Personal Finance for Inflationary Times - Chapter 2: Capital and Interest

Chapter 2: Capital and Interest

Capital explained

Capital includes both “productive” assets that help to produce either more capital or consumer goods, and money that can be used to purchase “productive” goods. In order for the asset or cash to be considered capital, it must earn enough of a return to “pay back” the owners (entrepreneurs and businessmen) and form a self-sustaining activity. To the extent that an activity does not earn a self-sustaining profit, it is consumptive in nature, rather than productive. Thus, an automobile in the hands of a profit-making traveling salesman is capital, while a student’s car used to go out for lunch is not. Cash, too, can be capital or not, depending on what it is used to purchase—a productive asset or a consumer good—and who is using it. Thus, by definition, capital increases productivity and, ultimately, standards of living. If it doesn’t, it’s not capital. Because most people consider higher living standards to be good, they look for ways to increase the capital invested in the tools of their trade or business and, consequently, their productivity.

“Capital” in the hands of governments

Because government activities are not profit making and self-sustaining in nature, but rather rely on taxation year after year, the otherwise “productive” assets used by governments are, by definition, being consumed, and therefore cannot be called “capital.” In short, government, by its very nature, consumes capital that otherwise would be used productively by businesses and entrepreneurs. Through taxes, money is diverted from productive uses into consumptive uses. Whether we consider roads/bridges, military spending, welfare distributions, or public education, in the hands of government, these are consumptive ventures. They either give away the funds (welfare), consume the funds directly (military), build things that deteriorate until new tax funds are spent for upgrades (roads/bridges), or forcibly educate without any expectation of profit and therefore no good way to measure its effectiveness. It is government’s lack of ability to calculate a return on its spending that distinguishes it from profit-seeking businesses and entrepreneurs. (To better understand the difference between profit-seeking management and bureaucratic management, click here.) To the extent that government priorities overshadow market priorities, there is a misallocation of scarce resources into capital-consuming projects. Many things governments do would benefit society much more if they were performed by profit-seeking individuals who economize while performing the same tasks that governments perform wastefully.

Capital consumption

During inflationary times, this consumption (some people are nice and call it a misallocation) of scarce resources becomes especially noticeable in a number of ways: 1. governments tax more to compensate for the reduced purchasing power of their money, thus reducing the availability of capital and increasing the possibility of recession; 2. if there is a shortfall in tax revenues, governments (and government-guaranteed companies *) can borrow money at a lower interest rate than can private companies because governments usually have better credit ratings (they have the force of law behind them to obtain their revenues), leaving a shortage of capital for businesses, depressing business, and potentially causing a recession; 3. they might print ever larger sums of money with which to purchase what they want, without raising taxes and/or borrowing, thus cheapening the value of the money; 4. governments that create their own money get to spend it first on the projects they prefer—government decisions gain in importance and governments get top value for the money they just created when they spend it; 5. there is an increase in the volume of currencies traded, and gold and silver purchases—smart people try to get out of the inflating currency and into something that will hold its value better (hard assets or a sounder currency); 6. the savings rate drops; 7. hoarding and goods shortages increase; 8. as price rises accelerate, more people become speculators looking to profit from the next bubble—whether it is in stocks, real estate, or commodities; 9. the appeal of gambling to “hit it big” grows; 10. law suits aimed at huge settlements from “deep pockets” proliferates; 11. foreign travel slows as it becomes more expensive, foreigners from a country with a sounder money visit to buy “cheap” goods; 12. as prices rise more rapidly, it becomes more difficult for businesses to calculate their costs (because they are using a changing measuring stick), raise their prices or income commensurate with the inflation rate, keep taxes in line (because “progressive” tax rates rise as incomes rise and aren’t adequately adjusted for inflation), and save and invest in things that keep their value, all while trying to have a life. In short, standards of living decline.

Keeping up with inflation

If we consider this same phenomenon from a businessperson’s perspective, we see that commodity prices rise during inflationary times. At first, when prices rise slowly, businesspeople think they are earning greater profits, but later, when it comes time to replace capital and inventory, businesses with a slower inventory turnover and/or capital goods replacement rate often find that they are unable to replace their capital goods and/or inventory at the new higher prices. They may not have increased their prices enough to keep pace with capital goods/inventory cost increases. Many small businesses fail because they are unable to compete with more highly capitalized firms for inventory items and/or new capital goods. They can’t buy in large enough quantities to buy at a reasonable unit price—enough on which to earn a profit.

