Monday, September 21, 2009

Serial Inflation or the cost of inflation

Everyone knows that inflation is a bad thing; deflation may be worse but neither is desirable. What central banks shoot for is price stability, so that businesses and consumers can plan accordingly to maximize their utility. However, it was Mark Twain that said “It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so.”

What do I mean? Well, inflation may be the cruelest tax but the drop in purchasing power may not be all that it is cracked up to be. See that is why people dislike inflation. It is ingrained in their head that if the dollar loses value, that their dollar purchases less goods and services. This is a bad thing, no? Here is their evidence.

Pretty rough. Since the advent of the Federal Reserve, the private bank has eroded each Americans wealth by 93.4%. The thinking described must advances a theory that American standard of living has dropped in step with the fall of the dollar. However, I don't remember seeing any HDTV, MRI machines, air conditioners during the 1913 period in my history textbooks. Not seeing these items is not direct proof per se, but until I see one I will assume they weren't prevalent, at least to the degree that they are today.

Another way of saying this would be that, the dollar is used to purchase goods and services. People provide goods and services at their job. Thus, the price level rising (the dollar's value declining) tends to net out because the inflation that drives down the purchasing power is also being inflated in the person's offered labor.

One last way of putting this is by numerical example. The CPI index states that inflation rose by 3% last year, (made up.) Last year, you received a 3% raise, so net net you are even. You have not lost purchasing power; your yearly bonus helps safeguard your standard of living.

I re-read my post and it makes sense but I wanted to add flavor and nuance to the argument. So I needed a multi-year argument to further convince you.
So I went and grabbed the Census department's median income in current (nominal) dollars and in real terms as well. I also added the BLS CPI price levels matching set of data from 1975 to 2008 year end.

So first I took a compound annual growth rate for both series, to bring about a unified number so that an apple to apple comparison could be made. To do this I took the last year of my data for each set and divided it by the initial year. I then raised it to 1 over the number of years difference, which is 1/33 years. I then subtracted by one to end up with a annual growth rate percentage. For median income it was 4.49% and for the CPI price level data it was 4.39%. What these two figures mean is that over the period between 1975 and 2008 on average, that is linearly, median income outpaced inflation (what the CPI price levels measure.) You may then draw the conclusion that standards of living have risen because income has outpaced inflation.

If you still do not believe me the Census bureau in the same data set provides the median income in real terms. From 1975 to 2008 the "real" amount of annual wealth accumulation has risen from $42,936 to $50,303. Meaning most households can purchase more than they could back in 1975, thus their standard of living has increased. (Note: I use median income because average income can be skewed by the Bill Gates-s of the world. Ever hear the quip, when Bill Gates walks into the room on average we are all billionaires?)

Though the fallacy should relieve you, inflation still does have an effect and can lower your standard of living in other ways. One is called shoe leather cost. It is the affect, where you have to change your paycheck into a store of value. That is instead of placing your paycheck into a demand deposit account, you because of your knowledge of inflation instead place your funds into a money market account. Now though you have to transfer funds back to the demand deposit account when you go to the restaurant or take the children to the amusement park. This isn't bad in the United States. However, imagine you were in Zimbabwe last year where inflation ran at 36,000%. The cost of your meal would be more the longer you ate, so I am positive that the Zimbabwe equivalent of McDonald's did brisk business last year.

Another is an effect called the menu effect, after restaurant menus. It means that businesses set prices and are reluctant to change them. Again our low inflation environment makes the effect a bit myopic but if inflation ran at a higher rate, businesses would be forced to change their "menu" more often so as to not be burned by their margin contraction as their inputs cost more while their own prices stayed the same.

Finally, there is one last way in which inflation can hurt you and it is in investing. Hypothetically, you buy a share of GM in 1971 for 100 dollars. Now almost 40 years later, after counting for splits the stock is worth 300 dollars. You would be assessed a capital gain tax on 200 dollars at a 20% rate. Here is where inflation stings. Look at the chart above. The dollar was worth 24 cents. Now it is worth 4.6 cents. It has lost almost 6 times its value. Meaning your 100 1971 dollars could buy almost 600 dollars today. So in fact your capital gain is not real, you have lost 50% of your money over the time period. Yet you are still taxed 40 dollars because taxes are assessed nominally and not indexed. Ouch!

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