Purchasing Power and Inflation

The following is another guest post from Free Money Finance reader Rod Ferguson. Though not strictly a personal finance piece, I find this very interesting and hope you do as well.

Money. Money is a hard term to understand. Sometimes money means currency, sometimes it means purchasing power and sometimes it means store of wealth. But one thing money definitely is: it's whatever people think it is. This is true of gold or silver or big rocks or paper, the thing only has value if people think it does. Today, almost every nation uses “promissory notes” as money, called “fiat” currency (literally means “let it be done” – it’s money cause the government says so).  Gold has had the longest run as "money" in human history as it's somewhat rare and impossible to manufacture or duplicate. In discussions of the gold standard versus fiat, many people talk about gold as a store of wealth, and some talk about it as a currency, but few talk about it in terms of purchasing power. For example: one ounce of gold at the turn of the 20th century could buy a nice suit, a hat, a fine cigar, a good meal, a night of drinks at the tavern and still leave you with change in your pocket. Today, an ounce of gold can buy you a nice suit, a hat, a fine cigar, a good meal, a night of drinks at the club and still leave you with change in your pocket. The purchasing power of gold hasn't varied much in the last few thousand years. I wanted to talk about purchasing power and how inflation works against it, both with a gold standard (historically) and under our current fiat system.

A brief history of US currency

To understand what our currency is today, we must understand what it has been.  Presented here is a short history of currency in the US. Currency revaluations are included; many people do not know that the US has had several currencies, and the revaluations themselves show periods where economic breakdown was occurring.  The dates have been borrowed from a variety of sources, including the Federal Reserve:

• 1775 - The first "United States" currency was issued - the Continental Currency (was fiat and used to pay for the Revolutionary War. Went inflationary so fast, we needed a loan from France to actually pay for the revolution towards the end of the war.)
   
• 1785 - The US Dollar is established as the unit of currency for these United States, issued by individual banks (the end result of the Continentals inflation and eventual worthlessness was incorporated into the Constitution as Article 1, Section 10, "...coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts...")
   
• 1861 - First Federally authorized currency created, the Greenback (used to finance the Civil War, has the distinction of still being redeemable at face value if you happen to find one in circulation.) Currency revaluation #1 (some contention here – bank notes were still in use, but Congress encouraged Greenback usage over bank note usage.)
   
• 1913 - The progressive income tax is instituted as part of the Federal Reserve Act (originally stated as never more than 1 or 2% of yearly income, implemented to pay interest on loans from the Federal Reserve.)  This is significant because for the first time, we taxed citizens to pay for maintenance of the currency.
   
• 1916 - The Federal Reserve (which is neither Federal nor has any reserve) opens its doors for business.
   
• 1934 - Private ownership of gold made illegal (gold bullion and coins were taken and federal reserve notes issued instead with the indication that they represented gold in storage.)  Silver is still used as a money standard.  Currency revaluation #2.

• 1944 - US Dollar established as global reserve currency at Bretton Woods, NH (the Bretton Woods Agreements).  Nations sent gold to the US in exchange for dollars and agreed to use dollars as the international exchange medium.
   
• 1963 - Federal Reserve notes were issued with no indication they represented anything but were “legal tender for all debts public and private”, yet were still redeemable internationally for gold. Currency revaluation #3.
   
• 1965 - The US removes the silver standard for domestic money.  Replaces silver money with a copper-sandwich thing that sort of looks like silver.
   
• 1971 - Nixon closed the international gold window and floats the dollar with nothing backing it but the full faith and credit of the US government.

Now, the nature of our currency reflects the value of our currency. We had gold and silver in circulation in the past - which guaranteed value in a foreign land regardless of the exchange rate - but currently have base metal replicas that have little intrinsic value. The face value of our currency is the same; once, you could redeem your paper for gold, now it’s just paper.  The dangerous thing about the currency now is that because the dollar represents a unit of our net worth, those dollars can really only be used to buy resources of the US – businesses, land, raw materials, etc.  This process is known as “economic colonization.”

