Size of the inflation wealth transfer
This section looks at the true impact of current inflation and examines who are the real winners and losers. The size of the transfers is truly staggering, probably totalling nearly £100bn in 2014 in the UK alone. They are taking place so subtly that few are aware of their magnitude and impact.
The £23bn annual loss to savers
The interest rate on cash savings is almost zero now and is destined to remain that way for potentially a decade or even longer to come. This means that everyone who holds cash in their wallets, chequeing accounts or many instant savings accounts, is losing purchasing power of that money at a rate equivalent to that of inflation. Even though official rates of inflation have fallen in many countries, what matters is the true rate of inflation of the cost of living experienced by those cash-holders.
For example in the UK, I estimate that a more accurate cost of living index for the average person is 1-1.5 per cent higher than the official CPI(H) statistics. However even if one uses the more conservative and less misleading RPI measure of inflation, this is still around 2.5 per cent in mid-2014.
Therefore, every year, every person in the UK is effectively donating £2.50p to the debtors for every £100 they keep in their wallets or effectively hold as cash elsewhere. That is a staggering amount, particularly when looked at over a period of time. Even at this low inflation rate, the value of all our cash is going to halve within 28 years.
It is not just cash that is impacted but all forms of savings. My calculations suggest that UK savers and companies are currently losing a total of £23bn a year in this way, nearly half of which comes from the low rates of interest on instant access accounts. In 2014 these rates were generally around 0.4 per cent after tax, significantly below RPI inflation at 2.5%.
Sources: Save our Savers, Bank of England, ONS, NS&I and Building Societies Association.
See endnote** for more details on the method of calculation and assumptions.
It must be remembered that this is a cumulative loss. UK savers have transferred more than £100bn to debtors in the last four years alone. Furthermore during the period from 2009-2013, the real purchasing power of all UK savings declined by an estimated 13 per cent and will continue to do so as long as financial repression persists.
Sources: Building Societies Association and ONS.
What is fascinating is how so few of those savers really comprehend the true impact that financial repression and inflation is having on them. In Cyprus in 2013, the public took to the streets in violent protest when their government tried to impose a levy of just half this loss (i.e. 6.7 per cent on savings). The people forced their government to retract the proposal. In contrast, in the UK the acquiescence of savers is such that a campaigning group called “Save Our Savers” has all but closed down in 2014 for lack of support.
Indirect loss to savers
The current low savings returns are causing many to seek better returns elsewhere – often on the stock market. However, things are not looking much more promising there either. Since 2000, the FTSE has traded sideways and so capital returns have been minimal on shares.
Admittedly dividend income has averaged around 3%. However, as I showed in my book Monkey with a Pin, most people investing in the stock market get a return that is about 6 per cent less than they expect, as they’ve not factored in charges, their low skill in stock picking, bad market timing and something called survivorship bias. Therefore, until the UK stock market breaks out of this trading range and we start to get capital growth again, returns are not going to keep up with inflation. Some leading economists like Martin Wolf are predicting that this may not happen for a long time. (However that may not be the case as we will see later. See: “20-Managing wealth as we head towards near-zero inflation.”)
Therefore those opting to invest in shares, might also lose purchasing power over time. But this time the transfer of wealth would not be via inflation but to the financial services industry through their charges and losses to their professional investors.
The loss to bond holders
The loss by cash savers is mirrored by those buying government bonds. Although this issue appears not to concern the general public, it should do since they primarily hold this debt, albeit via intermediaries.
As the chart below illustrates for the UK, the bulk of public debt (that the Bank of England has not bought), is owned by financial organisations such as pension funds, insurers and banks. They are investing it on behalf of their customers who are typically long-term savers and those with pension schemes. A large part is also held by foreigners, but again the ultimate owners are mainly just savers and pension schemes residing in other countries (just as UK pension schemes invest in other countries’ bonds).
Source: United Kingdom Economic Accounts (Q2 2014)
The problem with such bonds is that governments have helped push down their yields in the aftermath of the financial crisis with exercises such as Quantitative Easing. Therefore the yields have fallen significantly in 2014, the 2-year debt in key countries is producing close to zero return in many leading markets.
