Inflation and the Erosion of Savings

Posted by PITHOCRATES - February 4th, 2013

Economics 101

Some of the First Banknotes were Gold Receipts Redeemable for Gold on Deposit in a Goldsmith’s Safe

Money has a few important attributes.  It has to be portable so we can carry it to the store.  It has to be durable so we can use it and carry it without it wearing out.  It has to be divisible so we can buy things at a variety of prices and make change.  It has to be fungible so one $20 bill is the same as any other $20 bill.  And it has to be scarce.  Because above all else money has to store value.  For money is a temporary storage of value.  Which is why we don’t use garbage for money.  Because garbage isn’t scarce.  Nor is it portable, durable or fungible.  And it smells bad.  No one wants it.  And no one will take it in payment for anything.

Precious metals make good money.  They have all of the necessary attributes money should have.  Especially gold.  Which will last forever.  And it will never rust or lose its sheen.  And above all it is scarce.  No one can make gold.  It takes enormous costs to find it, mine it and process it.  So it’s not easy to make it NOT scarce.  Which means it will hold its value.  The only drawback to gold is that it’s not that portable.  It’s pretty heavy to carry around.  And a little dangerous.  As you can’t hide a large and heavy pouch full of gold very well.

So some people started thinking.  Who else has a lot of gold?  And needs to put it in a safe place where others can’t help themselves to it?  A goldsmith.  Who has a large safe they lock their gold in.  So, for a fee, the goldsmith would lock up other people’s gold in his safe.  And give them a paper receipt for the gold on deposit.  And the banknote was born.  People left their gold in the safe.  And used their gold receipts as money.  Paper currency.  Which were fully redeemable for the gold on deposit in the goldsmith’s safe.

The more we Increase the Money Supply the more we Depreciate the Currency and reduce Purchasing Power

Issuing banknotes for gold on deposit evolved into the gold standard.  Where we used paper currency that represented the gold on deposit.  And it was just as good as that gold.  Sharing all the same attributes.  Portable, durable and fungible.  As well as scarce.  If, that is, the amount of paper in circulation equals the amount of gold on deposit.  If so then the paper is as scarce as gold.  And as valuable.  So people will be willing to hold onto it.  Just as they are willing to hold onto the gold.  Because the paper currency is redeemable for the gold on deposit.

But as governments spent money they started to think.  They could spend more money if they just printed more.  And increase the amount of money in circulation beyond the amount of gold on deposit.  Allowing governments to spend more.  And they did.  But it made paper money less scarce.  And less valuable.  We can see how with the following table.  We start with $100 of gold on deposit.  And $100 of paper banknotes in circulation.  Then each year we increase the number of banknotes in circulation (the money supply) by 3% while the amount of gold on deposit remains the same.  Representing a 3% annual inflation rate.  ‘MSB’ stands for Money Supply at the Beginning of the year.  ‘New’ stands for the New money added to the money supply that year.  ‘MSE’ stands for Money Supply at the End of the year.  ‘100/MSE’ is the result of dividing the $100 of gold on deposit by the money supply at the end of the year.  And ‘Savings’ stands for the purchasing power of $750,000 in retirement savings after being adjusted for inflation ($750,000 X 100/MSE).

Inflation on Savings 3 Percent

When 100/MSE equals 1 the amount of banknotes in circulation equals the amount of gold on deposit.  Which means those banknotes are as good as gold.  For you can redeem every last one of them for that gold on deposit.  But when they start printing more banknotes the money supply grows greater than the gold on deposit that backs it.  Making each dollar worth less.  Depreciating the currency.  For the total amount of currency in circulation still equals the $100 of gold on deposit.  The more we increase the money supply the more we depreciate the currency.  Reducing the purchasing power of the currency in circulation.  Which erodes away the value of retirement savings over time.

High Inflation Rates greatly Discourage Savings and Encouraging Consumption

This was at a 3% annual inflation rate.  Which is something you may find in the United States or Britain.  Some countries, though, really inflate their currency.  Especially nations that have abandoned the gold standard.  Which removed all restraint from printing money.  The following table shows what happens to that retirement savings at a 25% annual inflation rate.

Inflation on Savings 25 Percent

Even though there is no longer an exchange mechanism between gold and dollars to keep the monetary authorities responsible they are still supposed to exercise restraint.  As if there was still a gold standard.  Because whether there is gold or not a massive inflation of the money supply still depreciates the currency.  And the greater the inflation the greater it erodes that retirement savings.  At this rate a person’s retirement savings loses over half of its value in 4 years.  It loses 74% of its value in 6 years.  And loses 89% in 10 years.  Greatly discouraging savings.  And encouraging consumption.  Graphing these results we get savings curves for these different inflation rates.

How Inflation Erodes Savings

Note that the higher the inflation rate the steeper the curve.  And the steeper the curve the faster your retirement savings lose their purchasing power.  Here you can see why people living in countries with high inflation rates don’t want to hold onto their currency.  They try to spend it as soon as they get it.  Buying things that hold their value.  Or exchanging it for a stronger currency.  Like U.S. dollars.  British pounds.  Or Eurozone euros.  Anything to avoid their wealth eroding inflation.


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