Inflation
Inflation: a persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money, caused by an increase in available currency and credit beyond the proportion of available goods and services. - TheFreeDictionary.com
Inflation: In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. - Wikipedia.org
Inflation tax
Practically, inflation is just another form of taxation. It is an indirect tax on money. This tax is paid by everyone hoarding money and using money as an investment. Thus, it should not concern people who don't have any money.
The poor are not affected by inflation directly, because usually they don't have any savings, and whatever they earn, they spend right away. The poor are affected by changes in inflation rate, because wages tend to increase more slowly than prices. When inflation rate is rising, the poor must instantly switch to survival mode and buy the bare essentials only. However, when inflation slows down and wages catch up, the poor can even start saving.
The rich don't invest in money. They keep their wealth in assets. The price of their assets usually appreciates due to inflation. In most cases the rich will have to pay capital gain tax on this inflation-induced price difference. Practically, even owning assets is a losing game. But by keeping their wealth in assets, the rich can at least defer some part of the inflation tax. The best class of assets appreciates faster than inflation rate.
Only savers are losers. But only those savers who don't invest their savings.
In summary, the best way to avoid this tax is to keep as less money, as possible. Any savings beside emergency monies should be invested.
The history of inflation (1774-2008)
Data acquired from MeasuringWorth.org.
Fig 1. Consumer Price Index (CPI).
Except for the last half of the 20th century, the prices seem to be quite stable, as any period of inflation was countered by a period of deflation. It seems that any loss of purchasing power was recovered in deflationary periods, and any net inflation to be very small. In fact, the loss of purchasing power in the 19th century is not small.
Fig 2. Inflation rate. Year over year changes in prices.
As can be seen on the chart above, up until the end of Civil War, the prices were swinging wildly between hyperinflation and deflation. That was a bad environment for business. It's possible that the only source of US prosperity of those times was slavery and exploitation of workers. For the most part of the 19th century, the country was in mild deflation with just several periods of high inflation. During such inflationary periods the purchasing power of money declined significantly, to be later only partly recovered by deflation. However, before money regained it's previous purchasing power, the next inflation hit.
It is true however, that despite moderate inflation in the last 50 years or so, the rate of loss in purchasing power of money is at the highest.
Fig 3. Loss of purchasing power - logarithmic scale ($100 in 1774 is equivalent of $1.26 in 2008).
Notable events:
| Event | Inflationary period | Years | Inflation |
|---|---|---|---|
| American Revolutionary War (1775-1783) | 1776-1778 | 3 | 81% |
| War of 1812 - U.S. vs British Empire (1812-1815) | 1811-1814 | 4 | 34% |
| American Civil War (1861-1865) | 1861-1865 | 5 | 96% |
| The World War I (1914-1918) | 1914-1920 | 7 | 109% |
| The World War II (1941-1945) | 1941-1948 | 8 | 72% |
| 1970s stagflation (1973-1982)* | 1973-1982 | 10 | 131% |
* Usually hyperinflation in the past was caused by war spending. But the 1970s stagflation (simultaneous inflation and economic stagnation) cannot be attributed to war spending (Vietnam War). It was not caused by dollar devaluation either. The high inflation hit after the war and two years after the end of gold standard, and exactly after the first oil crisis (1973). The real GDP per capita was declining for two years 1974 and 1975, accompanied by double-digit inflation in 1974 only. Inflation rate dropped to 5.75% in 1976, just to hit double-digit again in 1979 and last through 1981 (second oil crisis).
The 1970s timeline:
- Detachment of the dollar from the gold standard (August 1971)
- Smithsonian Agreement (December 1971) - dollar devaluation
- End of U.S. involvement in Vietnam War (January 1973)
- 90-day freeze on wages, prices and rent (June 1973)
- Oil price shock (October 1973)
- Stock market crash (January 1973 - December 1974)
- Watergate scandal (August 1974)
- 1979 Oil crisis (1979-1981)
- Iran hostage crisis (November 1979 - January 1980)
Conclusions
Many people blame the central bank (the Fed) for playing with the money supply, and thus causing inflation, business cycles, recessions, and what not. In reality, any increase or decrease in the money supply is made by people increasing or decreasing lending, borrowing and spending. The Fed may only encourage or discourage banks and people to lend and/or borrow money. If people respond too slowly to Fed's stimulus, then it must be done by increasing/decreasing government debt and government spending. The government acts as a lender, borrower, employer and spender of last resort. The Fed may only smooth out the business cycles. The most dangerous is hyperinflation and deflation, which can destroy economic stability and cause high unemployment. Because moderate inflation typically accompanies economic growth, most economists agree, that moderate inflation is the most healthy for the economy. Because the Fed's main task is to keep the unemployment as low as possible, the Fed must maintain the inflation rate at a low level, normally to a target rate around 2% to 6% per year. That's why we all should expect moderate inflation in any foreseeable future.
