Think Different About Purchasing Power
Thursday April 30, 2015 15:42
The dollar is always losing value. To measure the decline, people turn to the Consumer Price Index (CPI), or various alternative measures such as Shadow Stats or Billion Prices Project. They measure a basket of goods, and we can see how it changes every year.
However, companies are constantly cutting costs. If we see nominal—i.e. dollar—prices rising, it’s despite this relentless increase in efficiency. This graphic illustrates the disparity (I credit Tom Selgas for a brilliant visualization, which I recreated from memory).
CPI measures only the orange zone, the tip of the iceberg. Most people don’t see the gray zone, and that’s a result of the greatest sleight of hand ever.
We need an accurate way to measure monetary debasement. For example, in retirement planning it’s tempting to divide your net worth by the cost of consumer goods. This seems to show your purchasing power. For example, if you have $200,000 and the cost of groceries for a year is $20,000 then you can eat for ten years.
However, this approach is flawed. To see why, let’s briefly consider primitive times when there was no lending or banking. People had to set aside some of their income, to buy a durable good like salt or silver—hoarding. When they could no longer work, they sold a little bit every week to buy food—dishoarding. People accumulated wealth while working, and dissipated it in retirement.
Life got a lot better with the advent of lending, because interest enables people to live on the income generated by their savings. People no longer consumed their principal, worrying about outliving their savings.
Don’t think of capital assets as something to sell in order to eat. An old expression says, if you give a man a fish then he eats for a day, but if you teach a man to fish then he eats for a lifetime. Think of a productive asset like a fishery. It should produce for a lifetime. It should not be consumed as a mere fish.
Capital assets should be valued in terms of how many groceries they can buy, not by liquidation, but by production. Unfortunately, monetary policy is making this increasingly difficult. Interest rates have been falling for over three decades, and now there’s scant yield to be had anywhere. We are regressing to the dark ages of paying for retirement by dishoarding.
CPI understates monetary debasement, because companies are constantly becoming more efficient. Dividing wealth by CPI compounds the error, because asset prices are rising.
We need a different way of looking at monetary debasement. I propose Yield Purchasing Power (YPP). YPP is the yield on assets divided by the Consumer Price Index (or other index). The idea is to look at the productivity of assets to see what you can really afford.
Let me explain YPP with a simple example. If hamburgers sell for $5 and interest is 10%, then $50 of capital lets you eat one burger per year. Suppose the price of the burger doesn’t change, but the interest rate falls to 0.1%. You now need $5,000 in capital to earn that burger. Unfortunately, if you still only have $50, then you only get one burger every 100 years.
CPI doesn’t show this collapse in purchasing power, but YPP does.
Let’s take a look at YPP since 1962. The graph is inverted, to make the trend easier to see.
It’s interesting that the drop in purchasing power (rising in this inverted graph) begins around 1984, when the conventional view said inflation was tamed. CPI may have slowed down, but interest was falling too.
YPP shows us a staggering monetary devaluation—a classic parabola. The problem isn’t skyrocketing prices, but collapsing yields.
You need more and more assets to afford the same lifestyle. If your assets don’t keep up, then you have to liquidate your capital.
Interest – Inflation = #REF
I have to admit that I derive some pleasure in taking on hoary old myths. For example, some economists assert that the interest rate you see on the Treasury bond is not real. You see, it’s only nominal. To calculate the real rate, they say you must adjust the nominal rate by inflation.
Real Interest Rate = Nominal Interest – Inflation
It seems to make sense. Suppose you have enough cash to feed your family for 2,000 days. Then the general price level increases by 15%. You still have the same dollars, but now you can only buy groceries for 1,700 days. You’ve been robbed, some of your purchasing power stolen. Therefore you want to earn enough interest to overcome this loss.
This view is flawed.
Normally, you don’t spend your savings, only the income on it. In ancient times, people had to hoard a commodity like salt when they worked. In retirement, they sold it to buy food. Modern economies evolved beyond that, with the development of interest. Retirees should not have to liquidate their life savings.
Now, let’s examine this idea of correcting the interest rate using the Consumer Price Index, or CPI. We’ll skip over the problems in trying to measure prices, and avoid the controversy over whether CPI does a good job. We’ll just compare two retirees from two different eras.
1979 Cutlass vs. 2014 Camry - Click to enlarge
Clarence was retired way back in 1979. Suppose he had $100,000 saved up. According to the St. Louis Fed, the CPI was 68.5 on January 1, 1979 and it rose to 78.0 one year later. This means prices rose by about 14%—what most people call inflation. Also according to the St. Louis Fed, a 3-month certificate of deposit offered 11.23%. There are many interest rates, but let’s use this one for simplicity.
The popular view focuses on his lost purchasing power. He begins the year with $100,000. That amount could buy some meat and potatoes. Clarence ends the year with $111,230 in principal + interest. Liquidating that larger amount buys less hamburger and fewer fries at the higher prices at the end of the year. Therefore Clarence had a loss, and the loss is interest – CPI, or 2.77% of $100,000, which $2,770.
I suggest another view. The interest afforded Clarence $11,230 worth of food. According to the U.S. Census Bureau, the median income in 1979 was $16,841. Clarence made 2/3 of his former income. That’s about right for a retiree without a mortgage or commuting expenses. He could eat pretty well. Although the falling dollar did erode his wealth, we’re focusing on how Clarence experiences interest in the real world.
Now, consider Larry, a recent retiree. Larry has $1,000,000 in savings. CPI actually fell over the past year. Interest on a 3-month CD is negligible—0.03%. Again, we’re not focused on whether CPI is accurate. Just grant for the sake of argument, that some prices dropped and this was matched by a rise in others.
In the standard view Larry appears to be better off than ol’ Clarence. Larry lost no purchasing power, unlike Clarence’s loss of almost 3%. This is deceptive and misleading.
The stark reality is that Larry earns a scant $300 in interest. He can’t afford groceries on this paltry sum, so he is spending down his savings. The median income was $52,250 in 2013 (the latest year available). To earn 2/3 of that—and match Clarence—poor Larry would need over $116 million.
The notion of nominal interest paints a misleading picture of Clarence losing purchasing power and Larry keeping even. If you look at what they can buy with the interest on their savings—Yield purchasing power—you see that Clarence was living well while Larry is quickly spending down his life’s savings.
Keith Weiner is president of the Gold Standard Institute USA in Phoenix, Arizona, and CEO of the precious metals fund manager Monetary Metals. He created DiamondWare, a technology company that he sold to Nortel Networks in 2008. He has his PhD from the New Austrian School of Economics. He lives with his wife near Phoenix, Arizona. In March 2015 he moved his Gold Standard column from Forbes to SNBCHF.com.
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Greg Jaxon
Keith,
The real rate of return is not a meaningless or mythical construct.
Running the 11.23% interest+ 14% COL-inflator as an iteration, Clarence lives 9 years.
Larry, at .03% and -.01% inflation lasts 29 years.
Clarence needed $405,319 to last that long, which, oddly is an amount that (at the 1979 “real rate of 2.77%) throws off $11,233 of “real” income.What you say might better be stated along the lines you use in your conclusion:
To live forever, Larry needs $116M, what does Clarence need?
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