% per year. Employment is okay, but more than a 10th of the population is in their working years but not working.
    - Godel_unicode 9y ago
      Since '81 it's actually exactly 3% per year, and since '90 it's 2.36% per year. The variance is around 1%, I'd call that pretty stable.
      - tomrod 9y ago
        Fair point, and also depends on which measure you're looking at. https://fred.stlouisfed.org/graph/?g=iFuv https://fred.stlouisfed.org/graph/?g=iFuv
    - exHFguy2 9y ago
      Predictable increases == stable. "but more than a 10th of the population is in their working years but not working." Fed has very limited set of things they control. They don't do fiscal or policy.
  - dxhdr 9y ago
    > What problems has the fed caused since the 1980's? Prices are stable, employment is good. Which prices have been stable since the 1980s?
    - exHFguy2 9y ago
      Prices, in US Dollars, have more or less been stable. Some have risen a lot (e.g., medical, education). Some have gone down a lot (e.g., clothing). Overall though....stable-ish. Some of this the fed controls, some of this they don't. They are not all powerful. For example, the share oil revolution has done a lot to reduce prices. Has nothing to do the the fed. China coming online as manufacturing powerhouse has also reduced prices. Again, fed has nothing to do with that.
- JumpCrisscross 9y ago
  Real interest rates are a monetary measure, to be contrasted with nominal interest rates [1]. I believe you are referring to the rate of interest absent a central bank. [1] https://www.imf.org/en/Publications/WP/Issues/2016/12/30/The-Determinants-of-U-S-994 https://www.imf.org/en/Publications/WP/Issues/2016/12/30/The...
  - dantheman 9y ago
    correct - I used the wrong term.
OscarCunningham 9y ago
One could equally say that its bad for someone whenever a stock price moves. I think it's okay for interest rates to vary, that's just the normal reponse of the market to changing conditions. It's not contraversial that inflation should be steady. That's literally the point of a central bank.
simo7 9y ago
Actually according to Buffet even _constant_ inflation can be very bad if the business is capital intensive with high fixed-costs. See my point here: https://news.ycombinator.com/item?id=16458373 https://news.ycombinator.com/item?id=16458373
dheelus 9y ago
Bear in mind that most bonds are callable so the seller really has little choice in a falling rate environment.
exHFguy2 9y ago
"* In a rising interest rate environment, all bond purchases will prove unwise, since the investor could have earned a higher rate by waiting a bit longer. * In a falling interest rate environment, all bond selling (issuance) will prove unwise, because the issuer could have paid a lower rate by waiting a bit longer." Not quite. Bond prices incorporate future expectations of real rates and inflation rates and then also associated risk premiums. Thus, a bond purchase will lose money only if realized rates come in higher than what is already discounted. That is, it is possible for short term rates to rise, and yet a bond increases in value (i.e., because the ST rates came in lower than what was already assumed in the bond).
- runeks 9y ago
  > Bond prices incorporate future expectations of real rates and inflation rates and then also associated risk premiums. Thus, a bond purchase will lose money only if realized rates come in higher than what is already discounted. Isn’t the fact that bond interest rates falling for the past ~35 years — on a 5-year average — then a testament to the market being unable to predict future interest and inflation rates? If the market were able to correctly predict future interest and inflation rates, the rate of interest wouldn’t change. So, as far as I can see, the fact that it has been dropping, on average, for the past three decades seems to indicate that the market fails at this prediction under our current monetary system. Or, perhaps a better question: if the rate of inflation were to slowly increase by one percentage point per year, for the next 30 years, what would be the right real rate of interest right now — assuming we knew this were going to happen? In other words: how do you discount a rate that’s slowly but steadily changing (even if it’s in a known direction)? With regards to short term rates, I should have explicitly written “the long/bond rate of interest” since the two indeed are fairly independent.
  - tensor_rank_0 9y ago
    > if the rate of inflation were to slowly increase by one percentage point per year, for the next 30 years, what would be the right real rate of interest right now — assuming we knew this were going to happen? the rate would increase exponentially according to the number of days between the present and the maturity date. the rate for securities that could be redeemed on demand would steadily increase, but represent the lowest rate (because you would always have the option to decide to claim your money). whereas a 30 year cd would have the highest rate in the market.

pjc50 9y ago

A very different time when equity returns were 12% and inflation was in the 5-10% region.

