Trimming Your Hedges

Why are so many people eager to swap their "valuable hard assets" for your "lousy paper money"?


If I say that the world economy is going up in flames, people invariably want to know whether they should invest in matches. Many even buy books on How to Prosper During Rotten Times. Obviously, we can't all prosper in bad times, or they wouldn't be bad. All such advice is necessarily based on the unlovely idea of profiting at someone else's expense, which can't work when everybody's trying it. With all these bestsellers telling millions of people to buy something cheap and sell it to someone else at a higher price, you have to wonder who will pay that higher price and where he'll get the money.

Even the time-honored practice of buying one another's houses at progressively more absurd prices begins to look a bit shaky in my suburb. The next round of eager buyers has forgotten to show up.

Somebody advertises some dried figs that he says will become infinitely valuable in the next Stone Age, while your Federal Reserve notes, he advises, will be used to light the wood stove. The question is, why are these fellows so eager to swap valuable figs for your lousy money?

The key to understanding the current situation is that this is a fully anticipated inflation; there is no hint of "money illusion." Although inflation is never enjoyable for long, it is no fun at all when it is widely expected. An unanticipated inflation can sometimes stimulate business for a while, because prices rise faster than wages, and debts can be repaid in shrunken dollars. In the topsy-turvy world of anticipated inflation, however, orthodox fiscal and monetary measures to "stimulate" the economy just make people expect more inflation. The resulting rush to borrow drives interest rates up; wage rates and commodity prices soar; and the dollar sinks.

Inflation when it is fully anticipated has effects very different from when it is widely underestimated. In an unanticipated inflation, wealth is transferred from creditors to debtors or, more precisely, to those whose monetary liabilities (such as mortgage debt) exceed their monetary assets (such as bonds or money). Unanticipated inflation in effect taxes people in proportion to their claims on some fixed amount of money, with the gains going to those (including the government) whose debts constitute that money. If prices somehow doubled unexpectedly, for example, homeowners would experience a doubling in the value of their homes with no rise in mortgage liabilities, while mortgage lenders would find the real value of their corresponding monetary assets cut in half.

A fully anticipated inflation, however, creates eager borrowers and reluctant savers, driving interest rates up enough to roughly compensate for the expected inflation. Businesses and individuals attempt to evade inflation by taking on monetary liabilities (debt) and switching from monetary to real assets (such as houses, commodities, and durable goods).

Instead of responding to increased inflation by reducing debt and increasing savings, as was typical in the past, consumers have been trying to beat inflation by vigorously accumulating houses, consumer durables, and an endless variety of tangible objects that are expected to increase in value more rapidly than the average rate of inflation. The process has been fed by large doses of money and credit, enabling people to buy now against expected future gains in income and wealth—gains that may not materialize. The high ratio of debt to income leaves consumers quite vulnerable to any slowdown in income or to any softening in the value of homes and other assets.

Conventional data fail to capture the full scope of consumer inventory accumulation, because much of it occurred in casual markets for scarce goods produced in the distant past. The "antiques and art" section of the classified ads of any newspaper conveys some flavor of what is going on. The extraordinary price increases for many of these things are another indication of where the dollars are flowing. In the past decade, such things as coins, stamps, old masters, and Chinese ceramics have risen at two or three times the average inflation rate.

Spending incomes on ancient objects is of little help to producers or merchants of new consumer goods, nor does it add to the nation's capacity for future production. For every buyer of an Oriental vase or rug, there is, of course, a seller taking his money, and perhaps the seller then buys a car or a corporate bond rather than another vase or rug. But the apparent net diversion of demand into scarce objects, for both consumption and investment purposes, nonetheless involves a relative redistribution of purchasing power toward uses not commonly thought of as productive. The shift of investments from financial to real assets also increases measured inflation, because the prices of financial assets are not included in our price indexes. If the prices of bonds fall and the prices of houses rise, conventional statistics only notice the increase.

Like any excessive accumulation of inventories, the excessive accumulation of consumer inventories is inherently unsustainable. Buying now to avoid future price increases implies buying less in the future. Buying things to hedge against inflation can only continue as long as others are willing and able to continue to bid the affected price up (the notorious search for a "greater fool"). A significant reversal of consumer inventory accumulation could come about because of financial constraints or disappointment regarding gains expected from the sale of houses, beer can collections, or whatever.

When people expect very high inflation, it requires interest rates well above the anticipated inflation rate to damp the demand for credit and slow the growth of money. The situation is compounded by the sharp erosion of liquidity in business and banking, which spurs the demand for lendable funds while limiting the supply.

