The Capital Trilemma

by Atash Hagmahani | March 10, 2008

�Behold but One in all things; it is the second that leads you astray� Kabir

Was Kabir a Hindu or a Muslim?

Some people are posing the same kind of bifurcation regarding whether they should put their money into inflation hedges or cash and cash equivalents. I think they will be in trouble either way.

The word �stagflation� is an amalgamation of stagnation and inflation. Stagnation refers to an economy that isn't growing, but more likely this is a euphemism for an economy that is actually shrinking, since there is nothing to keep it in equilibrium. Inflation refers to a growing money supply. The empirical fact that the economy could shrink while the money supply is growing implies that creating new money does not make us richer. On the contrary, it makes us poorer because much of it ends up financing all sorts of ways to squander capital uselessly, and in general it tends to favor current consumption over future production. This isn't news to the kinds of people who are likely to be reading this, but a certain sort of mindset rejects it as being antithetical to its own schemes, and then is shocked when the economy continues its downward spiral despite attempts to �stimulate� it with new money.

Investing is not really a zero sum game in that the �pot� of potential winnings expands and shrinks. In a shrinking economy, investors are competing for as much as they can get out of a shrinking pot. In other words, all other factors being the same, you should probably set your expectations for return on investment to be lower than they had been in an expanding economy. This would seem obvious, but I keep reading a lot of questions from people who seem to be assuming, or at least hoping, that the current situation will be a profitable one. Before dreaming of riches, their first task should be taking steps to avoid losses.

More losers than winners

I suppose that every crisis is an opportunity, but in a stagflation it's hard to be one of the winners if one's place in life is too far from the spigots of monetary creation (as mine is, alas).

Here is a formula for calculating your percentage return on investments�including real estate or money in the bank�after taxes and inflation:

( (1 + return*(1 � tax-rate)) / (1 + inflation-rate) ) � 1) * 100

It's a little hard to read due to lack of fancy typesetting and a key. An example will clarify how to use the formula. First, lets figure out some numbers to plug in. Let's try to keep it �reasonable� but not necessarily realistic.

5%: typically quoted �conservative� rate of return.
15%: my rate for long-term capital gains. Due to sunset after 2010.
4.1%: what the US government claims the inflation rate is (do you believe it?)

Convert the percentages to decimals (just shift the decimal point two places to the left), then plug the numbers into the formula:

((1 + .05*(1 - .15)) / (1 + .041) � 1) * 100 = .144% (rounded to 3 places)

Not much, eh? The problem is in the numerator of the quotient; we're taxed on our pre-inflation return, as if inflation were not itself a tax and we're being taxed on a tax!

Some might complain that my hypothetical return on investment is too low; they would claim something like �US blue-chip stocks have consistently yielded 9% year on year over the long term�. Actually, yields are neither that high nor are they consistent. These kinds of claims are accurate insofar as they are accurate at all, by being selective about which years they consider. They ignore the Great Depression completely (claiming it as an aberration�sort of the same way that politicians keep real expenses off-budget for being �extraordinary�, despite there always being one extraordinary expense or another), and creatively account for the stealth bear market of the late 1960s through early 1980s. In any case, the �western� economies are now �mature� and not growing much if at all; the last stock market bull was speculation fueled by a credit expansion, and more to the point it is over.

A balanced portfolio would consist of stocks and bonds. 30 year treasury notes are yielding 4.36% as of this writing. That seems rather low for 30 year bonds considering as much inflation as the US government actually admits to. The average yield of the Dow Jones Industrial average as of this writing is 2.80%. Higher effective rates of return would have to come from capital gains that are unreasonable to expect in a shrinking economy.

I don't discount the value of stock-picking. On the contrary, my own rules for investment include filtering out all companies that don't have any real products, don't have any profits, look like they might be cooking the books, sell inherently harmful products, or are known to use slave labor (return on Karma being as important to me as return on investment, may Iqbal Masih rest in peace). Unfortunately for stock-pickers, the majority of stocks tend to follow the trend of the larger market; stock-picking is worthwhile but unlikely to save the day in bear market.

It seems reasonable to expect that the risk-to-reward ratio will tend to increase from now into the foreseeable future, as a result of debt soaring relative to productivity.

Now consider a few what-if scenarios, such as what if inflation is actually higher than government statistics admit to, or what if regardless of where it is now, it rises faster than yields. What if US Congress allows low current long-term capital gains tax rates to expire? What if volatility forces investors to either take short-term capital gains at higher rates, or lose their unrealized profits? What if we account for the whole combined impact of federal, state, and local taxes?

I tried a number of scenarios that I thought were realistic, consciously avoiding anything I thought looked like it might be a �doomsday scenario�. I kept coming up with negative numbers.

