Inflation, Money and Investment

Inflation, Money and Investment

Inflation is on the agenda for some developing countries and the whole world these days. I wanted to write my first post on inflation since if you live under persistently high inflation for a long time, like in Turkey, you should understand inflation’s adverse effects on savings and investment. So what causes high inflation? When we look at economics books, they say that inflation may increase due to supply-side and demand-side shocks. For instance, as a supply shock, the price of crude oil jumped from $50 a barrel to $200 in a short time. For sure, transportation costs will rise sharply soon. Then the cost increase will spill over to all goods and services.

Inflation and populism

Why don’t these shocks in the USA or European countries lead to systematic hyperinflation as in Venezuela? There may be different factors. In my opinion, the main reason is institutional setup and political choice. The trade-off between high economic growth and low inflation means politicians prefer high growth. If there is no growth, voters will not be happy. If the electorate is unhappy, the current Government may lose the first election, and the reign ends. It is the ‘survival’ problem for a politician. You have a problem if a country’s institutional setup cannot adequately limit the political leadership’s power. Unfortunately, this is the case for many countries in developing parts of the globe.

The high economic growth in an economy that has started to suffer from the disease of high inflation can not be sustainable in the long run. High inflation will decrease consumers’ purchasing power, eventually leading to aggregate demand decline. In addition, income distribution will deteriorate quickly at the expense of payroll captives. The country plunges headlong into the vortex of poverty. But how can politicians keep their political base under those conditions? Just check this: populism. Besides, they try to explain high inflation to their electoral base with conspiracy theories or blame others. Unbelievably, there are many buyers of these fairy tales. Populism is widespread among current and old political elites in Turkey. It was like that in the ’90s. That’s how it is now.

For those looking to save and invest, this background requires some questions to be answered. How do I deal with inflation? How do I preserve the value of my savings? Of course, it is impossible to address these questions in a single article. But let’s start with the top priority: What currency should I use for my savings and investment? Local currency or a stable foreign currency?

Features of money

In the macroeconomics course I took during my university education, our teacher said that money has two functions. The first is the money exchange medium. We go to the market to buy bread, yogurt, or batteries and exchange money for those goods. Another function of money is that it is a tool to preserve value over time. So we save for rainy days and store those savings in the form of currency. However, the inflation rate must be reasonable for the currency to fulfill this second function.

In the case of high inflation, the purchasing power of local currency and our savings quickly erode. The currency, which is exposed to high inflation, cannot fulfill its second function. That is what happens to the Turkish Lira. That’s why savers in our country are in demand for foreign currency deposit accounts and gold. If you plan to save and invest for 30-40 years, you should prefer a more stable currency. That’s why I took the global reserve currency, the US dollar, as the unit of account.

Fiat currency

The currencies in circulation today are fiat currencies. In other words, they are not supported by gold in exchange. The credibility of those who manage the state determines their purchasing power. Governments can print these papers indefinitely by pressing a few computer keys through their central banks. According to the quantity theory of money, if your money supply grows more than the output in the economy, inflation occurs in the long run, provided that the circulation of money is constant. However, in the short run, printing money stimulates economic activity and deceives the public. In economics literature, this situation is called the money illusion.

Money illusion

Money illusion is an invaluable blessing for populist politicians. At the same time, you can claim that the same risk exists for the US Dollar. Essentially it is correct. However, institutions in the USA are much more credible than those in other countries. The state’s power is more evenly distributed between the legislature, the judiciary, and the executive. Its institutions and bureaucracy are qualified and robust. It is difficult for a populist US President to exert complete control over the Fed. Well. Even the United States is not immune from populism, as seen in the Trump era. 🙂

A little inflation is good for the Government

Mild inflation is actually in the interest of any government because you can reduce your debts in real terms by creating inflation. For example, a government raises money for its treasury by issuing long-term bonds. The investor, who buys those bonds denominated in local currency, acts with the expectation that the return of the bonds will remain above inflation until the maturity date (and believing that the Government will fight inflation).

Suppose a populist government paid the interest and principal on the bonds issued by printing money at an increasing rate. Due to this policy, the value of the local currency would decrease over time. However, the local currency denominated principal and interest yield of the bondholder remained the same. Thus, while the Government reduced its debts in real terms, inflation acted as a hidden tax for the investor. In a sense, everyone who receives a salary and holds assets in local currency pays inflation tax.

In countries like Turkey, populism also means ample government spending and budget deficits. Reducing public spending or raising taxes may lead to a loss of voters and risk the end of power. Therefore, the desire to print money and constantly expand the economy above its potential (= budget deficit) to finance this deficit results in an inflationary spiral.

In conclusion

Inflation is the most significant risk for savers and investors in a country like Turkey, where populist politicians dominate, and institutions and rules are weak. Especially if both your investment horizon is long-term and there is rampant macroeconomic instability with symptoms of high inflation and depreciating currency, you have to act to reduce that risk. First, you should keep your savings using a stable major currency such as the Dollar, Euro, Sterling, or Swiss Franc. Secondly, you should diversify your investments from local currency-denominated financial assets to assets denominated in stable currencies. Finally, it would be best to think in real terms, not nominal. Otherwise, you may deceive yourself by money illusion and suffer from diminishing purchasing power of your savings and investment.

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