There is a consolidation in capital-intensive industries, or they leave for more stable environs. The number of mergers and acquisitions increases in an attempt to consolidate capital and remain competitive world-wide. Cross-border mergers and acquisitions increase as well, as a means of diversifying operations into countries with different markets, currencies and hopefully different inflation rates. Forum shopping for countries with lower tax rates also becomes more popular as inflation pushes taxpayers into higher tax brackets.

Think of what has happened to the price of automobiles during the last five years. Fewer people can afford to pay cash for a new car. More people must borrow funds (or buy used) to purchase replacement capital and pay it off in the future. Many business-people, instead of replacing their inventory and capital goods, liquidate their remaining capital goods, sell their inventory and go to work for someone else. The same thing happens to big companies, who lay off thousands of workers and move factories to countries where the costs of production are lower and hopefully where there is a more stable currency.

Alternately, businesspeople borrow more to purchase their inventory/capital goods. They pay this money back with future earnings; i.e., they mortgage their futures. Unfortunately, there is a limit to one’s future earning power and therefore one’s borrowing capacity. At some point, he/she may not be able to service any more debt and may have to call it quits.

Banks have more money to lend

Something else that happens during inflationary times is that banks receive more deposits, which, in turn, they must lend out to earn more money. (To learn more about how the U.S. banking system works, click here.) The pressure grows for banks to lend money. Some banks may take on additional risks by lending to sub-prime borrowers. As things become really hectic, banks may even cut corners in their loan approval process, encourage fraudulent applications, and lend to people who are unlikely to service those loans in the long run. Banks also tend to lend money for shorter periods of time and/or at adjustable rates, to reduce the length of time they are locked in to a rate that may be below the inflation rate.

Competition for Capital

As capital becomes more mobile through improved technological innovations, world-wide competition for capital grows. It becomes easier for capital to go where it can earn its highest return. Ofttimes this is in underdeveloped areas of the world. Consider China and India, for example. China has been the destination for new capital investment for many years. In turn, this has increased China’s productivity and income. India, too, is becoming a more popular destination for capital investment. What determines where capital goes? Two factors: 1. Real return on capital and 2. Safety.

During inflationary times, a real return on capital becomes more difficult to calculate because one must compensate for the inflation in addition to earning a competitive return. Thus, capital often seeks out inflationary hedges found in the form of natural resources; i.e., hard assets. Recently, this has presented a dilemma in that many of the countries with rich natural resources are politically unstable and/or government intensive. The question becomes, how does one extract the natural resources (requiring capital investment) in a place where capital investment is otherwise unsafe? The short answer is, you don’t.

As long as capital investment is safe, and has a high likelihood of providing a good return, capital will flow there. If a country is inclined to nationalize foreign assets, like Venezuela, Cuba, or Bolivia might, or back out of long-term agreements through new legal entanglements like Russia does, they are riskier and may have more difficulty attracting capital. If a country encourages costly lawsuits and/or high taxes, this too may chase capital away. In short, a lack of respect for property rights scares capital away, while a system that protects property rights attracts it. One’s right to be paid back in money of equal value is included in the notion of property-right protection.

U.S. Dollar as Reserve Currency

In recent years, the U.S. dollar has been the world’s reserve currency. This means that many countries have invested their surplus funds in U.S. government T-Bonds, T-Notes, and T-Bills, instead of in gold or silver. They hold those instruments as a reserve or liquid saving pool. These instruments, of course, are denominated in U.S. dollars, and the interest is paid in dollars. Thus, these countries’ investments fluctuate with the U.S. dollar. Their fate is tied to the dollar. Some countries even use the U.S. dollar instead of issuing their own currency— Panama, Ecuador, and El Salvador, for example.

Also, many commodity prices are denominated in U.S. dollars: oil, natural gas, gold, silver, and platinum, to name a few. This requires much of the world to have dollars to buy these commodities, and the sellers receive dollars.

Because of the U.S. dollar’s importance as a reserve currency and the currency of choice for many of the world’s commodity markets, U.S. dollar inflation can be felt world wide. The other side of the same coin is that the U.S. Federal Reserve Bank (Fed) has a large market, a world-wide market, for its dollars. This allows it to print more money before the effects of inflation are felt in the United States, and as long as non-U.S. entities accept U.S. dollars (and use them in their business dealings), the Fed will be able to inflate the U.S. dollar, thus reducing its value as a reserve currency and/or a store of value.

