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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Goldsmiths, Gold Standard, Fractional Reserve Banking, Sherman Silver Purchase Act, Panics of 1893 & 1907 and the Federal Reserve System

Posted by PITHOCRATES - January 24th, 2012

History 101

Goldsmiths Encouraged others to Store their Precious Metals with them by Paying Interest on their Deposits

Goldsmiths were some of our first banks.  Because they worked with gold.  And needed a safe place to lock it up.  To prevent thieves from getting their gold.  Other people who had precious metals (gold and silver) also needed a safe place to put their precious metals.  And what better place was there than a goldsmith?  For a goldsmith knew a thing or two about securing precious metals.

People used gold and silver for money.  But they didn’t like carrying it around.  Because carrying a heavy pouch of gold and silver was just an invitation for thieves.  So they took their gold and silver to the goldsmith.  The goldsmith locked it up for a small fee.  And gave the person a receipt for his or her gold or silver.  Which became paper currency.  Backed by precious metal.  The first ‘gold’ standard.  These receipts could be inconspicuously tucked away and hidden from the prying eyes of thieves.  They were light, convenient and a nice temporary storage of value.  Sellers would accept these receipts as money because they could take these receipts to the goldsmith and exchange them for the precious metal held in the goldsmith’s depository.

As these receipts circulated as money the goldsmith noted that more and more gold and silver accumulated in his depository.  Few holders of his receipts were exchanging them for the deposited gold and silver.  The precious metal just sat there.  Doing nothing.  And earning nothing.  Which gave these early ‘bankers’ an idea.  They would invest some of these deposits and have them earn something.  Leaving just a little on hand in their depositories for the occasional few who came in and exchanged their receipts for the precious metals they represented.  It was a novel idea.  And a profitable one.  Soon storage fees became interest payments.  As goldsmiths encouraged others to store their precious metals with them by paying them interest on their deposits.

The Panic of 1893 was the Worst Depression until the Great Depression

But there were risks.  Because they only kept a small fraction of their deposits in the bank.  Which could prove to be quite a problem if a lot of borrowers asked for their money back at the same time.  It’s happened.  And when it did it wasn’t pretty.  Because all borrowers eventually get wind of trouble.  And they know about that limited amount of money actually in the bank.  So when there is trouble in the air they run to the bank.  To withdraw their deposits while the bank still has money to withdraw.  What we call a run on the bank.  Which often precedes a bank failure.  Hence the run.

In 1890 U.S. farmers were using technology to over produce.  And some miners discovered some rich silver veins.  Making farm crops and silver plentiful.  A little too plentiful.  The price of silver fell below the cost of mining it.  And farm prices fell.  Making it difficult for farmers to service their debt.  They wanted some inflation.  To be able to pay off their past debt with cheaper dollars.  And all that silver could make that happen.  With the help of friends in Congress.  And the Sherman Silver Purchase Act.  Which required the U.S. government to buy a lot of that silver.  And issue notes backed in that silver.  Notes that could be exchanged for silver.  As well as gold.  A big mistake as it turned out.  Because silver was flooding the market.  While gold wasn’t.  Investors clearly understood this.  They took those new notes and exchanged them for gold.  Depleting U.S. gold reserves.

While this was happening there was a railroad boom.  They were building new railroads everywhere.  Financed by excessive borrowing.  In hopes to reap great profits from those new lines.  Lines as it turned out that could never pay for themselves.  Railroads failed.  Which meant they could not repay those great debts.  Which caused a lot of bank failures.  As this was happening people ran to their banks to withdraw their money while the banks still had money to withdraw.  Which only made the banking crisis worse.  Coupled with the depletion of U.S. gold reserves this shook the very foundation of the U.S. banking system.  And launched the Panic of 1893.  The worst depression until the Great Depression.

The Federal Reserve System did not work as well as J.P. Morgan

But this wasn’t the last crisis.  As soon as 1907 there was another one.  Involving another metal.  This time copper.  Not a metal backing the U.S. dollar.  But a metal that precipitated another rash of bank runs.  Including the downfall of the Knickerbocker Trust Company.  A New York financial powerhouse.   Instigated by someone who borrowed heavily to corner the market in copper.  Who failed.  Forcing his creditors to eat his massive loans.  Thus precipitating the aforementioned bank runs.

The bank runs of 1893 and 1907 were caused by liquidity crises as depositors pulled out more money than these banks had on hand.  That risk of fractional reserve banking.  At the time of these crises there was no central bank to step in and restore liquidity.  So a rich guy did.  J.P. Morgan.  Who on more than one occasion stepped in and used his wealth and influence to save the U.S. banking system.  The last crisis, the Panic of 1907, would be the last time for Morgan.  Who said another one would ruin him.  And the United States.

Shortly thereafter Congress passed the Federal Reserve Act in 1913.  Creating the American central bank.  The Federal Reserve System.  To prevent further bank runs by being the lender of last resort during future liquidity crises.  Which did not work as well as J.P. Morgan.  For the worst banking crisis of all time happened during the Great Depression.  Which followed the creation of the Federal Reserve System.  And just goes to show you that a smart rich guy is better than a bunch of government bureaucrats.

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