I’ve been reading a lot about inflation lately and wanted to write a quick post about what inflation really is. How the government reports inflation is grossly inaccurate, so I attempt to provide a clear example of how inflation is a cause of higher prices and not the other way around.
In order to understand the effect that inflation has on prices, we need to understand three relationships:
- The relationship between an item and its value
- The relationship between supply and demand and prices
- The relationship between dollars and prices
Once these three relationships are understood the overall effect of inflation on prices will be clear.
What’s the Real Value of Something?
This is a question that is almost always left out of a discussion of inflation and prices, but it is essential to understand that there is a difference between value and price.
If there was a world without money, the value of an orange would be expressed in terms of how great it tastes, or the nutritional benefits of the vitamins it provides. In the same vein, the value of a gallon of gas would be measured in the number of miles that can be driven in your car when that gallon is poured into the tank. If that gallon of gas allows you to get to your job for a couple days, then the value would be quite high.
While the value of an orange or a gallon of gas could be different to every individual person, it is important to see that value is not based on, or even related to money. If there was no money, things still have value.
Supply and Demand and Prices
Before we get to the relationship of inflation on prices, we need to understand supply and demand.
From our example above, if there is a frost and the orange crop is damaged, the price of oranges will go up. It’s important to note that this raise in price is not inflation. It is a common misunderstanding that inflation is a result of rising prices, but this is false. Inflation can cause prices to rise, but so can many other factors — the most notable of which is supply and demand.
The way governments measure and report inflation is actually flawed for this reason. If the Consumer Price Index (CPI) goes up, as a result of the price of oranges or other products going up, then the government reports inflation, but it would be more true to say prices are increasing, and it may or may not be caused inflation.
Dollars and Prices
Finally we can look at the relationship between the cost of an item and number of dollars available in the economy. In order to create a manageable example, we’ll take our orange and imagine eating it on an island country where the sum total of all money available is only 100 dollars.
If we go back to the “value” of an orange in this economy we could express that value (which is based on the benefit derived from eating the orange) as 1/100th of the total value of all the goods available on the island. Obviously this is just an arbitrary figure, but in reality, since our money is finite, the principle is sound… everything has a price which is a reflection of its value, that can be expressed as a fraction of all the money available to spend on any possible item for sale.
Now let’s double the total amount of money available on the island, due to the island government creating a stimulus package.
Now there is a total of 200 dollars available on the island, but the value of an orange has not changed. It still has the same great taste and health benefits. Therefore still has a value, when expressed as a percentage of all available money or 1/100th.
But now there are 200 dollars so 1/100th of 200 dollars is $2. The price of an orange, due to the government stimulus package which doubled the amount of money available, has also doubled from $1 to $2.
This is the essence of inflation as a result of money supply. This should help us understand what MUST result from the government’s recent bailout package.
Money. We work for it. We buy things with it. We need it for retirement. But what is it, anyway? And what gives our money value?
When you take a second to think about it, it’s amazing that people don’t ask these questions of themselves more often. After all, the saying “money makes the world go ’round” is true — but why? Why do we work forty hours a week (or more) for these pieces of paper? And why are merchants willing to trade us real goods for them?
Gold and Silver
There was a time when a “dollar” was simply a term for a set weight in gold. Through the start of World War I, you could take your dollars to the U.S. government and convert them into gold at a rate of $20.67 per ounce. Redemptions were temporarily suspended in 1914, but later resumed. Then in 1934, the value of the dollar was changed so that one ounce of gold was worth $35. Although citizens could no longer redeem their dollars for gold, foreign governments could, all the way up until 1971.
The U.S. dollar used to also be convertible into silver. As late as 1968, dollar-bills were “silver certificates,” convertible into silver by the government. The last silver certificates were issued in 1957.
But since 1971, the U.S. dollar has been convertible into absolutely nothing. Why then do people still work for them? The answer is legal tender laws. If you look at one of your dollars, you will notice it says, “This note is legal tender for all debts, public and private.” This means that people and business have to accept U.S. dollars — by law — for any debts. And of course, the U.S. government has to accept them for taxes.
But this isn’t good enough for a lot of people. They think that the “closing of the gold window” in 1971 put a death sentence on the U.S. dollar. Without gold or silver backing, there is little to stop the government from printing more and more paper money, and if adequate goods and services are not produced to equal the expanded money supply, then there is inflation. How much inflation have we had since going off the gold standard? Well, according to the Bureau of Labor Statistics Inflation Calculator, it would take $514.45 in 2007 to equal the purchasing power of $100 in 1971.
What Does This Mean to Investors and Consumers?
There are plenty of financial analysts slightly outside of the mainstream who have been preaching the coming “Financial Armageddon” for decades. So far, they’ve been wrong, but perhaps they will be right in the end. Regardless, it is probably a smart idea to diversify out of U.S. dollars so that you’re not vulnerable to inflation or a potential collapse of the dollar.
One way to do so is to convert your U.S. dollars into gold. No, the government no longer performs conversions for you, but you can buy gold in the open market. In fact, with gold-based exchange-traded funds (ETFs), it’s never been easier.
But gold isn’t the only investment that helps diversify out of U.S. dollars. You can convert your dollars to foreign currencies, invest in stocks (which have their own inflation-protection measures) — especially foreign stocks, or buy real estate. The collapse of the U.S. dollar is probably not something that should keep you up at night, but converting your dollars into real assets is probably a wise move, regardless. After all, your dollars themselves are worthless — it’s only what you can trade them for that gives them value.
I’ve been reading through my new copy of The Single Best Investment and right there on page one the author Lowell Miller, slapped me in the face with a very important reminder.
An often overlooked, or do I dare to say purposely neglected by most conservative personal finance writers and investment advisers is inflation.
Let’s take a look at some facts about inflation from the book.
The average annual inflation rate for the past 60 years is: 4.10%
Since 1945, there have only been 2 years when inflation has been negative.
What this means for your portfolio, and probably why most investment sellers don’t talk to much about inflation is, you start off, on average 4.10% in the whole each year! That’s before you even plunk your dough into the latest under-performing mutual fund, ohand don’t forget your 2.50% MER.
How’s that 7% annual return that the fund company is paying splash all over the sports page of your newspaper looking now?
Here’s what inflation looks like in real life…you’ll see what compounding looks like in actual terms.
A middle of the line Ford car, in 1980, cost $3,500. Today, approximately 26 years later,the same vehicle would cost you $20,000. This represents a period of higher than average inflation, but even on average, at only 4% inflation, prices will double every 18 years. That is without any other influence.
Since 1945 the Consumer Price Index reports that prices have risen over 900%.
Inflation and Your Portfolio, In Real Terms
What this really means is that if you invested $3,500 in 1980, if that investment is worth $20,000 now, pat yourself on the back…you broke even!
What I liked about the author putting this into his investing book was to encourage the average retail investor, his audience, to be more honest about the context of their investments.
It is easy, just as we investors tend to talk up the winners and quietly neglect our losses, to ignore the silent force of inflation when calculating our returns or even more importantly goals such as funds needed for children’s college accounts and our retirements.
The next time you’re evaluating a fixed income investment don’t forget to take inflation into the equation…if you do you’ll see that these types of holdings, which are often sold as “low risk” are actually very risky…since when evaluated within the context of the virtually ever present monetary force of inflation that we exist with, they will almost certainly lose you money.