What Causes Inflation And Why Should You Care?
Central Banks Are The Enemy To Your Wealth
Key Ideas
- Discover the shocking effect inflation has on your savings.
- Why Central Banks are the enemy of your wealth.
- The enormous consequences inflation has on financial planning.
According to the book This Time is Different: Eight Centuries of Financial Folly
, the median inflation rate for various periods in history is as follows:
| Time Period | Median Inflation Rate |
| 1500-1799 | 0.5% (half of one percent) |
| 1800-1913 | 0.71% (three quarters of one percent) |
| 1914-2006 | 5% (five percent) |
Look carefully – these are amazing statistics! For the first 400 years of our economic history, inflation was benign at under one percent. Then suddenly, in the last 100 years, it jumped dramatically.
Many people may not think a 5 or 10 fold jump in inflation is a big deal as the number is still relatively small at 5 percent.
However, that difference compounded over nearly 100 years was enough to destroy the purchasing power of the money you carry in your pocket by over 90% – not just once, but twice – in the last 100 years.
That's a VERY BIG DEAL! (Yes, I'm shouting, and I rarely do that!)
It's a super huge, really big deal!!!
Inflation Changes Your Life… For The Worse
Think about it for a moment. Every dollar held in 1914 is currently worth only a few pennies.
Just imagine what would happen if you retired in 1914 and were still trying to live off your savings today. (I know nobody lives 100 years in retirement, but you get the point.)
Some readers may try and argue with the stats above, claiming inflation has been closer to 3% since 1914, or try and shave hairs off the stats prior to 1914.
Save your breath – it's not relevant to this discussion. My point is inflation was benign prior to 1914 and escalated dramatically after 1914. No manipulation of the statistics is going to change that point.
If you save, invest and, build your wealth, then inflation is your number one enemy. It dramatically affects how much money you need to retire, how much you need to save for your kids' education, and how to invest your savings.
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In short, it effects every major financial decision you'll make. Again, it's a very big deal. And the inflation problem grew dramatically after 1914.
There was a sudden and abrupt change — but what caused inflation to behave in this way? What occurred beginning around 1914 that would instantly change 400 years of relative monetary stability?
Simple – the Federal Reserve Bank was established.
As Milton Friedman once said,
“Inflation is always and everywhere a monetary phenomenon.”
And who controls monetary policy? The Fed (or to be a little less U.S. centric – the central bank).
(Brief sidenote: another great saying is that inflation is a monetary phenomenon, but hyper-inflation is a political phenomenon. I agree, and that's why it's so important to keep a strong boundary between the Fed and Congress. Allowing the administration and Congress to encroach on central bank independence any more than already exists would be an extremely dangerous precedent and something to worry about.)
Getting back to my main point, why should you care that inflation has jumped dramatically since the Federal Reserve came into existence?
Because inflation is how the government taxes savings, and my readers are savers and wealth builders, so you should care.
It makes every dollar you've acquired worth less.
The government doesn't have the political will to directly tax wealth; it does it in an underhanded way by destroying the value of the currency the wealth is priced in.
They spend money that isn't theirs, thus destroying your money.
Always remember, the goal isn't just nominal wealth, but real wealth (inflation adjusted wealth).
It's not how many dollars you have, but what those dollars purchase that matters.
Unfortunately, the Federal Reserve maintains policies that destroy the purchasing power of your dollars over time. They're the enemy of your wealth.
Related: 5 Financial Planning Mistakes That Cost You Big-Time (and what to do instead!) Explained in 5 Free Video Lessons
Let me be ruthlessly clear: the government literally steals your savings through a monetary policy that allows them to spend what they don't have, thus causing a high rate of inflation.
The henchman for this financial bludgeoning is the Federal Reserve (central bank). Don't take my word for it – just look at the statistics. Judge by results – often harsh, always fair.
You don't need to get caught up in all the details of esoteric economic theory – just look at the results.
Before the Federal Reserve existed, inflation was mild. After the Federal Reserve was established, inflation went wild (maybe that's a little dramatic, but you get the point – it grew by multiples).
The gold standard existed both before and after inflation accelerated, so that wasn't the cause.
It's a monetary phenomenon, and the central bank is responsible.
How Inflation Changes Everything…
The whole inflation reality is so ingrained in the American psyche, we hardly even notice it. Like the frog comfortably lounging in water slowly brought to a boil until he finally dies, Americans have watched the value of their currency erode with such consistency it feels almost natural.
But now things are starting to get uncomfortable. People are taking notice – something doesn't seem right in the world of banking, and of course, the key player in the middle of it all is the Federal Reserve.
I recently had an experience that woke me up to how ingrained the inflation assumption is in my own thinking.
I asked myself a simple question: “How would my life be different if every dollar I had today was still worth a dollar when I'm 90 years old, and worth a dollar when my grandchildren are 90 years old?”
