Since the global economic crisis began in 2007, many observers and commentators of economic and financial events alike have suggested that inflation (a little, some, a lot) is part of the solution to our troubles. From Ben Bernanke to Joseph Stiglitz, from Paul Krugman to Jeremy Siegel, it seems like everyone’s got something good to say about inflation and its miraculous economic benefits.
But what has Warren Buffett, the “greatest investor of all time” and, by correlation, one of the greatest businessmen and economic actors of all time, had to say about inflation?
The arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislatures. The inflation tax has a fantastic ability to simply consume capital. It makes no difference to a widow with her savings in a 5 percent passbook account whether she pays 100 percent income tax on her interest income during a period of zero inflation, or pays no income taxes during years of 5 percent inflation. Either way, she is “taxed” in a manner that leaves her no real income whatsoever. Any money she spends comes right out of capital. She would find outrageous a 120 percent income tax, but doesn’t seem to notice that 6 percent inflation is the economic equivalent.
If my inflation assumption is close to correct, disappointing results will occur not because the market falls, but in spite of the fact that the market rises. At around 920 early last month, the Dow was up fifty-five points from where it was ten years ago. But adjusted for inflation, the Dow is down almost 345 points – from 865 to 520. And about half of the earnings of the Dow had to be withheld from their owners and reinvested in order to achieve even that result.
In the next ten years, the Dow would be doubled just by a combination of the 12 percent equity coupon, a 40 percent payout ratio, and the present 110 percent ratio of market to book value. And with 7 percent inflation, investors who sold at 1800 would still be considerably worse off than they are today after paying their capital-gains taxes.
I can almost hear the reaction of some investors to these downbeat thoughts. It will be to assume that, whatever the difficulties presented by the new investment era, they will somehow contrive to turn in superior results for themselves. Their success is most unlikely. And, in aggregate, of course, impossible. If you feel you can dance in and out of securities in a way that defeats the inflation tax, I would like to be your broker – but not your partner.
According to Warren Buffett and the simple arithmetic he shares, inflation is a tax. If inflation is a tax, it follows that it can not produce economic growth and miracles. Taxes represent confiscation of real wealth by taxing authorities, at which point that wealth is consumed as government authorities do not earn a profit on their expenditures and therefore these expenditures can not be looked at as productive.
Are higher taxes good for stock prices in the long run?
No. Higher taxes reduce the value of discounted future cash flows of any given asset and thereby reduce their present, capital value. Inflation is bad for stock prices (denominated in real terms) over time.
If inflation is a tax and taxes are not beneficial to economic growth, how does Buffett suggest American corporations can increase their returns on equity over time?
Corporate America cannot increase earnings by desire or decree. To raise that return on equity, corporations would need at least one of the following: (1) an increase in turnover, i.e., in the ratio between sales and total assets employed in the business; (2) cheaper leverage; (3) more leverage; (4) lower income taxes; (5) wider operating margins on sales.
Inflation, and taxation generally, do nothing to increase sales turnover, they do not make leverage cheaper, they do not create more leverage, they do not lower income taxes (obviously!) and they do not create wider operating margins on sales. Inflation/taxation are not a quick fix for an ailing economy according to Buffett!
To reiterate:
We have no corporate solution to this problem; high inflation rates will not help us earn higher rates of return on equity.
If inflation doesn’t help Warren Buffett earn higher returns on equity (that is, greater equity claims to real production on existing assets), what chance does anyone else have for benefitting from inflation in this way?
And again, if Buffett hadn’t been clear before:
As we said last year, Berkshire has no corporate solution to the problem. (We’ll say it again next year, too.) Inflation does not improve our return on equity.
Higher return on equity means more real value produced from the same base of assets.
And the taxation effect of inflation is so nefarious, it even extends to “tax-exempt” institutions, as Buffett explains:
At 7 percent inflation and, say, overall investment returns of 8 percent, these institutions, which believe they are tax-exempt, are in fact paying “income taxes” of 871⁄2 percent.
Everyone is caught in the net of inflation-taxation, even the so-called tax-exempt.
If inflation is a tax, and inflation, like other forms of taxation, consumes real wealth and depletes capital, and society doesn’t benefit from this, then who benefits? Who is consuming all of that capital?
The answer must be the individuals who stand outside of society and prey on its productive efforts, that is, the institution of government:
Investors in American corporations already own what might be thought of as a Class D stock. The class A, B and C stocks are represented by the income-tax claims of the federal, state, and municipal governments. It is true that these “investors” have no claim on the corporation’s assets; however, they get a major share of the earnings, including earnings generated by the equity buildup resulting from retention of part of the earnings owned by the Class D shareholders
You’ve heard it from the “greatest investor of all time”, Warren Buffett– inflation is a tax, it consumes real wealth and accumulated capital, it forces many corporations (and therefore, the people who work for them and own them) to run vigorously just to stand in place, and it places the equity of the country in a subordinate role to local, state and federal government.
Inflation is bad for the economy as it consumes the real returns of everyone’s productive efforts, sometimes so much that nothing is left over and in fact previous savings must be consumed, as well. Therefore, inflation is bad for your investments and bad for real returns in the stock market over time.
As Warren Buffett once said,
external conditions affecting the stability of currency may very well be the most important factor in determining whether there are any real rewards from your investment in Berkshire Hathaway.
And Berkshire Hathaway is no different from any other business, in that sense.
A House Rises 