Who Benefits From Inflation?

Several months ago, I wrote a post entitled “The Benefits Of Inflation” highlighting some of the advantages that moderate levels of inflation offers to modern society.  Among these advantages are allowing companies to push through price increases more easily, leading to higher profits, managing the unemployment rate by discretely lowering workers’ salaries when needed without them being aware of it (preventing lay-offs), and in general grease the wheels of capitalism.  Of course, it goes without saying that once inflation exceeds a reasonable limit, say 4-5%, the pitfalls begin to outweigh the benefits.

But Who Benefits From High Rates Of Inflation?

It is generally accepted in economic circles that moderate rates of inflation in the 2-4% range are actually good for the economy for the reasons mentioned above.  But what happens when inflation rates increase significantly above this “safe rate”, as is likely in the U.S. over the next decade?  When inflation hits 7-12% as many are expecting, who benefits?

• The Government - The most obvious beneficiary of higher inflation, at least in the short term, is the government.  Since they control the printing presses, the government will always be able to pay its debt, at least domestically since higher inflation effectively reduces the long-term cost of borrowing money.
• Borrowers - Anyone borrowing money for a long term for a fixed rate (such as a mortgage) benefits from inflation because, again, it effectively reduces the cost of future interest payments.  That $2000 per month mortgage payment may seem like a lot today, but 20 years from now it will be worth a lot less.  Your income will have risen to keep up with the constantly-increasing cost of living while your fixed-rate debt will have remained constant.
• Owners Of Real Assets - Owners of real physical assets such as real estate, gold, timber, farm land, mines, etc tend to do very well during inflationary periods since the price of these assets (and the commodities they produce in the case of mines and farm and timber land) tends to rise along with inflation.

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Who Loses From Inflation?

More people lose from high inflation than win, including…

• Consumers – Rapidly-escalating costs make things difficult for consumers.  How do you put food on the table when the cost of the table and the food is constantly increasing?
• Businesses – By far the best risk-management tool businesses have is meticulous planning.  But inflation makes it nearly impossible to predict how much things like office space, raw material, and labor costs will be in the future.  Thus, inflation will tend to choke off investment.
• The Economy – As a result of the pain businesses and consumers feel during inflationary periods, the economy as a whole is sure to take a hit.  If consumers cut back on spending and businesses cut back on investment, GDP will plummet and people will lose their jobs.  The only cure in this scenario is to raise interest rates through the roof a la Volker in the early 1980’s.  Yes, 15% mortgages would be painful but that is the best shot at avoiding permanent damage.

The take-away from all this is that you should devote a portion of your portfolio (perhaps as little as 10-20%) to commodities, preferably through a diversified, low-cost mutual fund such as the Permanent Portfolio.  There are two reasons I don’t recommend a larger allocation:

1. Commodities don’t produce income, so you’ve got to pay to store it.  This makes large-scale commodity-ownership outside of mutual funds nearly impossible for most small investors.
2. The Permanent Portfolio (PRPFX), while well-diversified and effective, carries a relatively high expense ratio of 1.11% as do most other commodity-focused funds.