Inflation

I've put together a short chart of wage and price inflation throughout US history, with some bullets mentioning major events that affected money. It is important to understand the difference between wage and price inflation; while your salary may be increasing, if the prices of goods are increasing faster then your wages you will suffer the negative effects of inflation.  Please note that positive numbers denote inflation (increase) and negative numbers denote deflation (decrease).  Unfortunately, due to lack of records there isn't really any way to account for US inflation prior to 1800 so these figures only reflect inflation rates from 1800. (click image to enlarge)

 

Bear in mind that the wage rate is based on unskilled labor and the price rate is based on the official CPI. So, if you look at the years leading up to 1934, you have 700% wage inflation and 24% price deflation compounded. From 1934 to 1971, you have nearly 800% wage inflation with only 300% price inflation. But, from 1971 to 2006 you only have 480% wage inflation with a price inflation rate of over 500% - your purchasing power is being eroded away.

The Value Trap

Taking a different tack, let's look at some averages in 1934; the year we went off the gold standard domestically (please note that data for a like-for-like comparison of automobiles was unavailable, nor were there any average prices available prior to the mid 1970’s, so the comparisons are not exact – but representative). The numbers below reflect the actual amounts as well as the percent of annual wages (in parentheses) they make up:

• Average wages per year $1,600.00
• Average Cost of new house $5,970.00 (370%)
• Average Cost of a gallon of Gas 10 cents (.006%)
• Average Monthly Rent $20.00 per month (1.25%)
• Studebaker Truck $625.00 (39%)

Now let's look at the same averages in 1971, the year we went off the gold standard internationally and attained a true fiat currency:

• Average Income per year $10,600.00
• Average Cost of new house $25,250.00 (238%)
• Average Cost of a gallon of Gas 40 cents (.0037%)
• Average Monthly Rent $150.00 per month (1.4%)
• Datsun 1200 Sports Coupe $1,866.00 (17.6%)

Now lets look at some averages in 2006:

• Average wages per year $44,472
• Average Cost Of a new house $299,900 (673%)
• Average Cost of a gallon of Gas $2.90 (.006%)
• Average Monthly Rent $991.00 (2.2%)
• Average Cost of a new car $24,400 (54.8%)

So, the "average American" didn't do too bad as far as their purchasing power is concerned once we went off the gold standard domestically. While inflation rose faster than before, wage inflation rose faster than price inflation. However, once we floated the currency completely, price inflation greatly exceeded wage inflation, especially for assets.

Per Capita GDP – the statistic nobody knows

Per capita GDP is simply the division of the total output of the US by the number of its citizens.  Per capita GDP is useful if you wish to determine purchasing power, although does not paint a complete picture when considering overall cost and quality of life. It is also useful to see disparities between “wealthy” and “poor” between different eras; technology makes an expensive luxury at one time a cheap necessity in another (i.e. – the telephone) so you have to look at the economy overall.  And, overall we're not looking good compared to less than a century ago - a person with national average salary of $1,858.00 in 1931 had the comparative wage of over $132,000 in today's dollars and the purchasing power of over $320,000. Not many people make over $130k per year nor have the economic influence of a third of a million dollars, yet $1,858.00 was the average. Today, the average is $44,765.00, which is the same as making $626.81 in 1931, with the purchasing power of $259.54.

What does this all mean?

When a currency has an asset backing it, only major events like a war or a national emergency causes price inflation, while wage inflation will naturally increase as goods are produced to collect more of the backing asset (which creates more "money") and technological advancements cause goods to be produced more cheaply. It's during incidents like a war that an asset backed currency is thought of as "inflexible" because it doesn't easily allow for borrowing from the future to pay for a critical situation today. When fiat currency is managed as if it has an asset backing (from 1934-1971), then fiat can function; the currency has more flexibility and can respond more readily to catastrophe or war. Once the currency isn't managed as if it has an asset backing, fiat tends to wobble and spiral out of control (1971-2006). Once the printing presses are on full time, pretty much everything is treated as an "emergency".  Fiat systems can work, but only for so long – this is a lesson that history has taught us that has no exception.

