Economic Flame Wars
I don’t like inflation. I think it’s one of the most harmful things to personal responsibility.
Forty years ago in 1969, if you had earned $1 from working hard, you could have gone out and bought $1 worth of goods or services. Or, if you were prudent and decided to save it until you retired in 2009, you could go out and spend that same $1 to buy 17 cents worth of goods! (There are many measures of inflation. This is based on the Consumer Price Index (CPI) which is the most commonly used and the most relevant to the example.)
Inflation is Difficult to Understand
Inflation is a difficult topic to understand for many people, because the nominal value of the money doesn’t change. That $1 doesn’t turn into a dime and 7 pennies. It’s still a dollar bill after 40 years.
The easiest way to understand it is to think that you could buy the same amount of goods with $1 in 1969 as you can with $5.87 in 2009. So if you think of things that you can buy today with $5.87 (e.g., a sandwich from Subway), you could buy those same things in 1969 with only $1 (this assumes the value of the good hasn’t changed over those 40 years; you get the point, though).
Personal Responsibility
It’s hard to save $1 today, knowing that when I want to retire in 40 years that $1 will only be worth 17 cents. The great things we do to invest our money and make it grow are partially a way to escape the the government-induced devaluation of our money. In fact, low-yielding investments like deposits in normal savings accounts usually earn interest at a rate below inflation! That means, the numbers in your account may increase, but your investment is guaranteed to lose real value (meaning you are guaranteed to be able to buy fewer goods with your money after the investment than before the investment).
For people who understand this, they realize that they must take on risk in order to avoid devaluation of their savings. They must invest in vehicles that have a chance at outpacing inflation, like stocks and bonds. Investing in these things is not bad; in fact, it is good. But as any financial planner will tell you, the key is proper diversification not only across stocks but across your entire portfolio of asset types. Meaning, you should have a certain percentage in cash (savings or money market account), a certain percentage in bonds, a certain percentage in stocks, etc. The key point here is that people who understand inflation will adjust those percentages for riskier investments upward, beyond where they would have decided was optimal without inflation.
Not Everyone Agrees
I recently got into a bit of an economics argument with someone on Slashdot, because that’s what I do instead of watching the idiot tube. He, as do many modern politicians, believes that monetary inflation is necessary (even though it wasn’t possible before the dollar left the gold standard).
Let us break down the ill logic.
$10 BOY deposit$9 = $10 * (1.0 – 0.10) => value of $10 after one year with -10% change in price level (deflation).
He has already screwed up. You have to realize he is talking in real terms, not nominal terms. In other words, he is stating $9 as the inflation-adjusted value of $10 after one year. But he says that a deflation of 10% (which is ridiculously high, by the way) causes $10 to be worth only $9, a 10% drop in purchasing power. This is exactly what inflation of 10% would do, not deflation. If prices all around you have fallen by 10%, then your $10 can suddenly buy more. The inflation-adjusted value of $10 after 10% deflation is $11.
$1 = $10 – $9 => nominal loss in value.
That is not a nominal loss in value. There is no nominal loss. That would be a real loss (here is a Wikipedia article explaining the difference). But, as I explained above, he’s not even correct about there being any loss, nominal or real! There is no nominal change, but there is a real increase in value of $1, because the saver can now buy what used to cost $11 last year with only $10.
We’re only 3 lines into his math and he already has 2 serious problems.
-9% => the bank’s advertised APR.
As we’ll see later, he us using a negative interest rate of 9%, based on his previous faulty math.
$9.10 = $10 * (1.0 + -0.09) => EOY nominal value, what’s in your account.11% = $9.10 / $9.00 => your real return.
Simplifying somewhat, a real return Nominal – Inflation. If inflation is 4% and nominal interest is 7%, the real return is 3%. If inflation is -4%, and nominal 7%, the real return is 11%. To get a real return of 3% when inflation is -4%, nominal is -1% (because 3% = -1% + -4%).
