Monday, May 18, 2009

Get Ready For The Inflation Tax

Aharrrhh Jim lad, no good ever came of a-pumpin' up the money supply

Throughout the ages, highly indebted governments have turned to the inflation tax to bail themselves out. By ramping up inflation, they impose an effective tax on all who hold any form of government debt fixed in money terms.

So if you hold £1,000 in I Promise to Pay the Bearer on Demand tenners stuffed under the mattress, 2% pa inflation means that by the end of the year it's only worth £980. You have lost £20 to that year's inflation tax.

If inflation ramps up to 5%, your inflation tax becomes £50. And if it's 10%, the tax is £100 (actually it's "only" £91, equals £1000 minus £1000 times 1/1.1, but let's not split hairs). Etc etc.

The inflation tax in Britain was at its height back in the 70s. In 1975-76, inflation was 25%, and with Public Sector Net Debt standing at £52bn (start of year), the inflation tax amounted to £11bn, a staggering 10% of GDP.

Where do we stand now?

As you know, we believe inflation is set to take off again - driven largely by the government's desperate need for increased "revenues" from this inflation tax. And with public sector debt ballooning, the tax-take will soon ramp up.

Based on the latest HMT budget projections, and using a range of very modest inflation assumptions, here's how it looks:

So after two decades when it has bobbled along at less than 1% of GDP, the tax is now set to soar. Which is pretty scary.

And it's especially scary when you realise that the HMT debt projections take virtually no account of the vast banking debts the government has taken on, and there is little reason to think inflation will stop at 5%. A £60 bn pa tax could easily turn out to be much higher.

So who are the poor schmuks who will pay this tax?

And more importantly, how can you make sure you're not one of them?

Well, like we said, anyone who holds government debt fixed in money terms will pay.

What's fixed in money terms?

Money is fixed in money terms, for a start. So you want to make sure you don't hold too much of that. Or rather, make sure that any cash you do stuff under the mattress looks like this:

Tomorrow's hardest currency

But most of HMG's debts are not money per se: notes and coin only account for around £50bn of the trillions they are busy running up.

No, the main chunk of debt comprises gilts and similar "interest bearing instruments".

And who holds them?

Here's the official breakdown for gilts as at end-2008:

As we can see, one-third of them are held overseas, so you may say fine: we don't care if they pay the inflation tax. Except we will care if scammed foreigners get so angry they stop buying any more.

The biggest chunk - 40% - is held by insurance companies and pension funds, and again, you may say fine. That's their problem not mine.

But of course, it is your problem if you're anywhere close to drawing a private sector pension. Because your pension will come from an insurance company or a pension fund, and will almost certainly be pretty well fixed in money terms, backed by gilts or similar bonds. And once inflation moves above 2-3%, you will be on your own, paying the full inflation tax on your gilts-backed pension.

So private sector pensioners are stuffed.

For most other people, the good news is that the inflation tax is largely voluntary. You simply have to get shot of your HMG fixed debt (including cash, but possibly excluding index-linked gilts), switch your High Street bank and building society accounts into a handy Renminbi Savings Account, buy gold, buy silver, plant carrots, and pray.

Of course, widows, orphans, and ordinary savers of modest means will never move quickly enough. And they will pay this tax with the money they would otherwise have had to heat their homes and eat.

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