My Opinion

The Federal Reserve is supposed to use the net worth of the US as its yardstick for printing money – that’s all fine and good.  But, we seem to be getting caught into this inflationary spiral of “we can print more money which inflates the net worth so we can print more money which inflates the net worth so we can print more money” etc, ad nauseum and therein lies the trap.  Milton Friedman once said:

“Inflation is just like alcoholism. In both cases when you start drinking or when you start printing too much money, the good effects come first. The bad effects only come later...That's why in both cases there is a strong temptation to overdo it. To drink too much and to print too much money. When it comes to the cure, it's the other way around. When you stop drinking or when you stop printing money, the bad effects come first and the good effects only come later. That's why it's so hard to persist with the cure.“

There is a point where we stop merely inflating and run the risk of hyper-inflating.  Are we there now? No, I don’t think so.  Can we get there soon?  Yes, I believe we can.  Can it be avoided?  Yes, but only if we make some fundamental changes to our monetary policy starting now.  It is hard to protect yourself from inflation, but it’s easy to start minimizing the effects.  Pay off your debt, buy staples in bulk when you can and lower your standard of living as much as you are comfortable doing so.

Rod Ferguson was born in 1969 in Iowa City, Iowa.  His family moved around the country quite a bit so he became very used to change.  After graduating high school, he joined the Navy and married his beautiful wife Anne.  Choosing technology as his profession, he rode the dot-com boom up and slid right down with the market at the turn of the 21st century.  After this rather frustrating ride, he decided that by learning about finance, and then economics, he might avoid this ride in the future.  His studies began with the stock market, branched to global currencies and foreign economies, then delved into the history of the US economy and histories of foreign economies.  The more he read and researched, the more he realized that economics was one of the major driving forces in our history – that the rise and fall of nations has depended much more on the management of economies than on the management of armies.  Armed with this knowledge, changed his approach to managing his personal finances and began teaching others what he knew and how to apply it to their lives.  This is his first foray into publication and he hopes you enjoy and can gain value from his works.

Comments

[Katy Raymond]

I've gotta weigh in on those 1971 figures. I live in Kansas City, certainly not the home of either the highest wages or the highest prices. "Average," we'll call it. I graduated high school in 1972 and promptly got a good entry-level job and moved in to my own apartment. I realize my job wasn't paying the average, since I was new to the job market. I made less than $6000/year working as a data entry recorder for a major pharma firm. My first apartment cost the supposed average of $150/month, and it was a total dump, almost unliveable. (Trust me on this.) Gasoline was indeed 39 cents/gallon, but I distinctly remember my grandfather plunking down cash on the counter for my first car--a 1972 AMC Gremlin. It and the Volkswagon Beetle were the lowest priced cars available. The car cost $2500, way more than the figure quoted here.

I also remember my father (a banker) lamenting for the rest of his life the day the U.S. went off the gold standard.....

[Richard]

Whats the average wage slave supposed to do about this? If our monetary policy is out of control then what are our options. The mantra of this blog is save less and save, ok I've been doing that before this blog existed. But if the value of my wealth, which is essentially all fiat, becomes worthless than what do you do?

[Rod Ferguson]

Katy, these figures were drawn from BLS, the Federal Reserve and other government sources. They are not necessarily reflective of what was really going on ;)

Seriously though, averages are just that - averages. Some areas of the country "averaged" a higher wage and lower cost of living, while others "averaged" in the opposite direction. These figures also measure the gamut - from the Mazzerrati to the VW bug. These are overall numbers for the nation (the earlier numbers, for example, didn't calculate the full 50 states, because we didn't have 50 states back then.) Just looking at one figure - gasoline - can have several different local effects; local taxes, state taxes, the cost of moving gas via tanker trucks from the coast to a specific location, etc, that can move the price per gallon wildly.

[rwh]

Certain things about the post stand out. I have read in many places that 1973 was a peak year in the US for purchasing power. The data in the post tends to bear that out.

But in 1934 the official national unemployment rate was over 20%, peaking at 23% around that time. Purchasing power may have been strong, but it may have been because a whole lot of people had no money.