I was stunned by my response! It would change everything (financially speaking).
Inflation and an unstable currency cause most of the financial uncertainty, volatility, and risk I currently must plan for.
- Financial planning could be so much simpler. Just imagine calculating the amount of money you need to retire without having to compensate for inflation's destructive power over a 50 year time frame.
- Imagine investing without having to speculate in an effort to grow capital faster than inflation destroys it.
In short, a stable currency and non-inflationary environment would change almost all aspects of financial planning.
It's that big of a deal. It's shockingly huge.
Try it yourself, you might just be amazed. Really, don't just gloss over this. Try it right now.
Close your eyes and imagine a world where the dollar you have today would still be worth a dollar 200 years from now.
The purchasing power of your savings doesn't decline with time, but holds constant instead.
Now consider how all your financial planning is affected by that reality.
You'll be amazed at how much easier your financial life would be than it is right now.
Thanks a lot, Federal Reserve!
Thanks for the uncertainty and difficulty you cause through a monetary policy that results in inflation.
Thanks for methodically stealing my savings.
And please share your comments below. How does the reality of inflation affect your thinking? How would your life be different if we returned to monetary stability?
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What are your thoughts RE investing in multi-unit rental properties now (before hyper-inflation kicks in)?
@Steve – I’m a huge fan of the strategy you discuss, but timing is everything. Let me explain…
I sold all my investment real estate by the end of 2006 partially as a risk management strategy in anticipation of the current decline. As of this writing I still believe we are in the very late stages of a bear market rally with much more to come on the downside before this deflationary process is complete. I could be wrong, but that is my best take as of right now.
Because a real estate strategy designed to capitalize on inflation requires some reasonable financial leverage (real estate price growth tends to lag inflation but with leverage can produce wealth growth in real terms) it means the risk of being too early can be devastating.
My personal choice is I would rather risk being late than being early. The evidence I see indicates the risk for real estate remains to the downside for another year or two.
With that said, I believe if there is another serious decline ahead as expected then valuations may drop to a point that it makes sense to begin shopping and not try to pick an exact bottom like everyone else will be trying to do. Deals will be done that make no economic sense and defy traditional valuation models due to bank liquidations, etc. Locking down a few carefully chosen deals that provide extreme positive cashflow will probably provide enough margin of safety (infinite holding period due to positive cashflow)to justify the risk of waiting through any continued downside for the eventual inflationary upturn on the backside of all this.
The other reason to be cautious about trying to find an exact bottom using this strategy is that a low interest, long term, fully amortizing, fixed rate mortgage is essential to this strategy working. The mortgage is an asset in this strategy as much as the property because it is effectively your short position on the dollar. No other type of mortgage will work, and without the mortgage the strategy doesn’t work.
Anyways, good mortgages may (almost for sure) be hard to find near the exact bottom. The studies I’ve seen show you are better off being early with a good mortgage than on time without – that is how important it is to this strategy.
In summary, I believe you are on track with your thinking but you will have to be very careful. There will be a sweet spot to do this – too early and you will get your head chopped off and too late may not work at all.
My two cents worth…
I’m having a hard time seeing any inflation ahead, myself…
US consumers are over 300% in debt at the moment, which is double (give or take) what they were towards the end of 1929 (it then sprung to around 300% before the climax of the great depression).
If Japan is any indicator, the road ahead is no growth, the printing press running full throttle for as long as it takes to put all of the consumer debt on the government’s balance sheet, and not the slightest hint of inflation in the meanwhile. If the government loses its credit card, we could either get mass-inflation (Weimar scenario) or mass-deflation (GD 2.0 scenario) follow.
Some are calling for Bernanke to stop printing. Others (Ron Paul in particular) even call for a return to cough “sound” money (gold).
The latter seem to miss that gold is a 6,000 year old bubble. It has absolutely NO intrinsic value. There are no industrial uses for gold that haven’t an equivalent, cheaper alternative. And as was noted in a comment I read recently, a shotgun is a much better store of value in the event that the dollar goes to zero. Were it to come to being nonetheless, using a commodity such as gold as money would contract the supply of money by a scale such that massive deflation would immediately follow.
The former completely misunderstand the nature of the “money multiplier”. Steve Keen and a handful of other competent economists have highlighted such a thing is wishful thinking. A central bank does not extend M1 so banks can extend credit. Banks extend credit first, and they reach out to the central bank so it extends the M1. Ben can print all he wants as long as banks aren’t extending this money to anyone else.
Then, there are others who don’t grasp the nature of fiat money, and thus inflation/deflation. Fiat money, as currently implemented, is interest-bearing debt (as opposed to Colonial Scrip, which was just paper). Be it the dollars that the Fed prints, or money that banks print by extending loans through fractional reserve banking, it’s all debt.
