The destruction of private savings through inflation (Part 1)

Alasdair Macleod – 22 February 2011

This is the first in a series of articles examining the economic costs of weak money policies.

One of the reasons government fiat currencies are facing eventual collapse is the savings of private individuals are now insufficient to support them through their old age. Unless Western governments are prepared to tolerate the deaths of the aged through starvation, neglect, inadequate heating and the cruel withdrawal of healthcare facilities, the escalating costs of welfare for the aged will fall to the state. The way the politicians tell the story, the problem has arisen through inadequate actuarial assessments of life expectancy, the retirement of the baby-boomer generation, and for private sector pensions, inadequate investment returns.

While these factors contribute to the welfare crisis, they are not its primary cause. The primary cause is inflation, which has been instrumental in dissuading investors from saving and has increased their reliance on the state for retirement benefits.

There is no better way of illustrating the point than by contrasting the value of savings and their deployment in an environment of sound money with the inflationary conditions we face today. Using a spreadsheet to bring values back to comparable real terms, it is easy to show that accumulated savings in the mildly and naturally deflationary environment that naturally accompanies sound money, such as a properly functioning gold standard, have a greater purchasing power than savings that have suffered an erosion of value through inflation. We can compare what actually has happened with a theoretical sound-money situation.

Over the last forty years, or a standard working life, an American saver investing $1,000 per annum into the ten-year US Treasury bond would have had an annually compounded savings value of $224,150, at an average yield of 7.18% for the bond over the period. It is this strong compounding effect that attracts most savings advisers’ attention. But over that time, inflation averaged 4.44%, reducing the true value of this savings stream to $139,734, still more than three times the amount invested. Simplistically, the saver has suffered an inflation tax on the difference of $84,417, while the same inflation has created the illusion he is significantly better off.

By way of contrast, an economy backed by sound money allows the long-run improvements from manufacturing processes to lead to a general fall in prices of two or three per cent per annum. This means that after a lifetime of work a man saving regularly and modestly will have enough capital to retire on comfortably, and be able to pay for those vital things, such as healthcare, which are an increasing financial burden on the elderly as they age. Applying the example of our forty years of annual savings contributions of $1,000 per annum to a sound money environment, we shall assume a compound return on the ten-year Treasury bond of only 2.5%, to give a nominal value at the end of that time of $69,088. With respect to prices, they can be expected to fall as described above. So taking a price deflator of 2% enhances the purchasing power of our forty years of savings to $99,748 in real terms.

That is the position up to the point of retirement. On the face of it, a real value of $139,734 in the inflationary economy is a far better outturn than the $99,748 in our sound money example. However, the position changes after retirement. Our two real values will now be spent, and we will assume our retiree has thirty years to live in retirement.

Let us further assume our saver purchases a thirty-year annuity, giving a fixed annual income from his lump sum. In the inflationary example our true value of $139,734 is so invested, giving a total real income stream of only $63,949 net of 20% income tax, and adjusted for inflation at the historical rate of 4.44%. The reason for the loss of purchasing power is partly due to tax deducted, but mostly the loss of purchasing power due to inflation over the thirty year period. Furthermore, the high yield of 7.18% applies to a diminishing balance of capital, compared with an increasing compounding balance while our saver was saving.

By way of contrast, in our sound money environment the lower lump sum of $99,746 in comparable true money generates an after-tax income stream of $112,816 in real terms. What our sound money saver lost from the lower compounding rate of 2.5% on an increasing capital sum, he has more than recovered from his annuity’s increased purchasing power over the course of his retirement.

From this we can draw some important conclusions, the principal one being that in a sound-money economy the saver is considerably better off over the saving and annuity cycle, in our example having nearly twice as much at his disposal in real terms from the same initial input. We can also see that the saver’s position is proportionately worse with a higher rate of inflation, and becomes effectively destroyed with accelerating inflation.

But there is also another point to note of great importance: the saver in a sound-money economy finds the purchasing power of his annuity increases over time. Thus, when he first retires and finds the purchasing power of his annuity at its lowest, it will be natural for him to take on some part-time work to supplement it; and when he ages and is generally less able to work part-time, the purchasing value of his annuity compensates by increasing. In an inflationary environment, the reverse is obviously true, with the purchasing-power of the annuity being greatest at retirement and least in old age. We can therefore conclude that not only is the value of savings enhanced by sound money policies, but their increasing value over time matches a saver’s practical requirements in old age.

The contrast between the effects of sound money compared with that of fiat currencies on long-term savings could not be more clear. We have identified the little-understood effect of inflation on the complete savings and retirement cycle, and we have seen that the improved position of the saver in a sound-money economy has the potential to reduce or eliminate his dependence on the state. In an inflationary environment the obverse is true, with the costs of the elderly who have saved increasing while the true value of their savings falls. And the greater their life-expectancy, the greater the gap grows between the two.

But this is only part of the story. The cost of unfunded schemes, such as pension commitments for government employees and for the payment of basic state pensions for all, have built up enormous future costs, because these pensions and the associated healthcare liabilities have to adjust for future inflation. The various estimates of the total cost to the US Government now amounts to many multiples of GDP, and properly accounted for shows the Federal Government to be effectively bankrupt, a finding which is becoming more widely known, and which we can add to our reasons for condemning inflation for its effects on savings.

With respect to savings there are therefore no winners, only losers from the Keynesian and monetarist policies that have sought to manage the general price level by printing money and expanding credit. Governments have discouraged private saving through long-run inflation and taxation of interest and capital gains. In socialist democracies, people now no longer save, fully expecting the state to look after them in their old age.

This has ultimately dumped the financial burden arising from the destruction of savings back upon governments themselves. The line of least resistance for politicians will be to accelerate weak money policies in the mistaken belief that it is the only solution: as we have seen, an acceleration of weak money policies will rapidly make things worse.

This is the true price of inflation on savings and savings habits.

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Alasdair started his career as a stockbroker in 1970 on the London Stock Exchange. In those days, trainees learned everything: from making the tea, to corporate finance, to evaluating and dealing in equities and bonds. They learned rapidly through experience about things as diverse as mining shares and general economics. It was excellent training, and within nine years Alasdair had risen to become senior partner of his firm. Subsequently, Alasdair held positions at director level in investment management, and worked as a mutual fund manager. He also worked at a bank in Guernsey as an executive director. For most of his 40 years in the finance industry, Alasdair has been de-mystifying macro-economic events for his investing clients. The accumulation of this experience has convinced him that unsound monetary policies are the most destructive weapon governments use against the common man. Accordingly, his mission is to educate and inform the public in layman’s terms what governments do with money and how to protect themselves from the consequences.

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