SMSF Investment StrategiesSharing Simple Strategies for Self Managed Super Funds
Case for Inflation
There was widespread fear of inflation when we saw central banks all over the world increase the printing of their respective currencies in response to the liquidity crisis in 2007-08. With more money floating around, wouldn’t it be worth less? That’s what we normally see when there is excess supply of any commodity. As we use money to buy goods, using the same logic, with more money chasing the same amount of goods, wouldn’t the price of the goods go up i.e. cause inflation? This was my simple reasoning back in early 2008 so I wanted to own hard assets, preferably assets that were limited in quantity like gold, silver or crude oil. In June 2008, I invested 20% of our SMSF funds into gold and silver and I was horrified when the price of commodities fell hard from July to November 2008 while the increasing abundant US dollar shot up in value over the same period! It completely defied my logic and that was when I realised I needed to learn more about how money supply affects the price of goods.
The first thing I learned about money supply was there are many different types of money ranging from M0 to M3. M0 is good old cash which is printed by the central bank. However, when cash is deposited into banks, banks only need to hold a percentage (typically 10%) of that in bank reserves and it can loan out the rest. Based on this modern banking practice, every dollar of M0 can be multiplied into a much larger amount in credit which is part of M2 and M3. The multiplier is equal to 1/(reserve percentage) so a 10% reserve means we can have credit of up to 10 times the amount of cash available. Central banks can only control the creation of M0 but it is banks and other financial institutions that control the creation of M1, M2 and M3, all of which make up the total money supply that is available to us to buy goods. Printing more cash does not automatically increase the total money supply. If banks chose not to lend it out, the total money supply can actually decrease even when M0 is increased. That is why the printing of more currency notes does not automatically cause inflation. The topic of money supply is quite complex and I don’t claim to be an expert in this but at least now I have a better understanding of what our money supply comprise of and how it can affect the price of goods. For more information on money supply, check out ‘Money Supply’ in Wikipedia.
In our attempt to predict our future, we tend to look to our past to see what we can learn from similar events in history. Those who predict hyper-inflation or at least high inflation, look at cases like the Weimar Republic or Germany after WWI, Argentina in the 1980s, and present day in Zimbawe. All these countries have been ravaged by hyper inflation. It all starts with the government needing large sums of money, typically to fund wars (but it could be for bailouts and stimulus packages as well). They would borrow the money by issuing government bonds which is fine for a while until the debt becomes so big that fewer lenders are prepared to buy the bonds for fear of default, and those who do demand higher interest to cover their risk. The government has to keep printing more and more money to pay for its spending and to re-pay its debts and at some point the money becomes pretty much worthless. I wrote an earlier post on this called “How safe are government bonds?” When I look at the amounts of money that the US government plans to borrow, I worry about this happening to the US as well, as do other prominent investors like Warren Buffet who warned US investors about this in his article in the New York Times on August 18, 2009 called “The Greenback Effect“. When this happened in Zimbabwe, I was not really concerned as I don’t own any Zimbabwe currency. However, I have quite a bit of my capital in US dollars because I trade the US markets and I will not be the only non-US citizen who would get hurt if the US dollar gets devalued. As the world’s reserve currency, many countries hold a big chunk of their wealth in USD. All these people will not want the US dollar to become worthless so I believe, some how the value of the US dollar will be propped up for some time to come.
So how about Australia? Most of the discussions in the forums were based on what is happening in the US but if most of your wealth is in AUD, then what happens to the USD may not be of great concern to you. Our government debt is quite a manageable amount. Based on the currency on issue data from the RBA, the increase in currency from June 08 to June 09 is about 13.3% (from $39.8 to $45.1 billion) which about twice the increase in preceding years, but still not a really alarming figure compared to the increase in the monetary base in the US. I don’t think we have the same risk of our government cranking up the printing presses to monetize debt as the US. Our current inflation rate at June 2009 is 1.5% which is down from 4.5% a year ago. The inflation rate seems to be on a downtrend and has been falling for the past 3 quarters, so I think there is not much of a risk for widespread inflation in Australia in the near future.
As pointed out in the first article in this series, inflation (let’s call this price inflation) does not necessarily mean asset inflation as prices of some assets have gone down in periods of high price inflation. However, inflation caused by the devaluation of currency would probably cause an increase in the price of everything priced in that currency. If anyone still thinks that this is a risk, your investment bias should be to buy assets and to use leverage where possible. From my own research, I don’t think high inflation is a big risk in Australia and in fact I think deflation is a bigger risk, which I will discuss in the next post. This does not mean I will not buy any assets – I will still buy assets if I see good value for the asset but I will not buy assets simply out of fear of inflation like I did in June 2008. As a final note on buying assets, investors should be also be wary of foreign exchange when buying assets priced in another currency. A good example is gold. Headlines everywhere have been screaming that gold has hit new highs of over USD1000 per ounce but as Michael Pascoe correctly pointed out in his article “Gold Drops 25%” in the Business Age today, gold has actually gone down 25% in terms of AUD so an Australian investor in gold would have lost rather than made money!
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