They're Never Gonna Pay it Back

Markus Muhs - Sep 24, 2020
Government debt, inflation, and retirement planning are a dangerous mix.
government broke
The difference between having a very well-funded retirement plan, or not nearly enough, can often come down to a single percentage point difference in the rate of inflation.
Inflation is truly the worst. In retirement planning—where we’re planning for an income need 20, 30, 50 years into the future—it’s the single most impactful input to the overall plan and means the difference between a plan being very well funded, or going completely off the rails. 
With the exception of the past thirty years, inflation is every bit as unpredictable as the stock markets.
Imagine you determine that you need $5000 a month for your retirement lifestyle needs over 30 years. If there were no inflation, you’d simply plan to have $1.8 million by retirement in a savings account (which would likely be interest-free), if your plan were to draw down the principal. OR, if you could find an investment that pays a steady 3%, and wanted to bequeath the principal to your heirs, a $2 million nest egg would do the trick. Retirement planning would be so easy, I’d be out of a job.
Back in July, after our former Finance Minister delivered his fiscal update, including a $343 billion deficit estimate (probably larger by now), I tried my hand at a twitter thread, which you can read in its entirety here.  
The chorus from fiscal conservatives on Twitter regarding the massive deficit was an alarm over how this debt will ever get paid back, “think of the children who will have to pay this back!” It’s a question I get from clients too on this subject; just how will all the debt ever get paid back? 
We haven’t seen or noticed that much inflation for the past couple of decades. In fact, since the Bank of Canada started to pay closer attention they’ve been pretty successful at maintaining inflation within a 1-3% band, averaging a little less than 2% over that time period. You can get the below graph, and more, directly from here.
Of course, the deep and quick recession we’re currently in (and hopefully exiting) is putting a damper on inflation for the time being. Despite the mountains of cash being “printed” and all the debt-financed CERB payments going out, Canadian consumers are spending less and saving more, so we’re not seeing much inflation yet.
What happens though when the economy starts firing on all cylinders again?
The federal and provincial governments are contributing significantly to Canadian GDP through their debt-fueled spending binge. They’re doing this for good reason; the most important component of GDP—consumer spending—is way down and needs to be replaced somehow lest we face an economic depression. $340 billion of new debt is an extra $340 billion flowing into the economy. Today it replaces the spending deficit, but tomorrow it'll still be in the aggregate economy in some form.
You can see what the effect of Canada’s fiscal (government spending) and monetary (what the BoC does) policies have had on the actual monetary supply here.
I extended the timeline on the above to the previous crisis to help put things in perspective with the last time they did this. You can find the raw data here
Notable is that M1+ supply (actual currency outside banks and checking account balances as described on that page) has already gone considerably higher than during the last crisis. We remember the BoC and U.S. Fed doing numerous rounds of Quantitative Easing (QE) the last time around and so much “money being printed”, but what’s notable this time around is that, due to extreme fiscal policy like CERB in Canada and equivalent U.S. programs, a lot more money is actually ending up in people’s bank accounts (as opposed to bailing out Wall Street, I suppose), where it can be readily spent by consumers.
The BoC website has an amazing plethora of historical stats and charts, but the one thing I couldn’t find for Canada was our savings rate. I did find a good resource for the U.S. on the St. Louis Fed’s website (also a tremendous resource for econ geeks). We see U.S. personal savings rates soaring to an all-time high of over 33% in April (almost double the previous record from 1975) and even as I write this, the July number of almost 18% is higher than we’ve seen since they started tracking this.
Prior to the financial crisis, the U.S. savings rate was at a record low of 2.2%, in July of 2005. The historical average seems to be in the high single-digit range, and indeed the 7-8% range the U.S. was at pre-pandemic was reasonably healthy.
Remember that one of the main things that led up to the 2008 financial crisis was the American consumer’s extreme reliance on debt; they got over-extended. If we ever get to that point again, with savings rates in the low single-digits, I’ll again be afraid for future economic prospects. While relatively high savings rates have been a bit of an impediment to economic growth post-financial crisis, they are a good set up for the U.S. consumer, giving them future capacity to spend. In other words, they’re not stretched thin and the risk for another crisis like in 2008 is lower.
The 33% savings rate was obviously a short-lived anomaly that we see coming down just as rapidly as it went up, but it still belies the fact there is now a lot of future spending capacity in the system, visible both in terms of high savings rates and general money supplies. All of this bodes well for the economy, in general, coming out of the pandemic (whenever that may be), but getting back to the problem at hand: inflation.

