Raghuram’s Dosa Economics was succinct and simple, inflation kills the principal amount as real interest rates fall with inflation, while all attention is diverted to the return in nominal terms when the interest rates rise with inflation; that is how the pensioner or the retiree would see and be mistaken by the more Dosas she could buy with higher return on her principal amount even adjusted for inflation but the principal itself would be eroded by a bigger absolute amount by inflation.
But what happens to the principal is the deep rooted question to the retiree? What options does she have for protecting the principal? This treatise has nothing to do with Rajan’s original hypothesis, it only looks at the erosion of the principal.
A retiree invariably looks for safe haven investments, not the speculative kind where returns could be high but could be fraught with risks; access to information could be tilted not to his favor, so he could be at the mercy of sellers who could be selling products that he could make little off. High return portfolios on one side of the pole have low return ones which are held by an equal number of people, retirees could be on either side, but chances are that they could be on the wrong side of the bargain.
Looking for safe haven will lead retirees to the safest haven, which is an annuity and there the rates could be bordering inflation after taxes are accounted for. The principal by the way is not owned by him at all, if he chooses to pass it over after death, the actual payments received are deducted in most cases.
Degree of erosion of the principal, if at all, is never to the retiree’s advantage, it has nothing to do with the prevailing rate of nominal interest rate against the inflation or the real return. We will see that even the most wealthy almost always failed to protect their principal, otherwise new wealth could never have been created at such a frenetic pace over old wealth.
Let me go back to the retiree’s puzzle of the principal protection.
Take an annuity product in U.S. and you will find the best one giving you $900 per month for an investment of $250000 (which you will never receive if you live for long), in fact this would mean that you would take 24 years to get to the full principal, so if you start at 65 and you live till 89, you might as well could have done the same by keeping the principal with you and spending $900 from it every month.
Why you would refrain from doing so is simple that you believe that you will live longer than 89 years! The annuity remains an opposite of the insurance product where cohorts who live longer gain from those who live short.
The principal remains an enigma, that is precisely the reason why “wealth principal” remains transitory. If the principal got protected, all wealth would have remained with the wealthy and their descendants.
Think of the wealthy of the last generation or a couple of generations back, if their principal had grown in real sense, they would have remained as wealthy as ever, but it is not so. The simple reason is that the principal hardly ever grows if kept in static investment products, whatever the product.
Of all the wealthy you see, the top wealth got created in the last eighteen years, not in the last hundred years. Look at the top wealth creator, the S&P 500, it has doubled from 1275 in 1999 to 2550 today, The bulk of the new wealth created has been in stocks of new companies, most of them did not exist a long time back.
The protection of the principal over inflation has never been such a certain event, that is the reason wealth has remained transitory. Wealth, or money will flow to the generators of highest return; it has no allegiance to the old holders or their nominees or the best product which looked so great at some point of time. Wealth changing hands is the ultimate reality.
You could do your best by putting your principal in a range of products, whether that principal would be protected forever, even with zero inflation, is another matter.