When it comes to money and economy and becoming wealthy, It seems most of the people have a vague idea about how economy system works. They only look at interest rate in the dollar amount that they have to pay back, which is actually right, but they really don’t have any idea how the government steals their wealth by injecting inflation into the system.
In this post I want to explain what inflation is and how it works in very simple way so everybody with any amount of knowledge understands it and uses it in his/her advantage.
A little on history of inflation
in the old days, before we have Federal reserve (FED) or any central banks, the price of the goods and services was determined by the supply and demand in the market. Though in short periods of time, kings used to tax people to finance wars, but for most of the times, the price of goods were stable. In the old Roman Empire or The Great Empire of Persia, if you had a gold coin, you could buy a good shirt, a good pair of pants, a good pair of shoes and food for one day. Surprisingly, this equation has not changed through all these centuries of human evolution. In today’s economy of consumption, with a gold coin, you can still buy a good shirt, a good pair of pants, a good pair of shoes and food for one day. Amasing! huh?
Now, let’s see what happened to economy and why conditions are not the same for ordinary people. As you may know, the prices of goods are not the same over time in the new type of economy that we have today. To explain this, we must answer some questions, why do we have inflation? Is inflation good? and why is this should be important for you?
Why Do We Have Inflation?
To start this discuion, I would like to ask whether you like to buy your groceries today for $100 or the exact same basket of goods tomorrow for $103? What would you do? Well. most likely you would like to buy the goods today. I would do the same, Let’s buy it cheap!
Inflation works in the same way. The prices of goods, companies, stock shares and everything increases over time, though not quite as fast. The government and central banks ( FED in USA and RBA in Australia) in every quarter of the year decide on the interest rate. If they decide on higher interest rate, they actually inflate the economy a little bit more than yesterday and if they decrease interest rate, the deflate the economy. But in general, The Governments like a little inflation in the economy. There are three reasons for this. Let’s see this through the eyes of the governments.
Three Reasons Why Governments Like a Little Inflation
The first reason is that you consume more, and as a result, you purchases start generating employment and wealth in the society. You might wait longer than one day, buy that basket of goods will be $103 in the near future. The central banks do this by increasing the amount of dollars in the society (generally, printing money). They keep adding more and more dollars to the system everyday so the prices of goods keep going up over time.
An important point to understand this is the difference between nominal dollars and real dollars. Nominal dollars do not account for inflation but real dollars do. So in you grandfather says he earned $1 an hour in 1913, he’s actually earned $1 nominal dollar. The equivalent of that $1 is about $24 real dollars (today dollars).
The second reason is that you are being taxed on nominal dollars. If you have bought a house for $100,000 and inflation is 2%, the price of that house in the next year is $102,000. The value of the house is the same, because nothing has been added to the house. but you are being taxed on the nominal dollars so because of the inflation you have to pay $102,000 to buy the same house today. This is how inflation taxes you in a very hidden way. The price of goods go up whereas the value of the goods don’t change. You have to pay more money for the same good that hasn’t been changed. If you look at it other way, It seems that your dollars have less purchasing power than last year, because you have to pay more to get the same thing. In othe words, you can sell your house (asset) in higher price but you you won’t be able to buy more with that money. You have actually a little less since you need to pay tax on that appreciation!
The third reason that government likes a little inflation is that debt is measured in nominal terms. Almost all the governments of the world have a lot of debt. This enormous debt is easier to pay back over time because the money supply increases and the value of the dollar decreases. They have to pay less in weaker dollars the money that they borrowed in stronger dollars with higher purchasing power.
Governments like inflation but it’s not good for you as an investor. It’s a drag that you must conquer. You must make more money to pay that inflation (tax) and make profit as well. So, the prices go even higher and higher every day.
The Problem Of Inflation
Too much inflation brings uncertainty to the market. You lose your trust in the dollar or actually in its purchasing power. When you know that you must pay more dollars tomorrow for the things you want to buy, you want to buy it as fast as possible today before your dollars lose their power, right? So you don’t save money and spend all you have as son as you get it. This hurts you and economy.
What is money? Money is what we agree upon in society. The real money is only Gold and Silver. The paper money or fiat currency is the receipt of the gold or silver that central banks and governments are supposed to have in their vaults. We use these receipts instead of the real money because we agreed to do this. A soon as we lose that agreement, those receipts lose their value. If we know that there is no gold and silver as the back up for the dollars that we use, we don’t trust them and dollars lose their value. To stop that, government and central banks must print (produce nowadays because everything is electronic) more and more to compensate that lost power. Now you know why money printing without the actual back up hurts the economy. It seems you have a receipt for something that doesn’t exist. You won’t trust it anymore, right?