Interest explained

Interest is comprised of three components:

1. Time value of money or the originary rate. Anyone who chooses to invest his/her money to receive interest payments is forgoing current consumption for later gratification. Money spent now provides instant gratification; the buyer knows exactly what he is getting for the value of his money. Saved money presents the element of uncertainty. The future is hard to predict when it comes to finances, and the value of one’s money tomorrow might be radically different from today. In addition, what might be available to be purchased today may not be available tomorrow. In short, the originary rate is the ratio of currently desired goods relative to future-desired goods, or the rate of interest that must be paid to induce someone to forgo the use of his/her money today (become a saver). Under free market conditions, the originary rate has traditionally been around 2-3% per year.

2. Debtor's risk premium. Debtor's risk premium is the portion of interest paid by the debtor due to the possibility that the principal and interest payments might not be readily forthcoming when due. In other words, what are the chances of the debtor’s being unwilling or unable to repay the principal and/or make the interest payments? What if the debtor dies or declares bankruptcy? Economic crises in the past have destroyed thousands of seemingly secure banks. Today, record numbers of individuals are declaring bankruptcy, and 96% of all businesses started in the U.S. fail in their first five years. Debtor's risk premium is an important component of interest and is determined on a case-by-case basis.

3. Inflation premium, the third component of interest results when there is inflation; i.e., when enough new money is created (or anticipated to be created) to reduce the price of the currency (relative to goods prices) during the term of the loan. The borrower must be charged enough interest to compensate for the loss the lender will incur because he will receive cheaper dollars when the debt is repaid.

Everyone understands these components, whether they call them the same thing or not. They may not have analyzed the matter in such detail, but they intuitively consider each component before they lend any money or purchase an interest-bearing instrument. Consider how inflation could affect the lending of money to a friend, a bank (through the purchase of a Certificate of Deposit or by depositing money into a savings account), a corporation (by buying a corporate bond), the U.S. government (by buying a Treasury Bond, Note, Bill, etc.), a foreign government (by buying one of its bonds), or someone who wants you to take back a mortgage when you sell them a property.

Lending Considerations

When lending money to a friend or a property purchaser, the terms of the loan are generally negotiable between the parties. During inflationary times, there are several things to think about:

1. Are you lending to someone with a productive or consumptive reason for borrowing the funds?

A productive loan is a loan used to purchase a productive asset; i.e., one that will produce an income with which to pay off the loan. This type of loan is more likely to produce an income, thus increasing the chances of being repaid. If the loan is for the purchase of a consumptive asset, then the borrower’s repayment ability depends on his/her earning ability, not on the return on the asset. This may be less secure because one’s earning ability can disappear suddenly.

2. Do you have adequate collateral underlying the loan?

“Adequate” collateral means that, if the borrower doesn’t make his/her payments, you will be able to take the underlying collateral, sell it, and thus pay off the loan. On the other hand, “adequate” cash flow is more important because it can be very costly to go through the process of obtaining a judgment against a debtor and collecting against the collateral. It’s much better to have the borrower service the debt on an on-going basis without having to liquidate the collateral.

Of course, non-mobile assets make the best collateral, while fixtures (more difficult to remove assets) and mobile assets are less preferable types of collateral. Stocks and other financial instruments are also acceptable under many circumstances; however, securing the assets may be tricky and their values may vary considerably.

3. Will the collateral go up or down in value?

The nature of the collateral may also be important. During inflationary times, tangible assets generally go up in value (although there can be deflationary periods and bubbles within a long-term inflationary trend). Also, what is the life expectancy of the collateral? Is it longer than the life of the loan?

4. Will the interest rate you receive adjust with the rate of inflation?

If you lock in the size of the payments you receive, you will be receiving cheaper and cheaper money as the loan is repaid. Your purchasing power will diminish over time. This is not desirable. It is better to have payments go up as inflation goes up. Perhaps payments could be tied to some sort of index. While banks often use a short-term interest rate, you might consider tying your loan’s interest rate to a commodity index instead.

5. A shorter-term loan is better than a longer-term loan because the longer the term, the more time there is for the currency to depreciate. Furthermore, in the long run, if the inflation leads to hyper-inflation, it becomes impossible to protect oneself from the loss of purchasing power by simply tying loan payments to an index. Under such circumstances, a loan requiring payment in a more stable currency, gold, or silver may be preferable. Of course, then the question becomes, how likely is it that the borrower will be able to repay you in that other medium?