The debt-laden governments of the world will not repay their debt.

They cannot repay their debt. 

It will get inflated away, over time.

Emphasis on “over time” because inflation is a slow and silent killer of wealth. We don’t see it happening in real-time; it just becomes apparent over the long-term.
My financial planning software, NaviPlan, has done a concise little write-up on inflation that I often include with my financial plans. 
If your plan is to spend $60K a year in retirement, and you’re retiring in ten years, by the time you reach your 20th year of retirement, in 30 years, your annual costs will be $110K. And that’s under normal inflation, based on the past three decades (2%). If we used a longer term historical average of 3% (based on Naviplan’s 2.95% average of the 100 years from 1918 to 2017), it’ll be $145K.
Elevated inflation averaged around 4% during the post-war period (during which all the debts built up during WW2 were inflated away). That rate would put your annual expense needs in the above example to almost $200K (!!!).
Obviously that can throw a real wrench into any retirement plan. 20 years after you left the workforce, where would you come up with all that extra cheddar?
Obviously, for governments, inflation can be a big win. The debt they’re racking up in 2020 is denominated in 2020 dollars and carries next to no interest (for now). In 50 years that debt will be pretty inconsequential in 2070 dollars. If we assumed 3% inflation for those 50 years, $1 trillion in 2070 would be the equivalent of $228 billion today. 
Do you think it’s more likely that our government will pay off $770 billion worth of debt over the next 50 years (that’s $15 billion a year, more than the largest surpluses the federal government ever ran), or that it’ll just get inflated away?
The losers on the other side of the coin are the actual holders of debt investments, and of course cash. It baffles my mind how much money these days, within pensions and from private individuals, is invested in debt that pays next to nothing and is due to become worth less and less as time goes on. On top of that, whenever the markets go into panic mode even more money flows into debt. 
Debt is the investment that really scares the bejeezus out of me when governments are spending and central banks are easing like there’s no tomorrow!
By extension, any money you have “invested” in securities that are denominated in depreciating “dollars” is at risk. That is cash in your savings account, GICs, bonds. I can’t predict exactly what will happen inflation-wise, whether it will hit this decade or next, but eventually one of two things has to happen:
  • Inflation devalues your money and government laughs all the way to the bank as they continue to borrow more money because their “debt to GDP” ratio goes down as nominal GDP rises.
  • Government gets crushed by a mountain of debt and declares bankruptcy.
Hint: the second one won’t happen as long as a country can “print” its own currency.
If we’re planning for the long term, there is nothing riskier than owning bonds, GICs, cash.
For a short term goal, of course keep that money in cash or some other kind of liquid securities that don’t fluctuate in value. The downside of 3% annual inflation on money saved for a 2 year goal is around 6ish% of your purchasing power, which isn’t even a bad year on the stock markets.
For longer term goals though you absolutely have to own some kind of “hard assets” that have a way of protecting your purchasing power. 
That can be land or real estate that presumably is just as much in demand in the future as it is now and/or can generate a rental income in the future in the form of a greater number of future devalued dollars.
My favorite way to protect my purchasing power over the long term is—you guessed it—share ownership in the great companies of the world that provide the goods and services that we need.
So long as we assume that capitalism continues to flourish and make our every day lives better, as it has for the past few centuries, and that publicly traded companies exist to sell us the goods and services we need—for higher numbers of depreciated dollars in the future—our wealth can be inflation-protected by owning their shares.
So, bottom line, the answer to the question:
  • Governments will NOT repay the debt, EVER 
  • ”Safe” securities, like cash, GICs, bonds are the LAST thing you want to own for the long-term, given the above expectation
  • You have to invest the money that you don’t spend today into something that will be at least as valuable in the future as it is today.
Inflation is effectively a wealth tax.

Markus Muhs / CFP, CIM


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