Monday, December 13, 2010

Taxation and Inflation – Economic macrotrends

After 1945, North America was in a stage of growing capitalism. With new technologies after World War II and a relative new economy, it was booming, requiring ever increasing amounts of resources. Europe was rebuilding its war ravaged countries as well and rebuilding its former prosperity took all its energy. It boomed as well and it also required ever more resources. BRIC and other developing countries were off the radar screen and mired in economic misery with the exception of Japan that also tried to recover from World War II. Europe, with an older economy and influenced by socialism focussed using the fruits of its boom into an extensive social network; while North America was more focused on creation of individual wealth (the American Dream).

By the 1970s, the world became aware of the limits of its resources. Energy and materials earlier on taken for granted became suddenly 'scarce'. The resource economies started to demand respect through OPEC and with an ever growing world population and ever increasing consumption, especially in Europe and North America, commodity prices sky rocketed. Simultaneously, the Baby boom generation was growing up and required expensive education programs before it could contribute to GDP and this combination forced many western governments into large debts. Rising commodity prices made life more expensive and increased debt required governments to pay higher interest rates in order to compete for money in an ever capital hungry world. Citizens demanded ever growing prosperity but were also confronted with higher expenses. The inflation cycle hit full bloom.

In the late 1970s, inflation from higher commodities, inflation from higher wage demands to continue or increase the standard of living, and corresponding high interest rates, kept driving up government interest payments and increased government deficits. The response was higher taxation, which in turn increased the cost of living of its citizenry and the inflation cycle became a maelstrom. Economies faltered as illustrated by the 1974 and the 1979-1980 recessions. Inflation and commodity prices got out of control and only a dramatic increase of interest rates to near absurd levels by Paul Volcker around 1982 broke the cycle.
Energy conservation, falling inflation, lower interest rates, the rise of cheap BRIC country labour, reduction of social programs, the end of the cold war, government debt reduction and lower taxes. These were the things that brought commodity prices and inflation down. Inflation kept falling until... the first decade of the 21st Century.

After a period of amazing prosperity starting in the 1990s fuelled by low commodity prices and ever falling interest rates combined with ever more deregulation in North America and Europe, in 2000 – 2005 the lessons of the past were forgotten. The world, benefiting also from the new computer technologies, took prosperity for granted and adored unbridled greedy executives who often did not much more than riding the boom. We saw the era of easy money and unlimited unthinking credit. It all culminated in the 2007-2009 crash. We underestimated the ever higher commodity prices starting in the late 1990s; we ignored normal economic conservatism and long term investing practices. This was a new economy where everyone would be rich; especially those greedy and by 'success' blinded leaders of Wall Street and the laissez-fair politicians. Nobody saw the crash coming except a few outside-the-box thinking dissidents.

By now we are standing in the first half of a new era of new rising commodity prices, increasing government deficits and pretty soon we will see inflation sticking up its ugly head again. The cycle has started over, with higher interest rates and higher taxes for the coming decade or two. Governments have run the money printing presses at a very high clip. This combined with artificially low interest rates however justified in the short term. will lead us into a new period of higher inflation. So how will this affect our personal finances in the future?

We have already started on this blog with looking at RRSPs versus TSFAs. Now with the scenario described in this post, we will be able to see how this translates in investment strategies and tax strategies.

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