Despite all the current hand wringing about the declining dollar and the Fed reducing interest rates to a point where many economists insist it has to trigger inflation, the year over year core CPI has remained essentially unchanged at around 2.4%.

And the point about improving technology clearly is valid. What new vehicle would you rather drive, a 1934 Studebaker, a 1971 Datsun 1200 or a 2006 Toyota Corolla?

[Rod Ferguson]

Richard - Knowledge is power. If you know that your money is being inflated away, then you have the choice to put your wealth into other forms than money; land, metals, goods, etc. In an earlier post about gold as an investment (last month sometimes.. I forget when) a comment was made that gold makes a lousy investment as it does not generate any returns. This is absolutely true - gold is a lousy investment. But, as a store of wealth, gold has the longest track record of maintaining its value. If your focus is to grow wealth, then the markets are a better bet. If your focus is to not lose wealth, then assets are the better bet.

rwh - It's funny you should mention the CPI; I'll be going into that next :)

[stlPastor]

Not only has technology made our lives better in terms of cars, but the size of the new houses we're buying is many times larger, and we presume that things like computers, televisions, internet, climate controlled houses, etc. are necessities,and most of us can still afford them. There is no doubt that I have more purchasing power in terms of cool stuff I can buy that makes my life easier than my parents and definitely than my grandparents. If I lived in a house with well water, heated by a wood stove, and had a huge garden where I canned most of my family's food like my grandparents, I could still almost live on the amount of money they made.

[DMD]

That wage/price comparison chart is a real eye-opener. Thanks!

[tracy ho]

Good post , you had highlighted many important issuse ,

thanks ,

Tracy Ho
wisdomgettingloaded

[rwh]

Richard:

I'll go out on a limb and predict you will take the position the cpi is poor measure of inflation.

[Rod Ferguson]

Only until the Boskin/Greenspan changes. :)

[Big Cheese]

FMF,

That was a great post... I've been asking you to do a post about inflation and this is a great start.

Now can you do a post on the theory of peak oil and the implications of this to our global, energy hungry economy? Remember this is informational and not doom n gloom.

-BC

[DumbAgent]

"When a currency has an asset backing it, only major events like a war or a national emergency causes price inflation..." - what about market bubbles?

[Rod Ferguson]

Market bubbles are more of a creation of credit expansion than true monetary inflation. This is not to say that you can't have a bubble with an asset backed currency (the Dutch tulip mania of the 1600's springs to mind as an example,) but a bubble can only get as large as the total wealth base in these circumstances; with credit, you can actually have a bubble far in excess of the wealth base, which eventually leads to devaluation (inflation) as these debts must either be paid or revoked (which negatively affects the lending institution.) Take a look at the global derivatives market outstanding value to see an example of credit expansion gone haywire; it's currently estimated at $516 trillion as of March (total global wealth is estimated at about $115 trillion.)

[rwh]

Rod: Sorry I called you Richard.

Does credit have anything to do with the current price inflation of commodities?

[Rod Ferguson]

rwh - No problem. In a manner of speaking, yes. Credit is used (margin) to buy and sell commodity futures, which affects the price. However, fundamental pressures are forcing a rapid decoupling the "spot" price of some commodities; these commodities are trading on the street for higher prices than spot on exchanges. Silver is a perfect example of this phenomenon: spot silver is about 17.20 as I write this, yet you can easily sell an ounce of silver to an bullion shop for 25 cents to a dollar per ounce more than spot. Buying that ounce of silver would cost you as much as $2 over the spot price, and I'm not even counting numismatic value. This is due to a lack of physical metal available; there was a period about 2 weeks ago where you simply couldn't buy silver anywhere and what silver was available was being scooped up for industrial usage. In silver, right now, spot price is pretty much meaningless due to over speculation in the futures market enabled by margin buying and selling.

While I haven't done the research necessary to say with any certainty on this, I believe that agricultural commodities might be another area where we are experiencing this; the pattern seems the same, which bodes well for the US if we can take advantage of it.

[Bronco]

My biggest takeway from this article is that houses are way overpriced. 673% of wages?! That is way out of wack with historical norms.