One of the main enemies of saving money is inflation. It is known as the silent killer and earns its reputation by its slow deterioration on the purchasing power of our money over time. Inflation impacts our life in small doses which make it easily overlooked from one year to the next but its effects can be problematic long term. Inflation pushes the price of goods and services up which in turn reduces the standard of living that people grow accustomed to requiring the need to earn more money simply to maintain the same lifestyle.
The remedy for protecting your investments and savings accounts from inflation is fairly straightforward and involves following some simple math. If you earn 2% on a bank CD and inflation is running at 2%, you have essentially broken even. You would not have earned or lost any money. However, there are taxes due on the 2% in earnings which results in a net loss. So, it is not enough to simply keep up with inflation, you must earn more than the anticipated rate of inflation and taxes combined.
As you can see, determining your break-even point is an easy calculation but I have to believe that for most people, the idea of just breaking even is not what they dream of when visualizing their financial future. I would contend that many people seek to have their money grow over time in an effort to create wealth for their future.
When it comes to money, inflation can leave you with a false sense of understanding about how much you will need in the future. An inflation rate of 2% seems like a small figure and can even be perceived as an irrelevant amount but when you multiply this reality over ten years it translates to 20% or 20 cents on a dollar. In other words, a $50,000 salary today will require you to earn $59,754 in ten years if you were to experience a compounding inflation rate of 2%.
… remember that you are saving to replace your future income not your current income.
If you make $50,000 today and plan to retire in 20 years, you would need to have $72,840 of income to live the same lifestyle. It is then important to understand that in 20 years you will need $108,237 to live the same lifestyle your $50,000 is providing today. So, when you are thinking about how much money you need to save, remember that you are saving to replace your future income not your current income.
Inflation is often a difficult concept to wrap your mind around. The effects of it are obvious but understanding how it is created is a confusing topic for most people. In the remainder of this chapter, we will learn how inflation begins and why it happens. This will help you to form a basic understanding of pricing of goods and services, our government, the Federal Reserve and business operations. It can help clarify many misunderstandings for how our economy works and provide you with an appreciation for how intertwined the system really is.
Supply and Demand
If you have ever experienced the desire or the need for something that was in short supply, you likely recall the fact that the item was difficult to find. Other people wanted and were buying the same thing you wanted making the availability of the item limited. Often when you have an item that is in high demand and there is a limited supply of the item, retailers and manufacturers will increase the price of the item to capitalize on the situation. However, there is often a balance of supply and demand which stabilizes prices. A company is not going to intentionally produce more of a product than what they believe they can sell and if the demand is high they will produce more to satisfy the demand.
An example of how this works is with the world’s oil supply. Oil is something that is in high demand since most of us need to fuel our vehicles. When we fill up our gas tanks, this triggers a need for more oil to be produced for the next person to fill up. The amount of oil pumped out of the ground to manufacture gasoline is regulated up or down based on how much gasoline is being used. The oil is extracted from the ground and distributed into the market at a high enough level to satisfy the need but it is kept at a low enough level to keep prices stable. Being that there is such a high demand for fuel, a sudden shortage of fuel would surely cause the price of a gallon of gas to soar.
(A couple of facts about oil are that it is highly political and it plays a significant role in our world’s economics. Since oil is traded globally using American dollars, the exchange rate of our currency with an oil producing country is a contributing factor in the price of a gallon of gas. As the dollar declines and the exchange rate widens, the price of gas goes up. This is an origination point of inflation leading to people having less money to spend on other things which in turn has a negative impact on the economy.)
Now, imagine for a moment that you have a small business that requires the transport of widgets from one location to another. If there is an increase in the price of a gallon of gas, your fuel costs rise causing an increase in your transportation costs. To avoid losing money, you are forced to combat this increase by reducing your expenses and increasing revenue. This is accomplished by cutting jobs, closing facilities and increasing the price of your widgets.
The effect of this is an increase in the cost for consumers to purchase the widget which in turn forces people to reduce other household expenses. Now, people are spending less money on goods and services which leads to companies not selling enough of their product and forces the companies to cut more jobs and raise their prices. The effects are a never-ending spiral of job losses and price increases. When this begins to happen, government intervenes.
Government
I read a book written by L. Carlos Lara and Robert P. Murphy titled, How Privatized Banking Really Works which does a great job explaining the banking system of the United States. In the book, the authors used the example of the former Roman Empire to explain the impact inflation and the devaluation of currency has on an economy. The book illustrates the destructive patterns of government and the influence they have on our daily lives.