No one likes inflation. And that's the point. Inflation is forcing us all to invest our savings and seek ways not to lose the purchasing power of our hard earned money. Inflation is forcing us to work. Because we, human beings, are all naturally lazy, we don't like it. We're being bombarded by media with news about high government spending and the impending hyperinflation. And yet, for the last 30 years or so, we enjoyed quite low inflation. Even currently (2009), we all hear about government bailouts, war spending, government spending spinning out of control, increasing national debt, etc. But due to deleveraging by corporations, and falling home prices causing people to borrow less than usually, the danger of deflation is currently higher than hyperinflation. Almost everyday, we hear about printing trillions of dollars for bailouts. By not being able to compare those huge numbers to anything known to us, we are in a deep fear. For example: 3 trillions of dollars in bailouts added to the economy in the next 3 years, compared to the size of economy (the current GDP is about $14 trillion), will produce a mere 5% inflation. And this may not even be enough to counter the deflationary pressure. What is more, the Fed and the Treasury is buying so-called "toxic" assets at disstressed prices. Since the WWII, several times the government did buy stock of private corporations on the verge of bankruptcy, just to sell that stock several years later at a huge profit. Do you remember the "buy low, sell high" rule? But the government doesn't act as an ordinary investor either. It has the power to make failing companies to return to profitability, for example: by changing the law. It's like insider trading. So, you can trust the Fed and the government. Apparently, they know what they're doing, after all.
Final advice
In the book Intellingent Investor, Benjamin Graham wrote: The Rule #1: Never lose money. The Rule #2: Never forget the rule #1. He didn't elaborate on it this way, but most probably what he meant, is that you're going to lose money or it's purchasing power, if you do not invest. By hoarding money, we lose due to inflation. By keeping inflation-proof assets, we lose due to taxes on gains produced by inflation. So, it's not the question whether to invest or not. The question is: What investment vehicle will lose the least? Making money from investing is of secondary importance.
Most personal belongings and assets of type: car, boat, motorbike, camper. These assets depreciate in value even when not used, they cannot be used for an investment. Buy them only to enjoy your wealth.
Hard assets: house, gold, silver, jewelry, wine and collectibles. In most cases, these assets only keep pace with inflation. What's more, one has to pay capital gain tax on the inflation gain. Keep in mind, that the first $250K of capital gain on sale of primary residence is exempt from taxes. Due to the maintenance and storage expenses, these assets have negative cashflow. As if it was not enough, the future value of such asset is unknown. Things to remember:
- buy a house for it's utility value (cash savings vs rent price)
- buy precious metals, when their current market price is close to, or lower than the mining costs
- buy jewelry, wine and collectibles to enjoy them
Bonds and CDs also only keep pace with inflation. The interest is taxed, so very often these assets lose to inflation too. But bonds lose less than cash. Invest in bonds to keep your wealth while you're searching for investment opportunities. These are good vehicles to keep your emergency funds.
Stocks is the only investment vehicle that can appreciate faster than inflation. These are active assets. It can be a stock of a private small business or a big publicly listed corporation. The most preferable is the stock of your own small business, because you may also enjoy company perks and use pre-tax money for business expenses. Do not invest in stock of any big public corporations unless you really know what is management doing. Think about it this way: the company assets don't work, it's the people that really counts. So, you're investing in people. The most important people in company is management. Do you really trust the management with your hard earned money?
Do what you should always be doing. Work and earn money, save at least 10%, and invest your savings. Stop worrying about inflation, economy, etc. Let economists and politicians worry about that. Just keep in mind, that about 5% inflation will always be present, and focus on searching for investments to avoid it.
Useful links:
- Forecast-Chart.com: US Inflation Rate Forecast
- MeasuringWorth.org: The Annual Consumer Price Index for the United States, 1774-2008
- BLS.gov: Bureau of Labor Statistics - Consumer Price Index
- BLS.gov: The Consumer Price Index—Why the Published Averages Don't Always Match An Individual's Inflation Experience
- FinancialSense.com: The Core Rate