Following my article earlier this morning about the real inflation rate, some readers e-mailed me in disbelief that the buying power of their dollar could be eroded as fast as the example I provided. In order to make the situation clearer, I'd like to go into that in more detail.
Briefly, if you assume that your dollar has 100 cents of buying power at today's prices, the rate of inflation is one factor (but not the only one, of which more later) that will reduce that buying power over time. Let's say the inflation rate will be 5% this year. That means something that costs 100 cents today will cost $1.05 at the end of the year: or, to put it another way, if I still have only my original dollar to spend, it will buy me only 95¼ cents worth of that something in December 2019, in terms of January 2019's purchasing power. To calculate that for any amount at any inflation rate, apply this formula: 100 cents, divided by the rate of inflation for the period in question (so that a 5% inflation rate would equal 105% of current prices at the end of the year), then multiplied by 100 to give you a percentage of the original purchasing power of 100 cents. Using spreadsheet operator symbols:
Using that formula returns this spreadsheet of how various inflation rates affect the buying power of one dollar over time. I've rounded the results to the nearest cent. Click the image for a larger view.
You can see that even at a 2% inflation rate (approximately what the US government claims is the "official" rate, which - as we saw this morning - is wildly inaccurate and underestimated), your dollar will lose about a third of its purchasing power over 20 years. At a more realistic 10% (which is where I'd personally guesstimate overall US inflation to be right now), in 20 years time, your current dollar will be worth a mere 16 cents in terms of purchasing power. I've lived in a high-inflation country (South Africa) enduring decades-long double-digit inflation, and watched the purchasing power of my money eroded to a frightening extent, impoverishing the country as a whole and most of its people. Inflation is no joke. The damage it does is very real.
Nor is inflation the only factor in the buying power of your dollar. The strength (or weakness) of the dollar is a major factor when it comes to the cost of imported products. If the dollar weakens against the Chinese renmimbi, it means that every import from China costs US consumers more dollars. (Conversely, if the renmimbi weakens against the dollar, US imports of Chinese products become cheaper). Import tariffs add to the problem. If the US government imposes a tariff on imported products, that has to be added to the cost of bringing them into the country, which ends up costing US consumers more dollars to buy them.
There are other factors affecting the value of the dollar and its buying power, but I won't go into them right now, because of their complexity. Suffice it to say that the buying power of the dollar in your pocket has been steadily eroded for the past several decades, year in, year out. This calculator takes multiple factors into account when determining what inflation has done to the value of your money. Try it for yourself, and see its results. For example, it shows that $100 in 1970 dollars was worth between $498.00 to $1,820.00 in 2017 dollars, depending on the factors used to calculate its then-current buying power. To put that the other way around, a 1970 dollar lost between 80% and 94.5% of its purchasing power between that year and 2017.
That's why, in a high-inflation environment, it's usual for people to spend their money on items that will hold their value well. That allows them to do one or more of a number of things:
- They can later sell or trade those items for things they need, knowing that the original item will hold its value better than their depreciating banknotes;
- They can buy things they know they're going to need in future, while they can still afford them. For example, every vehicle will need new tires sooner or later; but if the price of tires is going up by a quarter to a third every year due to inflation and/or import costs, will your income go up by the same proportion, so that you can still afford them? If not, it makes sense to buy a new set of tires for your vehicle now, while you can afford them, so they're available when you need them. (To illustrate how valuable this can be in financial terms: when Goodyear closed its plant in Venezuela last month, it gave 10 tires to each laid-off worker, which were worth a lot more money to them in that inflation-ravaged economy than their severance pay!)
- They can take advantage of having cash now, to buy things that will improve their financial position in the longer term. For example, during the hyperinflation experienced in the Weimar Republic in the early 1920's, those who had cash or hard assets used them to buy property, commercial enterprises, etc. at the equivalent of pennies on the dollar, from sellers who were desperate and had no choice but to accept whatever price was offered. When the period of hyperinflation ended. the new owners of those assets were sitting pretty, ready to exploit them in the newly stabilized economy. Many established families were impoverished during those years, while many others were enriched through having disposable assets at their fingertips at the critical moment. The same situation is playing out in Venezuela right now. If you have dollars at your disposal, you can buy properties there for a fraction of what they were selling for just a few years ago, because sellers are desperate: "The price of an 180 square meter [1,937 square foot] home has plunged from $320,000 to $100,000 yet buyers are hard to find".
- Finally, they buy things that will hold their value as a long-term hedge against inflation and currency depreciation. Gold is a prime example of this. As Roy Jastram pointed out in his well-known book, "The Golden Constant", gold has held its value for centuries.
"Throughout history, an ounce of gold would always buy a reasonable, but not luxurious, outfit of clothes. This was true in the fourteenth century, when an ounce of gold was £1.25 to £1.33; it was true in the late 18th century when an ounce of gold was around £4.25 or $19; it remained true in the current decade when an ounce of gold has so far (2000 to 2008) averaged £269 or $472. In contrast, neither £1.33 nor £4.25 nor $19 would go very far in a normal shopping mall today."
So, there you have it. In a high-inflation environment, holding on to cash is a risky business, because it loses buying power every year - sometimes precipitously. That's another good reason, while times are (relatively) good, to build up reserve supplies of things you might need. If you lose your job, and have to struggle to find money for a few months while you look for another, you can always eat your emergency food reserves, or change the oil in your car using the lubricant you've stored in your garage, or replace batteries from your emergency stash as they wear out - if you have those things. If you don't . . . you're S.O.L., and broke at the same time. That's not a good place to be.