MAY 2011                                                                                                                                     Download PDF Version

Education’s Real Lesson

Few assets have kept up with the steady rise of inflation over the last 40 years let alone other financial commitments such as education or healthcare. The controlled increase of inflation in the system may actually be the Fed’s ‘exit plan’ as they choose to protect asset values rather than consumer prices.

A colleague of mine recently  outlined the following set of figures: in 1970 the cost of a year’s education at Harvard stood at $4,070 and the median household income in the USA was $9,870. In 2010 the cost for a year at Harvard was c.$60,000 and the median household income was $47,000. The education bill has grown at c.7% per annum over the last 40 years, the median wage has grown by only 4%. These figures are, in themselves, salutary, however, they are even more shocking when your consider that inflation (as measured by CPI) has been running at 4.5% over the same period. This means that the inflation adjusted median household income over the last forty years has declined at 0.5% per annum; in effect there has been a ‘stealth inflation income tax’.

Very few things have kept up with tuition fees (possibly health insurance, though this is not a great solace to the US consumer!). In fact most investment assets would have struggled to keep up with the 4.5% inflation level. US equities did manage, growing at c.7% p.a. over the last 40 years; but an investor in equities will have had to put up with some extremely volatile markets and how many investors can genuinely confirm they would have stayed fully invested through the cycle?

Notional vs. Real Growth
Although consumers have spent on credit what the above figures show is that in reality anyone without assets was being taxed via inflation. Therefore keeping asset prices growing is key as it fuels the boom in borrowing; it is not surprising that the Fed now seems much keener to protect asset prices rather than to keep a lid on consumer prices. QE1 and QE2 have partially reflated equities but have not moved the US housing market, which continues to decline; this is a major problem and a sustainable recovery will only appear once the housing market has reached the bottom and has started to recover.

An Exit Plan
Currently the Fed has a number of ways to address their predicament:

  1. Austerity: The USA does not do austerity and Obama is even less likely to do it in an election year.

  2. Growth: The economy looks unlikely to grow sufficiently to get the Fed out of the hole.

  3. Default: An unacceptable solution, even restructuring would be problematic with banks’ balance sheets so intertwined.

  4. Hyper-Inflation: A possible solution, but there still exists significant global spare capacity.

Therefore the most likely solution would be for a long period of sustained negative real rates - i.e. inflation running at 4-5% with interest rates running at 2-3%. Such a scenario is not unusual as the period from the end of WWII to 1980 was a period of negative real rates; this allowed the governments to work off the war debt debt over a sustained period of time.

If this scenario plays out then the rich will get richer, the poor will get poorer and the middle will continue to get squeezed; in 10 years time the Harvard-to-median-income example will be even more shocking. In such circumstances simply ‘buying the market’ through ETFs or indexed funds will not deliver investors preservation of their wealth. Instead the only strategy which will produce proper returns is long-term investing in carefully selected asset classes.


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