outside1234 9y ago
we are probably on the verge of at least the inflation part of this - there is no way we are going to be able to do $1T deficits for long.
- pjc50 9y ago
  Why not? Not just snark, that's a key question. 30-year yields are currently at just over 3%.
  - adventured 9y ago
    $30 trillion * 3% = saying goodbye to Social Security, Medicare or the entire US military, pick one. That's assuming the market complies with 3% rates. And that the dollar doesn't do a nose dive (as it did when Bush & Co. went wild with spending), debasing the US standard of living, setting off a nasty chain reaction of consequences. Who is going to buy $1 trillion of new US debt every year? Sooner rather than later, nobody. That's nearly equivalent to the sum that Japan and China are each holding. There's nobody left on earth that can absorb another $10 trillion in US debt in the next ten years, while continuing to maintain the existing $21 trillion pile. What will happen, is perpetual QE, debt monetization. The Federal Reserve fiscal death spiral begins and they have to forcibly maintain hyper low rates forever. Already the $15 trillion those clowns have added to our national debt over just ~16 years, is going to steal the money we need annually for infrastructure spending. The interest cost on $15 trillion at just 2% is enough to not only rebuild all US infrastructure over ten years, it'd build us bullet trains out the wazoo. All because they couldn't maintain basic fiscal discipline after 9/11. Or, alternatively, taxes have to go up a lot. The US has spare taxing capacity that most developed nations do not, however the rich are likely to be inclined to absorbing inflation rather than seeing their taxes go up a lot, they'll fight that. They can adjust assets, to a reasonable degree, to respond to inflation. After Japan's savings rate hit near zero, and the people of Japan could no longer finance their government's reckless spending, they had to turn to Yen debasement to manage their debt interest problems (attempt to inflate the problem away by destroying the currency), the consequences of that are extremely ugly over time unless you slash spending, growing a lot faster, or massively raise taxes (or a combination). Today their debt interest cost is over 1/3 of tax revenue. At those levels, you stop being able to maintain things you need to maintain, and the debt robs you of being able to make large investments for the future. That's where the US is heading over the next 10 or 15 years, and it already can't afford to deal with its existing spending needs.

simo7 9y ago

There is an important aspect which is not well remarked in the article: high fixed-costs businesses are the ones that really suffer inflation. If every time you want to expand you need to make significant investments (and there will always be a delay before it starts making money), inflation will affect your costs way before it will affect your revenue. Even worse, because fixed assets need to be replaced due to obsolescence every once in a while, you'll end up increasing your costs way more than you're increasing your revenue just to maintain the current production level. TL;DR: The more the delay between investment and revenue generation and the more capital intensive it is, the worst.

tomjohnneill 9y ago
Depends how you fund the investments. If you fund them by taking on more debt, then higher inflation is a benefit - it reduces the value of your debt compared to your product.
- simo7 9y ago
  In a context of _constant_ high inflation that's not true: the interest rates will already be discounting the future inflation. You have a positive gain of that type in case inflation grows more than expected. Enough to offset the negative impact given by the delay costs-revenue? Probably not in most cases. In fact the positive effect applies to debt made in the past which precisely because of inflation is likely to be lower than the new debt you need to take on (on which the negative effect applies). Of course also the opposite could happen: inflation grows less than expected after you took on a lot of debt. So for a capital intensive business it'd just be better to operate in a context of constant low inflation.
  - BenoitEssiambre 9y ago
    Economists usually say that with constant predictable inflation money is "neutral" meaning that the interest rates adjust to offset any higher cost so that businesses shouldn't be affected by inflation (except for a bit of "menu cost", that is the overhead cost of having to update price lists more often. Low inflation has huge potential downsides in that fiat money can't have negative nominal return while it is quite normal for private investment returns to go negative sometimes (thermodynamics says that things, including stores of value, tend to degrade with time unless you put work and energy into them). This is the famous zero lower bound problem. It means that when private market rates go negative, people transfer their savings to cash, the world switches from producing real stuff and building real businesses to people hoarding intrinsically worthless pieces of paper (pieces of paper that might not be able to buy that much in the future because production will have gone down. On top of this, if you keep interest rates above market rates and inflation too low for a long enough time, that is if you keep rates high at 0% when they should be at -3%, market pressure will build for an uncontrolled inflation rebound when all the cash hoarded on the sidelines start flowing in an economy with lowered production. It is much easier to keep inflation stable if you keep it high enough so that the investment market can always clear and never hits the zero lower bound.

CPLX 9y ago

He certainly has a fair point. The problem, however, these days, is the way a monetary policy hyper-focused on eliminating inflation swindles the wage-earner.

ergothus 9y ago
I'm by no means well-educated on finance. However, it seems like inflation has been the boogeyman of every major policy decision in the US for the decades I've been watching. So far, the dire predictions haven't come true, but we've faced growing wage inequality for 30 years. I've read that the Fed has a dual mission - keep inflation/deflation in check and unemployment at healthy levels, but I only ever hear their concern for inflation risks. As a result I tend to discount concerns over inflation, assuming that the major problem will be the issue we aren't addressing...is my reaction reasonable?
- sidibe 9y ago
  All central banks have been focused on the other issue since 2008. No one has been very worried about inflation until very recently.
  - ergothus 9y ago
    Banks, perhaps. Everyone else (conservative pundits, fiscal pundits) seem to be declaring imminent crippling inflation on a regular basis, yet it never seems to happen, even when the banks/govt take the action (or don't take the remedy) to this threat. Qe1 and Qe2 in the US were both accompanied by much hand wringing and doomsaying (for example), but the logic of the fear never made sense to me.
- Godel_unicode 9y ago
  The Fed has used both lack of employment growth and lack of wage growth multiple times to explain holding off on raising rates.
  - ergothus 9y ago

zimbatm 9y ago

Is it still common to get 12% return on the market? My layman impression is that with ETFs, ~6% is the current average return.

