Why Investors Need to Plan for Inflation in the U.S.

Today's Wall Street Journal features an editorial, "Debt and Growth" containing the following statement: "...public debt isn't a free lunch. It has to be repaid, which means a country must either spend less, tax more, grow faster, repudiate the debt or inflate it away."

Keeping in mind the realities of U.S. politics in 2013, let's take a look at each of these possibilities:

Spend Less--unlikely that lobbyists will allow this to happen. Every recipient of public largess has powerful defenders today. This is probably the most difficult path and politicians wanting to be re-elected will not opt to put themselves in the cross hairs of strong interest groups.

Tax More--the Tea Party and its sympathizers are dead set against this alternative. We will probably see tax rates continue to rise but the U.S. is not Northern Europe. Most voters have a strong aversion to this option, and for good reason. They understand that it chokes off growth.

Grow Faster--This would be ideal. Unfortunately we are a developed economy and like every other developed economy, we seem to be locked into a slow growth pattern for the foreseeable future. Furthermore, there is no agreement on what policies will stimulate growth.

Repudiate the Debt--This would destroy confidence in the U.S. as a place to invest. It is hard to imagine any scenario in which this would come to pass, given that other alternatives exist, particularly the last one, namely...

Inflate it Away--This option sounds benign compared to the others (of course it can be anything but benign in practice). If we just increase the money supply, over time prices go up, and the interest payments on our government bonds become relatively affordable. The buyers of Treasury Bonds lose purchasing power, but that is a risk that buyers of Treasury Bonds (such as the Chinese) knew they were taking, isn't it?

In short, the last option is by far the easiest from a political standpoint. Many of the losers are overseas investors for whom U.S. voters have little sympathy. And the U.S. can still tell itself that we lived up to all of our obligations (unlike the repudiation/default option). Other losers are the 1% of the population who hold lots of Treasury bonds in their portfolios.

Given this political calculus, it seems almost inevitable that inflation is on its way. U.S. investors would be wise to plan and invest accordingly. One strategy is to make short-term loans since rising inflation and interest rates do not erode the value of such investments as much as longer-maturity debt investments are effected. Another strategy is to hold assets that keep up with inflation, which may include income property with shorter-term leases (such as apartments)