That’s the math: the bank pays you a premium over the prevailing changes in the price level — a real return — in exchange for your money. The problem is that you, as the holder of the original $10 in my example, are better off not depositing your money. If you accept the bank’s deal, you’re left with $9.10. If you ignore the bank, you’re left with $10. And $10 beats $9.10 any day of the week, come inflation or deflation. Most people figure that out pretty soon when faced with the prospect, and banks quickly become unable to attract deposits. Etc., etc.
This is utter silliness. The first problem with his argument is that no bank offers an interest rate of 7%. The real return on most savings account is negative. According to his argument, no one would ever deposit their money into a bank account because the inflation-adjusted return is negative.
He is attempting to say that banks would need to offer an interest rate of -9% in order to give a small premium (1%) over deflation. Again, though, he is screwing up his understanding of deflation completely. Deflation increases the value of money, not decreases it. In order to offer a small premium over deflation, all you’d have to do is offer an interest rate of 1%. So if deflation is 10%, then the real value a dollar stuck under one’s mattress is $1.10 after 1 year, and the real value of a dollar stuck in a savings account at 1% is $1.111 ($1 x 1% savings account interest x 10% deflation).
This isn’t rocket surgery. The inflation/deflation situation is largely independent of interest rates. The bank must compensate depositors for use of their money by providing an interest rate. Meanwhile, inflation and deflation will occur on an economy-wide level regardless. Depositing your money in a bank account does not magically remove it from the effects of deflation (or inflation).
The truth is, more money would flow into the banking system in a deflationary scenario, because depositors know they could spend their $10 today for $10 worth of goods, or wait a year and be able to buy $11 worth of goods. And this is the true (indirect) impact on interest rates. Since there is so much more deposited into banks, banks need to compete less to get the capital they need, so interest rates will fall (but that’s okay).
Real Deflation Happens Anyway
What is so odd about this fellow is that he is clearly a modern Keynesian, but doesn’t seem to agree with Keynes at all when it comes to the causes of inflation/deflation:
There is no such thing as real deflation from increases in efficiency. Change in the price level, inflation or deflation, is a monetary phenomenon.
Keynes believed only one factor of inflation is the money supply.
Anyway, the suggestion that there is no real deflation from increases in efficiency is just bizarre. The easiest way to debunk this nonsense is to transform prices from dollars to hours worked. In other words, a loaf of bread costs about $2 today and perhaps 34 cents in 1969, but if there is no real inflation-adjusted price change, then the number of hours (on average) an American must work in order to buy that loaf of bread would be the same.
But that isn’t what we see. The truth is that buying a loaf of bread today requires much fewer working hours than it ever has before. This is due to two things, both if which are the same thing: we are more efficient. We are more efficient, therefore we are paid more than we used to for every hour we work. We are more efficient, therefore it costs less to produce the same loaf of bread. The important part is the last part. Costs to produce the same goods decrease due to efficiency. That should cause prices to fall, or deflate, at a steady, gradual rate. But it’s hard to see this real inflation-adjusted price deflation because the money supply is manipulated in such a way that nominal prices continue to increase.
In other words, the numbers quoted by our government for inflation are misleading. If we have 5% price inflation due to monetary policy, we think that means that we “should” have been able to buy $1 worth of stuff for $1, but inflation requires us to spend $1.05 in today’s dollars for $1 worth (in last year’s dollars) of stuff. But that assumes that there would have been no price change without the monetary disturbance, and we know in a healthy, competitive, capitalist economy, prices should gradually deflate. So the comparison for inflation is not a price change of zero, it’s something negative. If, without monetary manipulation, prices would have deflated by 5%, then a 5% reported inflation is actually a total inflation of 10% (+5% inflation to counteract the would-be -5% deflation to bring the change to 0, and then 5% on top of that to bring the year-over-year change to +5%)!
I don’t claim to be an expert in economics, by any means. But even rather intelligent people on Slashdot (where your average joe has above-average intelligence, to begin with) can’t even keep inflation and deflation straight in their heads. How can we expect the general public to understand this? Meanwhile, their wealth is being eroded because money, which is supposed to store value in a constant manner, continually decreases in value due to the government’s monetary policy. The American people may not understand this phenomenon, but they nevertheless feel the effects of it when they’re trying to figure out whether they can retire.
