Buffett article in Fortune

Warren Buffett, picking up on themes he has discussed many times before has a remarkably clear argument for the long term power of investing in real assets.

While I think his argument is persuasive, I have written a short reply questioning one of his core assumptions: that popular governments will always pursue inflationary policies.  I am not so sanguine.  Popular governments have often found deflation fighting more difficult than one would assume, and it is not clear whether an aging population, such as in Japan, is not a significant and contributory factor to deflationary policies.

You can read the article here.



My response:

As always, Buffett has a clarity which is refreshing and insightful.

The core assumption that Buffett makes that he does not explicitly clarify (though he hints at it) is he believe that ultimately, governments will always prefer inflation, and therefore over any extended period, he rules out the possiblity of deflation, which is the one scenario in which nominal assets could outperform real assets, even under conditions of low rates.
That he does not consider this possibility is a real weakness in his argument, as several societies have indeed experienced prolonged bouts of inflation, including the US between about 1870 and 1892 and again between 1928 and 1940.  These were admittedly periods of extreme economic turmoil, as overleveraged households and firms folded, and bank failures encouraged credit and monetary contraction.

More recently, Japan is undergoing the same experience, even as the rest of the world has boomed.  What would be interesting, from my perspective, is Buffett's view on the affect of aging on asset prices and a tendency toward deflationary policies.  After all, old folks tend to have assets (and usually want nominal assets with steady, predictable cash flows, not lumpy albeit fast growing ones) - so their stronger voting power can encourage politicians to support policies favorable to creditors.  Moreover, consumption declines with age, which may lead to an environment of falling prices and lower economic activity generally.

Since most people in the world now live in countries that are either at or below the replacement rate, most countries are expericing significant aging.  Is it not possible as we look out over the 21st century that growth itself may grind to a near halt?  In which case, might nominal assets outperform after all?

2012 Theme: Inflation vs. Deflation

In the embedded video, "Bond King" Bill Gross discusses the outlook for inflation and deflation and shows why getting the right answer to this question is a major factor for investors: asset classes perform quite differently under "reflation" (increasing inflation), disinflation (lowering inflation) and deflation.



Mind you, most financial assets, both nominal and real, perform best under periods of falling inflation, the "30 fat years" described by Gross.  Under reflation, both nominal and real assets perform badly, but real assets perform much less badly, as they can "keep up" with rising prices, albeit slowly.  Finally, nominal assets do well in deflation and real assets do very poorly in deflation.  The problem for nominal assets (e.g. bonds) is default, which rises sharply and can lead to a permanent impairment of capital.

The real question is: which are we likely to have.  While Gross doesn't say - he makes it clear that the jury is still out - he does help to deconstruct the problem and lay out some of hte markers.