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A funny thing happens to the stock of insurance companies after dis-
asters. When a hurricane, fire, or earthquake hits, the insurance compa-
nies pay claims that can add up to billions of dollars. What do you think
happens to the stock price of these companies immediately after disaster
Inflation 109

strikes? You might expect the stock prices to decline to reflect the bil-
lions of dollars in claims. Quite often, however, the result is exactly the
opposite and the stocks rally.
Why do insurance company stocks rise on bad news? The answer is
that people tend to buy insurance after big disasters. So the insurance
firms are indeed hurt by the claims that they pay, but they also gain from
the marketing of their product. Often the gains exceed the losses, and
this can cause the stock price of insurance companies to go up after a
This response to disaster points out that in insurance, just as in other
areas, most people tend to be exactly out of sync with the money-making
strategy. The time to buy insurance is obviously before the event, when
no one is buying and the insurance rates are low, not after the event when
everyone is buying and rates are high.
Twenty years of Goldilocks has lulled most of us into exactly the
wrong position. We have come to expect price stability. That means our
lizard brains are likely to be underprepared for price instability, in the
form of either inflation or deflation. To the extent that many of us are in
the same position, now is the time to insure ourselves against price insta-
bility on favorable terms.
Here are three strategies to protect your wealth against both inflation
and deflation. They are all ways to buy insurance in case we leave the
Goldilocks world of low and stable inflation.

Buy at Today™s Prices
The first technique is simply to buy at today™s prices. If you buy the home
that you plan to live in for some time, then you are protected against price
swings. While you may suffer as compared to your alternatives, you will
be safe within your home. Similarly, some states allow you to pay college
tuition ahead of schedule.
If you buy the stocks of companies that own natural resources, then
you are protected from commodity price changes. For example, if you
own the stock of oil companies, then you will benefit from any subse-
110 The Old Art of Macroeconomics

quent rise in oil prices. If you buy the correct amount of such stocks, you
can completely protect yourself from the effects of commodity price

If You Borrow, Lock in Current Rates
Recall that high inflation is a jubilee where debts are effectively erased.
The higher the inflation rate, the lower the true cost of repaying debt. In
the 1920s, German debtors were able to pay off their mortgages with
marks that were essentially worthless. Thus, high inflation provides a
financial windfall to debtors.
This inflationary benefit to debtors is only true, however, for those
with fixed-rate debt. A growing percentage of Americans are financing
their debt with adjustable-rate loans. If inflation rises, these people will
find that their payments have increased commensurately with the new
If you want to insure yourself against price changes, choose fixed rates
for all of your debt. With fixed rates, your debts decrease in real value in
inflationary environments. What about in deflationary times? In defla-
tionary times, you can refinance your debts at lower rates.
So fixed-rate loans are better than variable-rate loans in inflationary
times, and fixed-rate loans are no worse than variable-rate loans in defla-
tionary times. Are fixed rates, therefore, a free lunch? The answer is they
are not, because the fixed-rate loans are offered at higher rates than vari-
able loans. The extra monthly payment for a fixed loan can be viewed as
purchasing insurance against price changes. If the previous analysis is
correct, then the world may be pricing such insurance at unusually low
and attractive prices. Thus borrowing at a fixed rate may not be a free
lunch, but it might represent a value meal.

Buy Inflation-Protected Securities
The U.S. government sells bonds that provide complete protection
against inflation. The amount that these bonds pay is adjusted each year
Inflation 111

for the prevailing inflation rate. If inflation is high, the bonds pay more to
reflect the lower value of each dollar.
Let™s compare the payoff to an investment in a 10-year inflation-protected
bond to an investment in a traditional bond without inflation protection. To
be concrete, we will compare a $1,000 investment into U.S. government
bonds with and without inflation protection. Both bonds pay interest over
the years and then make a lump-sum payment at the end. Whereas a tradi-
tional, noninflation-protected bond simply returns $1,000, the inflation-
protected bond adjusts the $1,000 based on the amount of inflation.
Thus, the inflation-protected bond returns at least $1,000, and per-
haps more. How much more? That depends on the inflation rate. To
see the specifics, Table 5.1 compares the final payment for the inflation-
protected and the noninflation-protected bonds under four different infla-
tion scenarios.
Scenario 1 is no inflation. Scenario 2 is a continuation of the Goldi-
locks environment of 3% inflation per year. Scenario 3 is a return to the
late 1970s in the United States with 13% inflation per year. Just for fun,
scenario 4 considers prices rising at 500% a year (although this inflation
rate is high, it is far lower than the rate in Germany during the hyperin-
flation). So what do our bonds pay in these four scenarios?

TABLE 5.1 TIPS Provide Inflation Protection (Payment at Maturity
per $1,000 Investment)
Standard U.S. Treasury Inflation
Government Bond” Protected Securities
no inflation protection (TIPS)
(10-year maturity) (10-year maturity)

0% inflation $1,000 $1,000
3% inflation $1,000 $1,344
13% inflation $1,000 $3,395
500% inflation $1,000 $60 billion
112 The Old Art of Macroeconomics

