Australia had a massive redistribution of wealth from savers to borrowers. As long as you didn't become insolvent the more debt you had invested the richer you got.
Borrow $100k as long as your salary kept going up so you could make the payments every year the amount you borrowed was worth less. Think salary goes from $20k to $50k over 5 years. $100k borrowed goes from 5 times salary to twice. Borrow, and invest in anything that isn't hit by inflation. In the 80s houses did that job.
Now if you had $100k in the bank (or government bonds or similar). 5 times salary saved just became 2 times salary saved. Ouch.
Unanticipated inflation is always a redistribution of wealth from lenders (savers) to borrowers.
Of course if you borrowed for a car or a holiday that's something different but you are still paying it off with devalued currency.
This is an interesting thought. I have mostly heard this advice for corporate. Companies are encouraged to take on as much leverage as they can without affecting their bottom line. But I never thought it can be applied to personal saving and market crashes too.
I had couple of questions - how do you calculate debt or leverage at personal level?
The savings example - wouldn't the savings increase as well?
Should you look to increase your leverage in times of high interest or a low one?
And lastly, how do you find assets which aren't hit by inflation?
> how do you calculate debt or leverage at personal level?
Can you make the payments? Chances of not making them next year etc. So much personally specific stuff in that there can be no rule of thumb. Is your job secure? Will your wages go up? How is your risk appetite? Why do you want more money - what do you want to spend it on, when, etc.
> wouldn't the savings increase as well?
You have $100k, you buy US Govt. Bonds with a 10 year term and an expectation of low inflation. Inflation rips (surprise!), your 100k buys a lot less stuff in 10 years time. The 5% coupon doesn't cushion that blow much. If the inflation is anticipated then you would have a very high yield on 10 year us govt bonds and there is no redistribution of wealth between borrowers and lenders. You get back a sum of money that buys a similar amount of stuff.
I've just described the simplest case with fixed coupon long term bonds, you can make it more complex with variable interest rate accounts or whatever and you'll see unanticipated inflation always is a redistribution to borrowers from lenders. "Pay off your loan with worthless currency." "Remember when you could get a beer for under $100?" Sounds ridiculous now, right? $10 beers used to be equally ridiculous.
>Should you look to increase your leverage in times of high interest or a low one?
No easy answer. Depends on your circumstances and preferences. If you do increase your leverage, can make the payments and your investment is an inflation hedge, unanticipated inflation is a win for you if that's what you want. There is additional risk involved, obviously. Putting money in the bank is almost certainly a losing proposition. In addition to the redistribution to borrowers the increased interest payments are taxed so you're going backwards. think 2% real interest 10% inflation for a bank interest rate of 12%. Well you're taxed on all %12. So some part of that 10% to compensate for inflation goes to the taxman and you're losing purchasing power of your capital.
> And lastly, how do you find assets which aren't hit by inflation?
Most assets are some kind of hedge against inflation. NOT bonds, obviously. But equities will likely be so, gold, real estate, antiques & jewellery. Think of an asset's price as a percentage of the average annual salary. If inflation rips will that percentage of salary change? Much? Why? With bonds the answer is yes and the reasons are pretty straight forward. With housing, rent is likely to be a fairly fixed percentage of salary, salaries double in nominal terms, rent will likely do the same. (But do consider what else is going on in an economy when inflation takes off, will the plant shut down making that place a slum? Likely it's more subtle than that). Buying an equity of a company that has sales, will their sale prices keep pace with inflation? You'd imagine McDonalds would, for example. Will their sales qty drop in an economy with high inflation is also worth considering and is a trickier question to get right. I'm partial to S&P500 index tracking funds, they're popular nowadays too. Obviously equities can crash in value over the short to medium term.
I don't think we will ever see 20% interest rates again because the level of debt here in Australia is so much higher now. If interest rates even get to 8% it will be like 1990.
EDIT: But I also recall that those times were when high flying business people like Alan Bond etc. were still getting banks to throw money at them even though interest rates were astronomical. A large part of the problem which probably lead to the eventual crash and burn of the economy...
Fixed rates are not free; you pay extra for the fixing. The longer the fixing, the more you pay.
It only makes sense to go fixed rate if you're very sure that the interest will climb over the next term. Not only that, that it will climb sufficiently enough to offset the cost of locking into the fixed rate so you still come out ahead. Once that term is up, you're no longer locked in; so you have to re-evaluate everything at the start of the next term.
(You don't have to do this upfront, either; variable rate mortgages have the option to switch to fixed for the remainder of the term.)
Anyway, people who go for fixed rate mortgages end up paying tens of thousands of dollars extra over the life of a mortgage, unless they are somehow able to game things in periods of rising interest.
When I was signing up for a mortgage, the financial institution offered to cover the lawyer's fees for all the paperwork, running into the hundreds of dollars. That offer was quickly rescinded when it became apparent that I'm declining the fixed term mortgage and opting for variable. That's obviously because the fixed term is good for them; that's why they incentivized it. When some aspect of a deal is good for you, it's never incentivized.
That's not true. I chose to pay an extra £30 a month on my mortgage because I'm not sure rates won't rise over 5 years, and I want to be confident of budgeting for the the next 5 years. I'm confident rates won't go down, but rates going up could affect me. Think of it as insurance. I don't take home insurance because I'm confident my house will burn down, I take it incase my house does burn down
Here's my (partial) heuristic. If you see adverts on TV for fixed rate mortgages, don't get one.
In the US, fixed rates are for a 30 year term. Countries like Canada and Australia have 10 year terms as a max, with most people electing for something shorter as the rate goes down.
No, you can get mortgages they are fixed for the life of the loan.
> Fixed rates are not free; you pay extra for the fixing.
You do typically start with a higher rate, but when we shopped for loans last, the variable rate loans all had a floor very near the initial rate and interest rates were at historic lows, so either the momentary extreme lows would last indefinitely or fixed rate would be cheaper over the life of the loan.
Further, if interest rates do drop, you can refinance a fixed rate loan down, minimizing the difference between it and a variable rate, even if the latter doesn't have a floor that prevents meaningful reductions, where variable would be best. OTOH, where fixed would be best (with rising rates), variable leaves you high and dry.
Also: variable mortgages can also convert to fixed. If the rate is sitting flat, you're better off variable, with the option to switch to fixed if it looks like it will climb, than vice versa.
The main downside of fixed loans is that you usually can't reduce your interest payments by making additional repayments (because ultimately they are backed by long-term bonds issued by the bank).
The "returns" were rarely above the inflation rate, plus you got to pay income tax on those illusory "returns".
Savvier people would shift their money into assets that kept or increased their value independent of inflation, such as equities and real estate.
Another way to look at it is inflation means the dollar is worth less, not other things that are not pegged to the dollar.
If I recall, people who were highly leveraged or had negatively geared property were hit the hardest. People with actual savings in the bank were actually happy with their interest returns being so high.
Household debt was not as bad back then as it is nowadays, so I don't expect it to go as well if we ever hit those levels again tomorrow.