With higher inflation, it takes larger increases of money and credit to finance the same amount of real activity. That is, inflation erodes the real purchasing power of people's money balances. Yet faster money growth would feed the spending that fuels more inflation, in a dangerous upward spiral. One conspicuous constraint on the process is the depreciation of the dollar in foreign exchange markets, which appears to inspire somewhat greater efforts toward monetary restraint than does the related shrinkage of the dollar in domestic markets. The Federal Reserve cannot continue to feed money to the inflation because foreign holders of dollars simply will not put up with it.

Whether instituted for domestic or international reasons, a sharp slowdown in the rate of growth of the money supply would soon produce a comparable slowdown in the growth of income and spending (nominal GNP). Because of long-term contracts and other rigidities, costs would continue to rise rapidly for a while, although softening markets would make it impossible to pass these costs along in higher prices. The resulting squeeze on profit margins would reverse the previously rapid growth of employment and labor income, thus undermining one source of the consumer boom.

All of the myriad threats of economic reversal are rooted in inflation and can scarcely be remedied by orthodox "stimulative" fiscal and monetary policies, which would simply aggravate inflationary expectations and the related excesses. Indeed, a credible, sustained shift toward fiscal and monetary restraint, although introducing temporary risks of its own, might well have some paradoxically beneficial effects through strengthening the dollar, bolstering stock prices and stockholder wealth, lowering inflation expectations and related costs (including long-term interest rates), and easing the financial strains of heavy Treasury borrowing.

There would, however, be some disappointed investors if we experienced a sharp slowdown in the growth of money and spending. Many homes and scarce objects have been purchased in the expectation of being eventually resold at a handsome profit. The expected increase in wealth had a powerful impact on consumption. People even borrowed against unrealized capital gains, taking second mortgages on the basis of paper gains in order to remodel houses or buy furniture. These wealth effects on consumption are strongly dependent on continued high inflation. A slowdown in total spending and reduction of inflationary pressures could be expected to unravel the whole process of consumer hedging and speculating. People would then become less willing or able to take on sufficient debt to support continued price increases, because their expected gains in family income and employment look less promising. That price resistance, in turn, would make existing owners of homes and other supposed hedges feel less wealthy, thus fostering further consumer retrenchment and rebuilding of liquidity.

It must be remembered that most hedges against inflation share the cyclical volatility of commodity prices in general, with prices falling sharply in recessions. And nothing will serve as a superior hedge against inflation if the present price currently discounts that prospect.

The housing market has already discounted an enormous amount of future inflation and incorporated that expectation into present prices (and interest rates). People have bid housing prices up by borrowing against expected future inflation of their nominal incomes, thus translating considerable future inflation into present housing prices. If some housing prices reflect more inflation and earnings growth than will actually occur (as is likely for at least the cyclical downturns), then the disappointment regarding expected wealth would tend to provoke consumer cutbacks. Housing prices did not keep up with general inflation in 1970 and 1974; that is, the real value of the housing stock fell. Gold prices in the last disinflation were cut in half.

It is generally understood that financial markets are efficient, in the sense that prices of financial assets at any moment accurately reflect the best available information about their future value. Unfortunately, the lesson is not often applied to markets for real assets, where many people are easily persuaded that current prices can remain perpetually too low (to reflect the asset's value as a hedge against inflation). But the demand for tangible assets has been strong for some time, so current prices of such assets already incorporate a lot of expected future inflation.

In a world of perfectly anticipated inflation, there could be no sure hedges against inflation, because current prices would already discount that prospect. Expected inflation increases the demand for "hedges" and drives up their price. The switch from financial to real assets weakens prices of the former and bids up prices of the latter. At some point in this process, financial assets have to become at least relatively more attractive than real assets, even as hedges against inflation. Real assets can't always be the better bargain, regardless of price. Speculation on continued rapid price increases has to get more risky the more the price has already risen (unless expected inflation goes higher and higher).

At the very moment you read this, the price of, say, gold and silver is neither too high nor too low. In the absence of shocks or surprises (and aside from some important complications concerning taxes), the prices of both real and financial assets should tend to rise at about the prevailing rate of interest. If expected future inflation goes up, there will be another upward revaluation of real assets and a downward price adjustment for stocks and bonds. If expected inflation goes down—just to a lower rate of increase—financial assets are apt to gain at the expense of tangible "hedges."

Skepticism about inflation may well be warranted, and that attitude has certainly paid off during most of the past decade. But periodic gestures toward slowing inflation do occur and can make long-term hedges a poor short-term investment. It is not enough to argue, while the hedge asset's price is falling, that the price is sure to go back up over a period of years. If the price (less dealer fees) does not rise as fast as the rate of interest, there is an opportunity cost involved in not selling the asset and investing in something else.

There is a time and place for everything, and this may not be the best time to be getting into hedges, regardless of past success.

Alan Reynolds is vice-president for economic research at a major US bank. His Viewpoint column appears in REASON every third month, and he frequently graces our pages with articles and book reviews.