Stealth bear

During the whole decade of the 1970s, and actually a few years previous and a few years later, the stock market barely budged overall. It went up and down a number of times but the rallies kept fizzling out. After accounting for inflation, the tiny gain in nominal terms was a huge loss in real spending power. This type of situation is called a �stealth bear market�. Remember that expression, because the na�ve are surprised by bears that sneak up on them from behind.

Inflation hedges compromised

�L'argent papier finit toujours par retourner � sa valeur intrins�que, c'est a dire z�ro.�
(�Paper money always ends up returning to its intrinsic value; that is, zero.�) Voltaire

Let's take the case of gold as being representative of inflation hedges in general. Over long periods of time, the value of gold is fairly stable, at least, relative to the value of fiat currencies. I've often heard that one ounce of gold buys a man's tailored suit in London. Now, gold did recently run up in value faster than the rate of inflation, but that's because it hadn't moved much except to go down for a long time, while inflation was going up. In other words, it was just a game of �catch-up�.

Gold is not an �investment�. Investment implies money at risk in the marketplace. If one has bought real, physical gold, and has it in storage somewhere, that is not �investment� any more than burying a jar of pennies in the backyard. Like the pennies, our gold isn't going to multiply. What will multiply are the units of currency that will bid on the gold.

There are legitimate reasons that one might bury one's pennies in the backyard�or for that matter to hoard gold. Pulling money out of the system is a bid of no-confidence in the system. It means that no investment opportunity available to you is worth risking your capital. If there were an honest gold standard in place, then one could become rich simply by promptly pulling one's capital out of the economy whenever the risk-to-reward ratio got too far out of line�in other words during bubbles�and then re-investing after the deflationary collapse. Instead of the gold-cum-money soaring in nominal value, it has retained the same nominal value, but prices have fallen. On paper there is no taxable profit, but buying power increased. This is why gold standards are essentially out-of-the-question; there are implicit rules in place regarding who is allowed to become rich.

Beware the tax collector

It is an observable phenomenon that governments tend to spend at least as much money as they collect in taxes.

In the USA in 2011, the following federal taxes are set to rise:

Top wage tax to return to 39.6% after having been temporarily lowered to 35%. Rising inflation will push wage earners into higher tax-brackets generally.
Long-term capital gains to return to at least 20% from the temporary 15%. Presidential candidate Barack Obama is on record for advocating 24% taxation on long-term capital gains.
Tax rates on �qualified dividends� will return to up to at least 35% from the temporary reduction to 15%.
Inheritance tax will skyrocket. This is complicated to explain, so bear with me. First off it's worth noting in passing that it lapses in 2010! Thereafter the amount exempted from taxation plunges from $2 million to $1 million. That might still seem generous, but it is not for several reasons: money you've given away before you die gets counted as part of the exemption; inflation is pushing the nominal values of all our estates higher (tax-collectors love inflation); and the rates on inheritance tax are very high. The purpose of inheritance tax is to prevent upstarts�that is, those not connected to the financial establishment�from accumulating capital over multiple generations.

None of the presidential front-runners had a history of opposing higher taxes, although McCain claims to favor the tax-cuts that will be sunsetted in 2011 precisely because he opposed them while not running for president. In any case it does not seem to matter as all of them have a list of agenda items that sound expensive. The only candidate who is on record for consistently voting �no� to more government and higher taxes with which to pay for it all�hence his nickname �Dr. No��is Dr. Ron Paul, who is losing due to a taboo on favorable publicity for him in the media.

The political establishment seems to be firmly in favor of more government and higher taxes.

What about the state and local level? I perceive even more trouble there, because unlike the federal government, the states and local governments can't just go to the Federal Reserve and have it buy up their debt (I suppose legally they could, but that would turn into a free-for-all and a panic, and is therefor unlikely to happen).

Most of the states and municipalities are already in trouble. That's probably why their debt has been failing to sell at auction. Without going into all the details regarding why they are in trouble, here are some strategies I have noticed the states and municipalities using to increase their tax receipts:

increasing real estate taxes. My own have doubled, despite the fact that I'm not twice as rich nor do I have twice as much income to pay them. The problem with real estate is that it is far too conspicuous a form of wealth not to be a favorite target for predatory taxation.
�Use taxes� such as tolls on roadways and bridges. These taxes will result in at least triple taxation since gasoline and automobiles are already taxed ostensibly for the same purpose of maintaining the roads and bridges.
Higher taxes on public utilities. You will pay them rather than have your water shut off or your property condemned. They would not necessarily be based on usage, but might be per-capita, so you won't be able to avoid them by sitting in the dark, not bathing, and drinking only bottled water.
More different types of taxes. States that have sales tax but no income tax will get income tax. States that have no sales tax will get it. The argument will be something like �sales taxes (say) place an unfair burden on the poor. Let's have an income tax to relieve the burden on the poor�. Once they get it, the local politicians will have another tax to distribute the total burden around on, fixating on the fact that no single tax bears the full brunt of the increase and being rather obtuse to the plain fact that the only thing that matters is the total tax burden. It will be the political class that benefits, and not God's poor, who not only will have a higher tax burden themselves, but their wage-earning opportunities will be compromised by the collapse of business from its own tax burden.

