Inflation, Deflation, and You

Every day, people come up to me and say things like:

Frank, what are these inflation and deflation things that I keep hearing about? Are they something I will enjoy? Do I need any special skills to participate?

Inflation is when the prices of everything go up. Put another way, it is when the value of money, US dollars for example, goes down, so it takes more of it to buy the same old stuff. Deflation is the opposite, when prices go down and the value of money goes up.

That sounds like fun for the whole family! What causes inflation and deflation? Are they something I can make at home?

Folks (by which I mean economics professors) used to think that inflation/deflation was caused by changes in things like the level of production and unemployment. Currently, the consensus is that it is a “monetary phenomenon” which means that it is really all about money itself. Inflation is caused by one of two things: an increase in the supply of money in the economy or an increase in the “velocity” of money, how fast it is changing hands in the economy. Deflation is the opposite, caused by a drop in the money supply and/or a fall in the velocity.

The money supply is what people usually watch to predict inflation/deflation because velocity is pretty constant over time. It really only drops in very extreme circumstances, such as the early 1930s and right now.

That sounds awesome. How can I spot inflation or deflation myself? What are some of the exciting things that will happen to me because of it?

Spotting inflation/deflation is easy. Look for prices of the things you buy to go up/down.

Under inflation, what will probably most concern you is that although the prices you pay have gone up, what you get paid may not go up as quickly.

In the long-run, the more significant effect is on the value of dollar-denominated assets you own and debts you owe. Since the value of dollars is decreasing, the value of bank deposits you have and bonds you own will decrease, possibly faster than the interest paid is growing them. On the other hand, the value of your debt also goes down in the same way. In principle, the value of “real” assets, such as your house and shares of stock in companies, do not decline under inflation. In practice, this is not so easy to see because periods of inflation are also often bad times for the economy so the value of assets tends to go down.

Deflation is similar but worse. You will notice things getting cheaper and the amount you get paid may not immediately go down, which will be fun while it lasts. But it is hard for companies to cut salaries. The last time we had meaningful deflation, at the start of the Great Depression, instead of cutting everybody’s salary companies laid off some people and stopped hiring. If you were one of the lucky who still had a job, then things were fairly good since you could buy more with your salary. If you were one of the one third of Americans out of work, things were not good.

The same effect on dollar denominated assets happens under deflation as inflation, but backwards. The value of your bank deposits and bonds increases, but so does the value of your debts. If you have money in the bank you should be rooting for deflation, if you owe money you should be rooting for inflation.

They both sound like a blast. Is there a reason to pick one over the other?

Go with inflation. Deflation has really nasty effects on the economy. If the value of your dollars is increasing every day, you have less incentive to spend or invest them. And if today’s dollars are worth a lot less than the dollars of a few years from now, borrowing money becomes expensive, even at zero percent interest. This can lead to a vicious spiral, with people hoarding money because of deflation, which causes a drop in velocity, which causes more deflation.

Okay, I’m ready to play. What should I expect first, inflation or deflation?

For the moment, we appear to be in a period of deflation. The fiasco in the financial system has caused a lot of people and companies in the economy to hold on to their cash, which has greatly reduced the velocity of money. But the Fed and the government have made it clear that they will go to whatever extremes necessary to keep deflation from setting in for long. Fed Chairman Bernanke has hinted that if he has to he will fly over cities in helicopters dropping cash. Bernanke believes that the Fed caused the Great Depression by not increasing the money supply when it should have (in fact it decreased it) and he has made it his life’s mission that that particular debacle not be repeated.

The medium- and long-term effect of the massive increase in the money supply now under way should be obvious. Velocity will stabilize and/or rise and we will get inflation. Lots of it. Inflation is good news for debtors, those that owe dollar-denominated debts. And who is the largest dollar-denominated debtor in the world? Not at all coincidentally, the US Federal Government. Runner up are American homeowners, who could use a break.

Getting Rich and Losing Weight

There’s a post today on WiseBread entitled “6 Ways that Dieting and Budgeting are Exactly the Same.” This money-food analogy is remarkably common. It’s in the title of the blog. Several personal finance books (e.g. Dave Ramsey’s Total Money Makeover) are openly modelled on weight-loss books. And there’s that old quip that you can’t be too rich or too thin. (Which, let us remember, was once meant as a joke.)