Table 5.1 shows that when the original $1,000 is returned, the inflation-
protected bond is always at least as good as the standard bond and usu-
ally much better. Even in extreme conditions, the inflation-protected
bond ensures that the investor is protected.
This inflation protection, however, comes at a price. That price is the
lower interest rate paid on the inflation-protected bond. Currently that
difference is about 3% a year. Therefore the most that inflation insurance
could cost you is about $30 a year for each $1,000 investment. This max-
imum price will be paid only if there is no inflation at all. If there is even
modest inflation, however, the price of insurance is even less than $30 a
year for each $1,000 investment.
Because inflation protection has been unnecessary over the last 20
years, the behavioral economic research suggests that our lizard brains,
and consequently the market, may be undervaluing the inflation-protected
bond. Furthermore, U.S. government bonds are fantastic investments in
deflationary times. Therefore the inflation-protected bonds are almost
unique in being great investments under both inflation and deflation.
Thus, I believe that the inflation-protected bonds represent good value.
There are two types of U.S. government, inflation-protected bonds.
They are the I-series of U.S. savings bonds, and the Treasury Inflation
Protected Securities or “TIPS.” There are some legal differences between
the two types of bonds. For example, the savings bonds are restricted
both in the amount of purchase and the type of investor (mainly U.S. cit-
izens). Both bond types, however, are essentially identical when it comes
to inflation protection.
What about stocks as a protection against inflation or deflation? At
first glance, this seems like a crazy suggestion. Consider three of the
most famous periods of inflation and deflation. They are the current Jap-
anese deflation, the U.S. deflation during the Great Depression, and the
U.S. inflation of the 1970s. In all three periods, stocks were terrible
investments. So stocks would appear to be a very bad way to protect
wealth against an end-of-the-Goldilocks era of price stability.
While stocks were bad investments in past periods of price instability,
they may be good investments now. Company profits have a built-in
Inflation 113

inflation protection, just like the U.S. government bonds. Inflation, with-
out other economic change, simply inflates a company™s revenue and
costs. Thus company profit”the difference between revenue and cost”
ought to rise in lockstep with inflation.
If corporate profits are inflation protected, why have stocks done
poorly in previous periods of price instability? The answer may be that in
those previous periods the inflation and deflation were symptoms of
deeper problems. For example, the poor stock performance in the United
States during the 1970s may not have been caused by inflation. Perhaps
the oil shocks of the time caused both inflation and poor stock perfor-
mance. Thus, in future periods of price instability, stocks may provide

Magic Paper

As Professor Friedman suggests, money is a fascinating topic. The mag-
ical little pieces of paper and electronic entries in bank computers allow
us to leave behind the inefficiencies of barter and to amass wealth that we
will use over many years.
The form of money has changed over time from commodities to pre-
cious metals to the current standard of fiat currencies. These modern
forms of money are perfect with the exception of one enormous risk.
That risk is that monetary authorities will misuse their power to deter-
mine the rate of inflation. In the past, such monetary mischief has bank-
rupted many families.
The United States has lived through 20 Goldilocks years during which
inflation has hovered near optimal levels. The science of irrationality
suggests that these halcyon years will have left most of us unprepared for
any future price instability. Therefore, when most people™s lizard brains
feel that the risks of price instability are negligible, we may have an
opportunity to buy low-cost protection for our wealth. Fortunately, there
are both traditional and innovative investments that allow us to protect
our wealth.
chapter six

Uncle Sam the International Beggar

Neither a Borrower Nor a Lender Be

A few years ago I went to dinner in Los Angeles with a group of close
friends and a couple whom we had recently met. Because some people
had very expensive meals with cocktails while others consumed very lit-
tle, we decided not to divide the bill equally, but rather to each pay for our
own consumption. When the bill came we all pitched in what we felt was
our fair share (or so we thought).
We came up about $40 short of the tab. Since I had eaten a very mod-
est dinner consisting of a turkey burger and a diet coke, I was pretty sure
that I had not made a major mistake in calculating my share; nevertheless
I pitched in an extra $5. So did most everyone else, and we paid the bill.
A few days later we revisited the embarrassing shortfall, and we began
to piece together the puzzle. Because we were all good friends, we soon
figured out that the new couple had consumed the most extravagant
meals and had drunk the fancy cocktails yet had contributed almost

116 The Old Art of Macroeconomics

nothing to the bill. We thus labeled the man “Cheapskate” (he had “paid”
for the couple™s dinner).
We resolved that in future interactions, we would not allow Cheap-
skate to take advantage of us. We even practiced confronting Cheapskate
over the bill. “I had the turkey burger, what did you have?” Even though
such displays are deeply embarrassing, we found them preferable to hav-
ing Cheapskate take us for more money.
Our role-playing was never put to use with Cheapskate because he met
a fate similar to Elvis. He died on the toilet from a heart attack just weeks
after shorting us on the bill. After his death, his girlfriend discovered that
she had a big mess to clean up”Cheapskate owed money to almost every
single person he knew.
A small-scale con artist with a drug dependency, Cheapskate had put
“the touch” on everyone by borrowing money and never repaying it.
Interestingly, although he owed many people money, his total debt was
only a few thousand dollars. People were quick to cut him off. Just as he
was never going to get more than $5 from me, others were not willing to
make repeated loans.
A lesson from Cheapskate™s life is that it is hard to be a perennial
borrower. People are built with instincts that prevent and limit exploita-
tion. When we loan money, we expect repayment and stop lending to
The same is true of countries. Those that consume more than they pro-
duce must return the favor or get cut off. The “current account” describes
whether a country is consuming more or less than it is producing. Coun-
tries with current account surpluses, like Japan, are producing more than
they consume. The excess Japanese production is being sent to other
countries in return for IOUs in the form of money. The current account is
the broadest measure of a country™s consumption and includes every-
thing from cars to movies, legal services, and investment income. Thus
the current account includes the trade deficit and all other international
As shown in Figure 6.1, unlike Japan, the United States has a large
Deficits and Dollars 117

U.S. Current Account Deficit ($Bns)






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