When lending money to the bank, a corporation, the U.S. or any government, the terms of the loan/bond offering are usually set by the borrower and therefore are not subject to negotiation. The only question left is, “Take it or leave it?” If you don’t have a better place to put your money, then lending it for a shorter duration is better (until you can find a better long-term investment).

Of course, you also need to consider how sound (secure) the borrower is. Many people believe that a sovereign can not default on its obligations, but look at what happened in Argentina in 2001. For information about which countries are risky debtors and to learn more about international debt collection, see East-West Debt, TCM Group, and ABC/Amega Inc.

Borrowing Considerations

When borrowing money during inflationary times, there are several things to think about:

1. Is the loan for productive or consumptive purposes?

A productive loan is a loan used to purchase a productive asset; i.e., one that will produce an income with which to pay off the loan. This is really the only type of asset for which one should borrow funds. Even so, productive assets need to be managed and are not always able to produce enough income to cover the costs of debt service. All consumptive assets should be paid with cash from savings or current earnings.

2. Do you have adequate collateral underlying the loan?

Lenders not only want to see “adequate” capital (so they can liquidate the capital and use the proceeds to retire the loan), but they also want to see an “adequate” cash flow, so the loan can be serviced on an on-going basis without having to liquidate the collateral. Of course, lenders prefer non-mobile assets, while fixtures (more difficult to remove assets) and mobile assets are less preferable types of collateral. Stocks and other financial instruments may also be acceptable under many circumstances.

3. Will the collateral go up or down in value?

During inflationary times, the collateral prices usually go up; however, bubbles can occur, driving prices in one industry higher than others. Of course, bubbles can burst, driving prices down more quickly than they rose. Depending on the point at which you seek a loan, the value of your collateral may be expected to rise or fall. This could have a bearing on whether you receive the loan and/or whether you must provide more collateral to obtain the loan. Bankers generally like to lend money to people who don’t need the money. Can you look as though you don’t need it?

4. Will the interest rate you pay adjust with the rate of inflation?

Fixed-rate loans stay at the same interest rate throughout the life of the loan, regardless of the inflation rate, and this is best for borrowers. On the other hand, once it becomes obvious to lenders that there will be inflation, fixed-rate loans generally carry a higher interest rate than the initial period on similar variable-rate loans. Thus, in the short run, variable rate loans may actually be cheaper (lower monthly payments); however, in the long run, the interest rate on variable-rate loans generally rises above the rates for fixed-rate loans (offered at the same starting time), making the payments higher. Be sure there is a cap on the allowable lifetime increase for the interest rate on an adjustable rate loan; i.e., the interest rate can’t rise more than X% above the initial rate during the life of the loan. Furthermore, it may be possible to make a pre-payment of principal (assuming your lender recalculates the payment amount based on a lower principal amount, the higher interest rate, and the original maturity date), and thus maintain or lower your monthly payments when your loan comes up for a rate adjustment.

5. A longer term fixed-rate loan is often better than a shorter-term loan because the longer the term, the more time there is for the currency to depreciate and for your income to rise, allowing you to pay the loan off more easily. Obviously, the interest rate can make the difference between a good short-term and a good long-term loan.

6. When borrowing money from a bank or the U.S. or any government (student loans), the terms of the loan are usually set by the lender and therefore not subject to negotiation. The only question left is, “Take it or leave it?”

If you don’t like the offers made to you by conventional lenders, you may want to approach unconventional lenders; i.e., family members, the seller of the property, wealthy individuals, retired people with a large savings account and minimal living expenses, or your network of friends and business associates. This requires a little imagination, determination, and know-how, not to mention negotiation skills.

Conclusion

A relatively stable currency is needed to accumulate capital. Without a stable currency, capital goes elsewhere—in search of a stable currency. The more capital a country/company can attract, the more productive its citizens/employees will be. The more productive people are, the higher their standards of living and the happier they are.

As inflation is introduced into an economy, interest rates adjust to compensate for the added risk of non-repayment or for re-payment of loans with money of a lesser value.

* See page 12 of Berkshire Hathaway's annual letter to shareholders, starting after the 12 asterisks in the middle of the page. It's Warren Buffett's thoughts about competing with government guaranteed companies and the interest rates they pay. Even Warren Buffett is feeling the consequences of competing against government. Just think about the rest of the non-guaranteed non-AAA rated businesses out there!