To an extent, it is a valid analogy. A generic instruction for losing weight might be “Eat less, exercise more” which could easily be translated into “Spend less, earn more.” Neither is likely to inspire a fat/poor person, but the inescapable underlying truth is there in both cases.

That said, the analogy is far from perfect and can lead to some unfortunate money behaviors.

The biggest difference between dieting and increasing wealth is that successful dieting comes from winning most, but not all, of many small battles, and successful personal financial management comes from winning a few big ones.

If you fall off the wagon one afternoon and have a big meal, you may feel terrible about it but it’s still only one meal. It will not sink your weight-loss program. The goal is to keep from eating big meals almost all the time. On the other hand, if you succumb to temptation and buy that hot new convertible instead of the used sedan that you went into the dealership to look at, you really have done damage to your get-rich program. You can maintain a frugal lifestyle for a very long time and still not make up for one big financial sin.

The other big difference is that eating is a biological imperative. When you are hungry, your body creates hormones that have a physical effect on your brain and your judgement. You may feel that you desire the latest iPod in the same irrational way as you wanted that slice of pie, but it’s really not the same thing.

Both of these differences, if ignored, can lead to serious problems. Living a frugal lifestyle but then making mistakes in the handful of financial decisions that really count is a tragic waste of effort. (Although you do get to feel good about yourself as you wash your Hummer with bucket and hose instead of taking it to the car wash.) And treating spending as an uncontrollable compulsion just makes the problem worse. The truth is that not spending is not exactly like not eating. It’s easier.

Lightbulbs and Lattes

Sometimes we confuse the number of visible acts we make working at something with the progress we actually make towards our goal. Let me explain what I mean with a story about what our leaders in Washington have been up to.

Did you know that Congress voted to ban the familiar incandescent light bulb? More than a year ago? It’s true. Starting in 2012, no more 100 watt bulbs and by 2014 none of any wattage. Clever of them to pass something that doesn’t take effect for 5+ years. The small number of folks who really care are happy, and everybody else won’t even notice until after what must seem like an eternity to the guys inside the beltway.

And people will notice. Although the law does not, strictly speaking, ban the incandescent bulb, it only mandates energy efficiency standards that amount to a ban, the bottom line is that consumers will have to replace the familiar old bulbs with compact fluorescents. And earnest green hype aside, CFLs are not the same. The light they give off is a little bluer, they cost about six times as much (twenty times as much if you want to use a dimmer switch) won’t fit in all existing fixtures, and, let’s face it, look dumb. Oh, and also they contain mercury so are bona fide toxic waste. Not only can’t you recycle them, putting them in the trash is illegal in many places.

So what’s the benefit for this inconvenience? Why, we reduce greenhouse gas emissions, of course! By how much, you ask? Good question. For that I will have to do actual research, as none of the news articles seem to cover that. According to the EPA, burning fossil fuels to generate electricity accounts for 38.9% of CO2 emissions in the US. And according to the Energy Information Administration (which is a real government agency, even though it sounds like I made it up) residential use of electricity is 37% of the total, so 14.4% of CO2 is due to the electricity we use in our houses. And how much of electricity used at home is for lighting? Only 8.8%. To put that in perspective, 13.7% goes to the kitchen refrigerator. 3.5% is for stand-alone freezers. The total percentage of our national CO2 output due to household lighting is 1.27%.

And how much of this 1.27% will we eliminate by doing away with Edison’s greatest work? That’s not so clear. But let’s get real, even cutting it in half isn’t going to move the CO2 needle much. Banning stand-alone freezers would probably be just as effective and much less annoying. There is even the argument to be made, which I don’t buy, that switching to CFL will not reduce CO2 emissions at all because CFLs don’t give off heat, so people will burn more oil and gas heating their houses.

This is bad policy. Even if you accept that looking to take out CO2 from the 14.4% of it that goes to household electricity makes sense, then looking at the 8.8% of that that goes to lighting is nuts. So when this law kicks in people will rise up and protest and force its repeal? I doubt it. Most people really like the idea of saving the planet and the fact that this particular way is a little bit of a sacrifice just makes it that more attractive. The best part is that it is so everyday. You get to remind yourself that you are saving the planet every time you see that funny looking bulb in your living room.

