If you're like a majority of average American investors, you earn 1 percent or less in your savings account, mutual funds or bonds, and lose 2-3 percent to inflation. Ever wonder where that 2 percent difference goes? To the government, through a reduction in the cost of repaying its debts, something known as "financial repression."
No, financial repression isn't some strident Occupy Wall Street call to arms. It is a term coined in 1973 at Stanford, and revived today by economists to describe how governments taxes assets to reduce the value of their own debt.
Controlled Inflation Works Wonders -- For the Government
Many investors today are afraid of runaway inflation, but they shouldn't be. During the recession, the government increased the money supply in an effort to stimulate the economy. But because the Fed controls both sides (interest and inflation rates), generating a 2 percent spread is more than enough financial repression to lower public debt over the long term. The government has no need to get greedy and push inflation higher.
The problem is that investors are still stuck in the wealth preservation mindset. A recent survey commissioned by BlackRock revealed that average Americans are still holding 60 percent of their financial assets in low-risk, low-yield investments like certificates of deposits or in savings accounts.
"Many investors confuse the nominal rate of return of their investments -- the growth in the amount of money they have -- with how much their investments have increased in value. But if you cannot buy more with your money, are you really any better off? The real measure of an investor's success is how much their money has grown after subtracting for inflation," says Marc Prosser, publisher of LearnBonds.
How Financial Repression Works
When the government collects taxes, it expects - all else equal -- that each year its taxes will also grow at the rate of inflation. In this way, inflation increases the actual dollars that the government extracts.
The only thing that does not grow with inflation is past debt, which is essentially a contract for fixed future payments. If the government can engineer 2 to 3 percent inflation while paying 1 percent on debt, it can grow future tax revenue faster than it owes interest.
To make financial repression more effective, governments craft laws requiring that private industry hold more government debt. For example, regulators may decide that insurance companies must hold a higher percentage of more highly rated securities, of which Treasuries are defined to be the leading constituent. This ensures a steady demand for the government's low-yield paper.
The flipside of the government's debt is your assets. A bond is an intangible financial asset that has value because of a contractual claim -- in this case, lending money to the government. If the government owes you money, then you have an asset. Your ability to convert this asset into milk, potatoes, steak, and gas is shrinking by 2 percent (or whatever inflation is) per year.
Escaping from Financial Repression
The only way to escape from financial repression is to earn more than inflation, and this is precisely why I favor private credit market investments such as peer-to-peer business and consumer loans, receivables lending to medium-sized businesses, and collateralized real estate bridge loans over low-yield public debt. These investments offer higher returns without exposure to a volatile stock market.
Consistent annualized returns of 9 percent or more put private credit markets comfortably above inflation, and thanks to the technology used by online lenders, these alternative investments are more transparent and accessible than ever before. Every portfolio should have some exposure to these attractive, low-risk investments.
Investing in private debt provides protection against inflation and can even offer regular cash flows due to their relatively short duration, so that if inflation accelerates, your investment won't get crushed like most bonds do. You don't have to be an investment guru to liberate yourself from government-sponsored financial repression; you just need to know where to look.