The municipalities will also increasingly fund their expenses using bonds, so that either the taxpayer or the bondholder is stiffed, but the spending spigots remain wide open.

High returns will be offset by losses from great risk and high tax rates.
Investments in inflation hedges to escape high inflation will be snared by high taxation; nominal gains against the falling fiat currency will be taxed as if gains. The result will be a net loss.
Attempts to reduce taxable transactions through �buy and hold� strategies will tend to result from net losses from a shrinking economy. By the same token frequent asset allocation to take advantage of arbitrage opportunities will generate large numbers of taxable transactions; the break-even window will be narrow.

Strategic implications:

It will take some effort and planning simply to minimize losses from inflation and a declining economy. Focus on protecting what you have (�preservation of capital�) before scheming to make windfall profits in the crisis.
An asset allocation scheme whereby the assets are chosen to hedge against inflation, debt repudiation, and a declining economy will take some advantage of the perturbations in these trends. Re-balancing on intervals of one-year-and-one-day allows the advantages of lower long-term capital gain rates and reduces the costs and risks of frequent trading. While far from optimal, the more important consideration is that it is simple enough for average investors. Carried out faithfully, it will result in superior performance (I have a bad feeling this will mean �smaller losses�) to that of average small investors. This is a friendly observation for the benefit of those who can benefit from it, and is not investment advice.
Since in this allocation scheme you are only re-balancing, the small amounts of gold or other hedges that you might be buying and selling should not keep you up at night worrying about them.
Avoid taxes. It is a sad state of affairs that I must point out that this is perfectly legal, and is not the same thing as �tax evasion�. Tax avoidance refers to figuring out ways to rack up the least amount of tax due while accomplishing your objectives. Let's give a simple example that is subtle enough that many people don't even think about it: suppose that you are playing miniature golf with your friends somewhere in King County, Washington. You bend over to fetch the ball and your trousers split. If instead of heading to Southcenter to buy another pair, you stitch them back together, carefully reinforcing the seam this time, you have not only deferred the cost of the new trousers but have also deferred the 8.8% sales tax rate. It could be argued that in an inflationary environment it makes more sense to buy things earlier rather than later. Ah, but in that case you'd have to buy the new trousers but not wear them until the old ones are beyond repair; but since you have already wisely invested some of your money in inflation hedges, don't trouble yourself.
With apologies to restaurant owners: if you cook for yourself you avoid restaurant tax, which stands at 9.1% where I live (and don't forget tips). Car-rental tax in my part of the world is somewhere around 30%. In general, avoid high-tax items.
I can only lead by example: I am giving away all my money before I die. I started when my children were born so that returns on investment�including false profits from inflation�accumulate as much as possible after the gift has been given. I continue over time to take maximum advantage of annual gift tax exclusions; these are counted in my estate for calculation of estate tax but there won't be any estate left to tax. My children understand that they are responsible for taking care of their parents when we are old. I am not concerned about the possibility of abandonment (for one thing, we are already an extended family), and if it happens, I accept it as my well-deserved punishment for not having raised them properly.
I can think of a lot more ways of avoiding taxes than the examples given, but alas explaining them through a public medium means alerting the tax-collectors as well. Obviously the best strategies deserve the most protection. One more, though, that is not a secret:
I can not emphasize enough the need for income diversification. You diversify your income for the same reasons that you diversify your assets: to reduce risk. By they way, non-wage income is generally taxed at lower rates than wage income, or as they say, �the rich always give themselves a safety net�.
At the risk of looking like a Y2K dupe (having been in the software biz I always thought Y2K was a hoax), you might consider storing and rotating emergency food reserves (mostly dry-goods like beans, rice, and flour, such as are cheap and easy to store) and if possible growing some of your own�being careful to keep these ventures cost-effective. The point of this is that it doesn't take much to survive; it is the dysfunctional urge to self-actualization (to use Maslow's term)�the need to feel important�that motivates people to destroy themselves pursuing whatever is supposed to be on the other side of the rainbow.

A man saw a ball of gold in the sky;
He climbed for it,
And eventually he achieved it --
It was clay.

Now this is the strange part:
When the man went to the earth
And looked again,
Lo, there was the ball of gold.
Now this is the strange part:
It was a ball of gold.
Aye, by the heavens, it was a ball of gold.

A man saw a ball of gold in the sky, Steven Maria Crane

There's nothing there. If you ever achieve Bodhi, you could be happy chopping cabbage to prepare your children's supper.

Financial information and observations cited in this editorial do not constitute financial advice. Make your own financial decisions after consulting with appropriate professionals.

Atash is the editor of MutuallyAssuredSurvival.com, where you can find ideas for surviving petroleum depletion, globalization, economic starvation, and other hazards of the 21st century.

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