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SJan 21, 2009

How to “Circle the Wagons”

Scott Burns

Q. I suspect that the $700 billion bailout plus the new president's spending plans will result in 1970's-style high inflation. How does one protect oneself in inflationary times? ----N. H., by email from Kilgore, Texas

A. While future inflation is the most likely result of more government spending and more government debt, it’s not a sure thing. We won’t face high future inflation, for instance, if the spending fails to stimulate the economy and demand. Right now, asset values and spending are falling so fast that government spending can’t increase fast enough to offset it.

There isn’t a lot you can do to protect yourself from inflation. You’ll also get arguments about how effective each method will be.

One tool is to invest in commodity-producing companies such as energy companies. Another is to invest in firms that invest in real estate, which becomes more expensive to replace when prices are rising. Still another is to invest in Treasury inflation-protected securities because their principal value is adjusted upward to reflect changes in the consumer price index. And still another is to invest in foreign bonds on the theory that high domestic inflation will cause the dollar to fall in value relative to other currencies.

Of all these tools, the last is subject to the most argument because other governments are at least as likely to foster inflation as ours is.

Q. I think my quandary is not unique. Do I pay off deductible debt or hoard cash?
In other words, I can pay off my home and some business and investment notes with current cash, or I can keep on managing my debts while hoarding cash?

In this environment I am not sure what is proper, more cash or less debt. ---J.P., by email

A. Your quandary isn’t unique. Indeed, my mailbag has been flooded with “circle the wagons” questions. How much liquidity you need depends on two major factors: (1) your personal situation and (2) your assessment of the world around you. The liquidity needs of a retired person are very different from those of a young family. Similarly, the needs of a securely employed person are very different from the needs of a contract worker.

Knowing what to do is complicated still more by the unspoken assumptions that some people carry around with them. Some people are so debt-averse that they will pay off debt even when the prudent course is to hold cash. Others seem to think they will never be offered the opportunity to borrow money again, so they are reluctant to pay off loans.

The hard measure, as I see it, is very simple. Exactly how long will your current liquid resources last if your earned income stops before you are forced to sell something or default on a debt? If you are a young worker who can easily change jobs even in a tough economy, you might need only a few months of spending in reserve cash. If you are an older worker, a higher-income worker, or an independent business person, your reserve need is probably at least six months and as many as 18 months.

Many retirees, on the other hand, don’t need much in reserves because Social Security provides a large portion of their income. If, for instance, Social Security benefits cover half of your spending needs--- and they do that much, or more, for well over half of all retirees--- your reserve needs may be only a month of spending.

Note that I haven’t mentioned interest rates. That’s because what you earn on your reserve fund isn’t very important when the concern is liquidity and security. It’s nice when interest rates are high. It’s tough when interest rates are low. But it shouldn’t influence your decision about how much to keep in reserve.

Instead, decisions should be based on what payoff gives you “the biggest bang for the buck.” If the choice, for instance, is between using $3,000 to pay off an aging car loan where you are paying $500 a month or applying the same $3,000 to a home mortgage, you should pay off the car loan every time.

Reason: Applied to the car loan, $3,000 reduces your monthly cash need by $500 a month. Applying the same sum to your home mortgage has no effect on your monthly cash needs because the mortgage payments continue until the loan is paid off.

Filed Under: Government, Taxes & Other Disasters, Q&A (from print)