spacehome 9y ago
I think the more commonly cited number is 7% as an inflation-adjusted total return.
adamt 9y ago
It’s not been hard to get more than those returns in recent history. The Nasdaq-100 total returns have been 32% last year and 155% over the past five years. This is a average of just over 20% a year. Source: https://www.nasdaq.com/markets/indices/nasdaq-total-returns.aspx https://www.nasdaq.com/markets/indices/nasdaq-total-returns....
- gdubs 9y ago
  I imagine if you looked at the 5 years leading up to 2000, the nasdaq would have some astronomical annualized returns. However, it’s too specific an index and too narrow a time range to draw any meaningful conclusions about the kind of total market returns an investor can expect over the next several decades.
gdubs 9y ago
Important to remember that they’re averaging over a decade to get that annual return figure. I still hear 10% thrown around as a rough estimate (if you believe anyone is capable of making such a prediction) — though Jack Boggle has been cautioning that we should expect much lower returns over the next twenty years (more like 3-4%).
- mancerayder 9y ago
  But if that's true, isn't that just keeping, just barely, with inflationary predictions? Especially given the new tax bill increases the deficit wildly, which will lead to a bond glut / money printing exercise? If so, what's the market going to do, if not reallocate capital from the stock market to a less risky asset?

zaroth 9y ago

Inflation is one of the primary justifications for a lower capital gains rate, because getting taxed on inflation is quite the slap in the face.

vslira 9y ago
While I agree that being taxed on inflation is unfair, it would not be that hard to discount inflation when assessing taxes. Surely a tax system could accommodate that.
- matte_black 9y ago
  But the fact is, it doesn’t and that’s the world we live in. We need to lower capital gains taxes sometime in these next few years.
  - randomdata 9y ago
    The fact also remains that the world we live in doesn’t have a lower capital gains tax rate. If we’re going to propose tax changes for the future, all proposals are as good as any other.
    - skybrian 9y ago
      I didn't know what part of the world you mean, but in the US the capital gains rate maxes out at 20% for people earning over $425,000 a year and that's pretty darn low. The question to ask is why capital gains tax should be lower than taxes on wages? If encouraging work is the priority, it should be the other way round.
      - hanklazard 9y ago
        Not exactly. Long-term capital gains in the US max out at 20%. Short-term capital gains (those investments held < 1 yr) are taxed at your marginal tax rate, which can be significantly higher than 20%. https://www.nerdwallet.com/blog/taxes/capital-gains-tax-rates/ https://www.nerdwallet.com/blog/taxes/capital-gains-tax-rate...

ikeboy 9y ago

>Virtually every corporate treasurer in America would recoil at the idea of issuing a “cost-of-living” bond — a noncallable obligation with coupons tied to a price index. But through the private pension system, corporate America has in fact taken on a fantastic amount of debt that is the equivalent of such a bond. https://www.treasurydirect.gov/indiv/products/prod_tips_glance.htm https://www.treasurydirect.gov/indiv/products/prod_tips_glan... So do any companies use tips to fund their pension obligations?

misnamed 9y ago
I assume so these days, but TIPS didn't exist when this article was written. And probably not exclusively TIPS in any case (but perhaps combined with equities, etc.).

csdreamer7 9y ago

The main takeaway for me is that is Buffett encourages investors to invest in companies that reinvest all earnings in resource saving capital investments. He argues that is the proper way to increase standards of living, and not with distributions of earnings to investors or redistribution to the government in printing money. That is, stocks that don't pay dividends, and require the government to have a balanced budget. My argument against this, and is one he has made in later years, is the greed of modern management discourages investors from long term investments in a company. Specifically, outrageous salaries for subpar results, golden parachutes, or acquisitions of questionable value. Wells Fargo's management either lied or was not doing their job, and yet their CEO was paid compensation of $20 million in 2014 (did a quick google search for a figure). Meyer's spent Yahoo's money on acquisitions that people she knew owned, enriching many friends in her network. I really don't feel like subsidizing a connected person's cash grab. Dividend stocks are a way to get some control over management that tries to pocket the earnings for themselves. Investors flee a stock that even looks like it could cut it's dividend which avoids some of the wasteful acquisitions and compensation (management is forced to buy in as an investor to get the dividends). If the stock goes down you can reinvest the dividends. If it goes up you can sell the stock and reinvest in one that has a better yield.

pjc50 9y ago
"Looting" of companies by their management is starting to look like an increasing problem. Usually in failing companies, but one day it will turn a success into a conspicuous failure. UK examples: Jaguar Land Rover, BHS, Carillion.
- csdreamer7 9y ago
  > "Looting" of companies by their management is starting to look like an increasing problem. I think it's been a problem since the 80's. When I look at management pay issues and corporate raiding that was the era Buffett began talking about it if I remember correctly. Futurama even made fun of it indirectly in an episode.
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