Inflation/deflation occur only if the total amount of money in circulation expands/contracts. With a debt-based fiat currency, that means money and credit outstanding (some would argue minus interest); not M1. As debt defaults occur, money in circulation contracts.
Now, employment decreased by several million since last year, and walking into a strip mall on a Saturday afternoon should convince anyone that the next couple million job losses are in the pipe already. In this context, Alt-A, Option ARM, Prime mortgages, CRE. student loans, car loans, credit cards, bond markets… are in serious trouble. It’s going to be very ugly.
Currently, the policy is for the US to try to inflate, and eventually pay its debt in funny money while retaining its status as the world’s main currency. They’re trying very hard, but they won’t succeed in my opinion because of the coming defaults across the board.
An equally unlikely but probably healthier outcome, would be for OECD governments to step in and take themselves from Japan 1989 to Japan 2009 in one swift go. In other words, they’d take their respective consumer debts on their balance sheet, in full or nearly so at under 1% interest; and call for a jubilee across the board. Consumers would then have a huge increase of disposable income in spite of a large tax hike, and get back to spending. It would also be greatest moral hazard in history.
The last and most likely outcome, in my opinion, is that debt will be defaulted on across the board. That will be massively deflationary. We might even see the US default on its debt for the first time. Who knows…
So, back to Weimar or Great Depression 2.0. If the US prints the daylights out of the USD, what happens?
My hunch, and it’s of course my own opinion, is that if the US goes down the drain, the rest of the world will get gang-raped. And the USD will be the last man standing:
My two cents worth…
@ Denis – Thank you for the insightful overview of the squeeze Bernanke and Company find themselves in.
History tells me the deflation cycle is not complete until the debt bubble is liquidated to a point that asset values and debts make sense from a cash flow standpoint. We are far, far from being anywhere near that point as of now. Thus, my bets remain on continued deflation and asset liquidation resulting in AT LEAST ONE more serious leg down.
The exact sequence in which all this will transpire remains a guess. Many of your scenarios are plausible. Fortunately, for now I don’t have to know that answer in order to manage risk and investment positions.
With that said, the norm is inflation. It prevails the bulk of time under normal circumstances and is the clear objective of government as the worlds largest debtor and greatest beneficiary of inflation. I fully expect inflation on the back side of this deflation/credit bust. We just aren’t there yet.
It would be nice if these posts had a date when written. Bernanke left the fed chairmanship in Feb 2014, and real estate prices in US cities other than the top 20 have not fallen. If one followed the strategy of investing in real estate with medium leverage, say 40-50%, and being strict that the property must cash flow, one would have done well, been able to increase rents during the ensuing five years, and had the tenant paying down the mortgage. In other words, one would be in a strong position now, whether prices fall or not. Bear in mind that during the great depression 2.0, the top 20 cities crashed, but the rest of the country did not, with real estate in the hinterlands declining about 5%. If your rentals cash flow, that’s simply not a big deal.
I don’t know what Todd’s definition of deflation is, but a drop in asset prices is not deflation. Maybe liquidation of debt is his definition. With an electronic fiat currency, the liquidation of debt is unlikely to proceed very far, as we witness ten years ago. It’s probably better to position for the recovery, not the crash, since this deflation bugaboo just is not going to happen. At this writing, it appears that the fed will attempt to “get ahead” of any crash. Even though there’s likely to be hard times ahead due to the crazy financialization/manipulations, I suspect it’s several years in the future–and I’m just about as doom and gloom as they come.
Btw, we’ve been buying real estate, at least one rental per year, this whole time. We’re doing fine.
I appreciate you closing your comment by sharing your personal investment position and time-frame. I always state that you can never understand an individual’s opinion until you know how his pockets are lined.
In general, your ideas are on track, but they’re a bit “polarized” by your investment position and time-frame.
For example, you’re accurate in stating that real estate declined more in the biggest cities than it did in the “hinterlands”. That is because valuations had the highest premium and the largest run-up prior to the decline in the major cities so the mean-reversion is also the greatest when the decline arrives. However, my experience, and the experience of friends and coaching clients, was that the “hinterlands” (defined as not a major city) declined by more than the 5% you’re stating.
Another nuance is understanding that your investment time-frame of 2014-2019 is all bull market so your investment has enjoyed a favorable tailwind. I absolutely guarantee that will change.
With that said, I agree with your position that positive cash flow with modest leverage was still a relatively safe strategy, and one that I’ve advocated in my wealth planning course here, but that comes with the caveat that you must use fully amortizing, fixed-rate mortgages (not variables and not balloons) because the ability to refinance can be a serious risk during a deflationary decline.
So anyway, I generally agree with the important points you made, but I think essential details and nuance are missing causing your statement to come across a bit one-sided (aligned with the side of your investment position) than is necessarily true.
I hope that helps clarify.
In other words, I don’t disagree with you. But I don’t agree with unilateral, polarized way that it’s stated.
Hope that helps.