In the book, the authors used the example of Caesar who was the king of the former Roman Empire. I will summarize their point here by saying that Caesar was a man that was known for overindulgence and power. The key to his success was his military which he used to conquer neighboring territories to strip them of their assets coupled with the enforcement of collecting taxes from the people. The acquired wealth along with the taxes collected was used to pay for the expansion and the funding of his military, architecture, and infrastructure.
Over time, Caesar found himself in a situation where he was not collecting enough gold from the people of Rome to pay for the needs and expenses he had to keep his empire running. So, he had a choice to make, cut spending or reduce the size of his government. Well, he did not want to do either so he decided that he would keep doing what he was doing and would pay for his expenses by creating more money.
Caesar shaved his gold coins in order to produce additional coins which he then used to pay for goods and services. He manipulated the currency being used for commerce within his kingdom and attempted to pass it off the counterfeit coins as being the same as before. The result was an increase in his bank account which enabled him to continue to operate without cutting expenses. However, this did backfire on him when the merchants were handed the new coins for goods and services and noticed that the coins were smaller. The merchant’s in response to the lighter coins demanded two coins for the same goods and services.
As time went on, Caesar was faced with yet another deficit spending year and responded in the same manner. He attempted to counterfeit the coins again but the merchants responded by added safety features to the coins to easily detect if the coins were altered. Now that he was unable to reduce the size of the coins, Caesar decided to melt all the coins down to then reproduce them using a combination of gold and another metal to create more coins. Caesar continued this process until the coins ultimately contained less than one percent gold deeming the money worthless. Well, we all know what happened to Rome and, unfortunately, our modern day government is repeating the errors of the Romans by spending at unsustainable levels.
The United States of America once used physical gold and silver as currency then adopted the use of a paper certificate replacing physical gold for ease of transporting currency. The certificate guaranteed that there was gold somewhere to support its value. In the meantime, our government incrementally reduced the content of silver in our coins until ultimately removing the precious metal altogether. Then finally the government removed the gold standard which debased our money from the value of gold. More on this in a moment…
The money we now use is called fiat money or in other words, money made out of thin air. It is a form of currency that governments from around the world issue and control its value so they can fund their obligations. The way this works is that if the government needs more money, they have the ability to have more created. Since the government seems to continually need more and more money, they seem to have more and more created. This process devalues our currency spurring inflation.
Earlier I discussed how rising gasoline prices can create a ripple effect ultimately leading to inflation and job losses. These are contributing factors to government involvement since a reduction of income and spending reduces the amount of taxes they collect. Now, you would think the government would cut back on its spending just as you and I would if income was to be cut but that is not exactly how our government operates. You would also think that the easy solution to this is to raise taxes (which our government does do regularly directly and indirectly) but they also know that they can only tax its population so much before there is a revolt. There is a limit to what they can force us to pay without creating more problems leaving them holding the proverbial bag and unable to cover its obligations. So, just as Caesar did, they create more money by literally making more currency.
So, how do they do this? Well, this is difficult to explain but essentially how this works is that the government issues an I.O.U to the Federal Reserve Bank similar to how you would go and borrow money from the bank to buy something. They make a promise to the Federal Reserve to repay the money with interest. The Federal Reserve then lends the money to our government who then uses the money to pay their bills. This process floods the economy with new money (benefiting the government) which causes the dollars already in circulation to be worthless due to having too much money in circulation similar to the effects of Caesar’s actions in ancient Rome.
The key takeaway from this is that the Federal Reserve creates money out of thin air to pass it on to the government. This is what we have heard about in recent years under the name of “Stimulus” or “Quantitative Easing”. There is also something called Fractional Reserve Banking that also floods the economy with money every day.
Remember what happened when Caesar flooded the market with manipulated coins, the merchants, in turn, demanded more of the coins for the same goods and services. This is what happens in modern times as well but we have to think on a global scale.
Goods and services, including oil, are traded around the world. The exchange rate between one currency to another is in part how inflation can seep into the system. If we are buying oil from Saudi Arabia, their rival’s exchange rate for our dollar may be low, forcing them to charge more for the oil. This is the same for gold and silver as well. As the dollar goes down in value, the value of gold and silver along with other precious metals tend to rise. It is all about conversion rates, supply and demand and government actions.
Though simplified (but still complicated), these are a few of the components for how inflation is created. The challenge of inflation is not something to focus on since you have limited control of how it is created. However, having the awareness of the fact that it exists is important to enable you to combat the erosion of the purchasing power of your money. This means saving more money to get to retirement and to sustain your lifestyle throughout retirement.
As always, if you have questions about this or would like to discuss how to incorporate an inflation hedging strategy into your financial plan let me know.
Brian
