Investment

One of the most difficult investment disciplines to master is to learn from one’s experience but not to over-learn. It is human nature to give greater weight to those things one has experienced and less to the experience of previous generations. Inflation is one of the most fundamental of investment concepts. Its effects are extremely pervasive and hard to avoid. Yet chronic inflation is a very modern phenomenon. For most of British history, periods of falling prices are as common as those of rising ones. One reliable estimate puts prices at the beginning of the first world war as little changed from Samuel Pepys’s day. Nor was this confined to the prices of goods and services. The Moyse’s Hall museum in Bury St Edmunds has the deeds of a Suffolk farmhouse which was sold in 1924 at the depths of the postwar agricultural depression for the same price as it had fetched in 1647. As readers of 19th-century novels know well, it was not inflation but debt defaults and the associated bank failures which were the biggest threats to savings of previous generations. One such failure is a plot device in Elizabeth Gaskell’s Cranford.

Although the first world war resulted in a large rise in prices due to shortages, prices fell back after the war ended. This was in line with experience and Britain avoided the hyper-inflation that afflicted many countries in the interwar period. It has been since the second world war that inflation has emerged as the saver’s great enemy—and the borrower’s dearest friend. The high inflation of the 1970s was ruinous to the savings of the older generation and a boon to the younger generation who had borrowed to buy homes. Given the opposition to inherited wealth by the government of the day this was more than a little ironic. The ability to borrow in order to acquire a real asset and to then pay back the loan in depreciated currency created the conditions for one of the biggest tax-free generational transfers of wealth in history.

It’s easy to see how inflation crept up on a generation of investors who had been conditioned by a long period of falling as well as rising prices and how the exceptional circumstances of the destruction of industrial capacity by the war were seen as temporarily prolonging a period of high prices. The story is also an object lesson in not uncritically applying the lessons of one’s own experience however hard learnt.

For investors, of course, the issue is not just the inflation rate but the rate of return on investment. There is a common misperception that savers were willing to accept an interest rate below the rate of inflation, a so-called “negative real interest rate.” What really happened was that they persistently underestimated the future inflation rate. By the early 1980s the lesson had been comprehensively over-learned. Long-term government bonds in Britain yielded over 16 per cent and something similar in the US. Inflation rates were peaking and these instruments, popularly known at the time as “certificates of confiscation” due to their parlous performance over the previous decade were to prove outstanding investments. In October, the US celebrated 30 years of government bonds outperforming equities. Germany and Japan had already recorded their 50th anniversary.

Britain has just experienced what is by the standards of the last 20 years quite an inflationary episode. It left investors with few places to hide. Interest rates did not rise to compensate and house prices and stocks have fallen rather than risen. Inflation-linked government bonds and index-linked National Savings certificates, neither of which typically feature in the “best advice” supposedly provided to investors, have both provided protection and something on top. Longer dated index-linked gilts have been excellent investments but now offer little more than protection against the ravages of inflation. It may not sound much but there are many periods in which breaking even is a good result. One of the investors I respect most once told me sagely that one is more likely to repeat the mistakes of one’s grandparents than one’s parents—that would make deflation and debt default the greater risk. There again he is now convinced that the endgame of the current debt imbroglio is high inflation.

Global inflation is peaking and will fall sharply next year as the world economy slows and commodity prices come down. In Britain’s case the fall will also reflect the change in VAT rates which will mean it is even more marked. For the first time in several years the Bank of England’s forecast is likely to be met. The bigger issues remain, however. The tremendous build-up of debt in the economy and the prospect of only moderate economic growth at best will pit creditors’ demands to be repaid against debtors’ desire to maintain their lifestyles. Widespread debt defaults, whether inflationary ones or deflationary ones, are very likely (Equitable Life was a very 19th-century failure). The cyclical ups and downs of raw material prices shouldn’t be allowed to distract attention from the bigger question—inflation or bad debts?