What this has to do with personal finance is that it is exactly the same dynamic as the idea that you can save your way into wealth by giving up a minor daily expense or two. Give up the lattes at Starbucks and you will be rich when you retire. The fact that the math doesn’t really work doesn’t stop millions of people from embracing the principle. Its attraction isn’t so much that you save money but that it’s something tangible that you can do starting tomorrow and everyday. As with the light bulbs, it is as if progress towards the actual goal is less important than maximizing the number of noticeable acts in the right direction.

Meanwhile, I’m buying light bulbs to stash in my basement. Look for them on eBay in 2014.

Predicting Stock Market Returns

Amongst the nice things about blogging is that you get to write your own headlines. I imagine that Jason Zweig isn’t all that happy with his editor’s “hed” for his column today in the Wall Street Journal. It reads “Why Market Forecasts Keep Missing the Mark.” I was a little disappointed, but not really surprised, to find that the column doesn’t really address that good question at all.

So I will try. How hard could it be?

Market forecasts, such as “the Dow will be up 14% in 2009″ are doomed to failure because the market is impossible to forecast.

That was easy.

Some things are forecastable. The weather, for example. Or how many votes a candidate will get in an election. You can look at certain data, do a little math, account for a special factor or two, and presto, a useful estimate of the near future.

But for other things you really can’t create a useful estimate. The score in the next Super Bowl. The next roll of the dice. It is not that you are stupid or lack data. And it is not that you don’t understand what is going on. You can say some useful things about these unforecastable future events. The Steelers are heavily favored. Seven is the most likely dice roll, and fourteen just ain’t gonna happen. But these are not predictions, they are statements about likelihoods and probabilities.

So it is with the stock market. (And for that matter, the bond market, commodity markets, etc.) Occasionally somebody will throw out a prediction like “the Dow will be up 14%” but nobody, the speaker included, expects it to be taken very seriously.

Sober predictions about the stock market are really estimates of the so-called expected outcome, the probability weighted average of all possible outcomes. E.g. seven is the expected outcome of a roll of two dice. The most common way to come up with an expected outcome for a year in the stock market is to average historical performance. Depending on which years are used, and which indexes, the answer is usually something like 10-12%.

So a personal finance pundit will tell you to expect 10% average annual returns in the stock portion of your investment portfolio. That’s a reasonable thing to say, but I think that too many people, possibly including the pundits, misunderstand what it means.

Imagine that on January 1, 2006, based on being told to expect 10% annual returns in the stock market, you invested $100. With the help of Microsoft Excel, you work out that you should have $672.75 on January 1, 2026. But over the next three years the investment actually goes down, so your January 1, 2009 balance is $81.88. Now what is your expected 2026 value?

Way too many people would say $672.75 or something like it. They think that the 10% number they were given was a forecast of what was actually going to happen over twenty years, rather than an estimate of the expected outcome for each year. Put another way, they think that the market has a memory, that it will remember it had some bad years and make up for it in the future, in order to return to the “normal” long-run average.

Well, sorry kids, it just don’t work that way. The 10% number may still be sound as an annual estimate. Assuming it is, then 17 years at 10% compounds to 405.44%. Starting with $81.88, the expected value on January 1, 2026 is now $413.86. Sorry ’bout that.

Frugal Friday

Fridays sometimes put me in a certain mood. I thought I might highlight a few frugality tips from this week in the blogosphere:

Free Money Finance asks can you pay for a Costco membership by eating free samples? That is, if roaming the store and snarfing up food samples can substitute for a meal, would that savings be enough to cover the annual membership fee? I’ve read this post several times now, and I really think it’s a serious question.

The Frugal Mom Blog has a list of even more amazing ways to save money on food. My favorite is saving the wrappers from your sticks of butter to grease baking pans. If you baked enough, I estimate that you could save the equivalent of an entire stick of butter in a year. Now that’s real money.

The Frugal Duchess had two posts listing ways to watch the inauguration for free, assuming you do not own a TV. The answer is that you could have watched it on any one of several obvious websites, e.g. CNN.com or CSPAN.org. (You may not have a TV, but you’ve obviously got high-speed web access, right?) Also, it turns out that it was on every TV in every public area in the nation. Come to think of it, a post listing ways to manage to spend money watching the inauguration would have been more interesting.

Rounding out the week’s insights, The New York Times’ Frugal Traveller reports that Cape Cod is cheap to visit in January. How true. In a similar vein, I will add that admission to Fenway Park is much cheaper on days that the Red Sox are not playing.