Source: Bloomberg. Bond yields are from October 2014 and inflation levels are latest published at that time i.e. August/September 2014. For the UK, inflation is RPI.
The 2-year bond yields are below the rate of inflation in each country in the above table and purchasers of such debt are guaranteed to lose money if inflation remains at its current level. Clearly the loss is different for different bond maturity dates, but even buyers of 5-year bonds are making a loss in all these leading countries.
The £33bn question
This wealth is being transferred to national governments, which are benefiting when they issue new debt through being able to do so at these low rates. The counterparty is typically a saver or someone with a pension scheme. In theory it should be possible to determine the magnitude of the wealth being transferred due to the impact of financial repression on government bonds yields. However in practice it is difficult to determine both the size of the gain and the recipient.
This is because only a limited proportion of new bonds are issued in any given year at the new low rates. New ones only need to be issued to cover the budget deficit and to refinance ones maturing in that year. Therefore the vast majority of UK government bonds continue to pay out the interest rate that was set when they were issued. When base rates declined, the price of those existing bonds increased, making their yield to any new purchaser very low. However, long-term holders of government debt were unaffected and are only being gradually impacted as their portfolios of bonds mature. If that is not complicated enough, different length bonds are issued at different yields. In 2014 new bonds issued by the UK government yield around 2%-3%.
Having said all that, here is my attempt at the calculation. In the last five years (2010-2014), the average after RPI inflation yield of UK debt issued was -1.1%. Contrast this to pre-crisis where the average after inflation yield used to be around +2.2 per cent (from 1998-2006). In the last five fiscal years ending 2010-2014, the UK government issued about £900bn of new debt. Therefore, in 2014, it was benefiting by about £33bn a year in reduced interest payments because of financial repression. That gain is all at the expense of the typical bondholder, which as explained above, is ultimately pension holders and savers, i.e. the general public.
In late 2014, the UK government has decided to redeem some old debt dating back originally to the 17th and 18th Century and to World War I. They are doing so because they can now re-issue it at even lower rates of interest. It remains to be seen if the UK (and other governments) will take advantage of financial repression to re-issue much larger quantities of debt they owe, saving themselves even larger amounts in interest payments. If they do, it will be paid for by savers and pension scheme owners in further diminished returns over the coming decades, making the net annual loss to bondholders much larger than my current estimate of £33bn.
The £20bn-£50bn question
In addition to this, one needs to factor in that pension schemes also frequently invest in corporate bonds (debt issued by companies). The average yield of these has been forced down by financial repression as well and is only about 0.3 per cent higher than the average UK government bond yield***. Moreover that premium is unlikely to be enough to cover the higher default risk of such bonds versus sovereign debt, so their true yield is probably even lower. As the size of the UK corporate bond market is similar to that of the UK government debt market, it is likely that UK businesses are benefiting in similar sums to that of government, probably in the range £20bn-£50bn a year.
The ultimate losers with debt and inflation
Returning to the conveyor belt analogy this chapter started with, it is useful to summarise who are the beneficiaries from inflation related to debt in the current situation and who are ultimate losers. The table below summarises this together with estimates of the size of each of the associated debt markets.
What is clear is that the eventual losers with inflation are nearly always individuals, via erosion of the purchasing power of their savings or pension wealth.
Sources: Bank of England, ICMB, The Money Charity.
* Although other banks/speculators are the ultimate loser with bank debt, tax payers have also been a loser in the bailouts following the financial crisis as bank debt was taken on to government balance sheets.
** Savings amounts were derived from calculations made by Save our Savers based on November 2013 data from the Bank of England. Average interest rates were derived from data provided by the Building Societies Association for July 2014 and the tax rate assumed was 20%. For NS&I, a half of savings were assumed to be tax free e.g. premium bonds and other accounts. Inflation was based on RPI for July 2014.
*** Data source: Fixed Income Investor on 16 October 2014.