Sunday, April 1, 2012

The Myth of the Inflation Tax

Last time we looked at inflation as a "tax' from the incomes perspective. We established that the devaluation of the dollar (i.e: price inflation) over the last century is completely irrelevant, as average incomes have vastly beaten inflation.  So in short, Ron Paul's diatribes, that the sky is falling, the dollar lost 95% of its value, while technically correct, is very deceptive.  He conveniently ignores the fact that average incomes have vastly beaten inflation [1].

Along the same vein is the Paul's claim that inflation is a "tax" on savings. That would be a valid point, if we lived in a parallel universe where everybody holds most of their savings in cash.  Clearly we don't, but let us look at actual data for verification.

A recent academic study looked at the wealth distribution of Americans from 1983-2007 (pdf). Let us look at the non-home net wealth distribution (mostly financial) during the period (see page 46).  You see four distinct classes. First, the bottom 40% with an average net non-home wealth of -$10,500 (yes negative). Then, the 3rd quintile (40-60 percentile) with little net non-home wealth on average (just $26,500). Then, there is the 4th quintile (60-80 percentile) with a modest $135,700 on average. And finally, we have the top quintile with an average non-home net wealth of $1,863,600.

Paul's argument is completely irrelevant for those bottom 40%, who have no savings. They live paycheck to paycheck. A little inflation, will actually help reduce their debt burden. Thus real income gains are what matters to these folks. I will cover, in the next section, why is it they have no savings. For the top 3 quintiles, their non-home investments beat inflation on average by 122%, 87% and 66% over 24 years. Even the 3rd quintile who had no REAL (i.e adjusted for inflation) income gains in the same period, gained 66% in their financial investments. I will grant you, this was in 2007 before the financial crisis. By 2012, average cumulative returns were cut by 25%. They still beat inflation. The point is that, real people, who have actual savings are clearly NOT holding 100% cash.  If they were, the average REAL return would have been negative 52%. 

In reality, as of 2007 the average American held just 6.6% in liquid assets, (see pg.47). This study doesn't break down how much of these liquid assets were held in cash.  Fortunately, the Fed flow of funds (FOF) does break it down.  See Table B.100 line 11 (pdf).  Currency and checking accounts amount to just 0.11% of total household assets in 2007 [2].  Even in Q4 2011, it is still only 0.42% (of total assets).  Besides, the "liquid assets" category in the study includes money markets funds, online savings accounts and CD's.  And even they beat inflation when the target Fed Funds Rate (FFR) is a real rate (i.e set above inflation).  And you can see from this chart, normally the FFR is indeed set to a positive real rate.  Before the FFR rate cuts in late 2007, CDs, and even online savings accounts beat inflation.

So to say that inflation is a tax on savings is outright propaganda.  Not on actual savings of real Americans.  Clearly real Americans are not stuffing cash into mattresses.  When the FFR is set to a positive real rate, as it usually is, even grandmothers can beat inflation [3]. 

The Real Tax on Savings

You know what is really a tax on savings, bank engineered financial crises.  The average American lost 25% of their total net wealth due to the Great recession of 2007. Some of the lower quintiles lost as much 50% of their net wealth, as more of their wealth is tied up in their homes. Now, that is the real tax on savings. During the 50 years from the mid 1930s to the mid 80s, there were no significant financial crises, as banks were tightly collared. There were a few mild recessions, but not a single one was due to a financial crisis [4].

But is Paul for collaring banks? No, he wants them to be even more free. He wants to take us back to the 19th century era of free banking. This was a time, when there were financial panics every 2 years. I am not kidding... On average, from 1836-1929 there was literally a recession 2 years after the end of the previous one. And most of them were caused by financial panics. A total of 19 recessions and 5 depressions including the Great Depression [5]. This was time when many people actually kept their money in mattress, because if they kept it in a bank, their savings along with the bank could go poof one day [6].  Talk about a tax on saving, but apparently that's okay because banks are free...

Wonder why is it that the bottom 40% don't have any savings? It wasn't always the case. During the New deal Era (1933-1973) average earned income of the bottom 90%, beat inflation by 405% (4.13%/yr), while during the market liberalization era (1979-2006) it was just 1.6% (0.059%/yr). Yes really, a cumulative 1.6% REAL income gain over 27 years [7].  Three decades of market liberalization, have transferred more and more income to the top 1% from the bottom 90%.

From 1979-2006 the top 1% captured 62.5% of the average REAL income gains. The top 5% captured 84.9%. On the other hand the bottom 90% captured just 4% in those 27 years!! In stark contrast, from 1933-1973 the bottom 90% captured 70.6% of the average real income gains [8]. It doesn't take a genius to figure out that the bottom 40% took the brunt of the upward income transfers since 1979. And wonder why they have no savings...

The real tax on savings is not inflation, it is under-regulated banking and excessive market liberalization.  But yet, Paul's supporters claim that he represents the interests of the average American.  If he was, he would be for tightly regulated banking, and rolling back three decades of market liberalization. But his actual views are diametrically opposite.  The bottom 90% fared vastly better during 1933-1973, when finance was tightly controlled, and top marginal taxes were high.  Hell, even the bottom half of the top 1% fared better back then.


1. Paul's claim is even more irrelevant, given that nominal average incomes should at least keep pace with inflation, as prices are income for producers.   Most consumers are also producers.  Your income derives from your role in the production of a good or service. But of course, it is true, income gains may not be distributed evenly. Obviously when there are real gains, incomes beat inflation.  Average incomes beat inflation by 230% from 1913-2006. 
2. While the Levy Institute study only includes households, the FOF table B.100, not only includes households, but also non-profit institutions and for some reason domestic hedge funds.  B.100 seems to be a "rest of" category, after taking into account corporations, banks etc:   So households themselves probably held more than 0.11% in cash and checking.  But it is definitely well below 6.6%.
3. Of course, if the  FFR is set to a negative real rate for a long time, average savings may (but not necessarily) fall behind inflation.  It may not as liquid assets are only 6.6% of total assets.  Homes are a big component of total assets, and a low FFR helps somewhat in that regard, enabling low mortgage rates. Mortgage rates are based on 10 yr treasuries, and 10yr  treasury bonds have never deviated more than +/- 4% from the FFR.  But, what is root cause for the target FFR to be set low right now?  Economic weakness due to the bank engineered financial crisis. The root cause is again under-regulated banking.
4. The recession of 1937 was the only severe recession during this period.  It was primarily due to FDR balancing the budget. But he quickly reverted and resumed even bigger deficit spending than before.  Thus recovery came quickly and the recession was over in about a year. From 1938-39 Real GDP increased 8.1%, 39-40: 8.8%,  40-41: 17.9%  etc:
5. Even though the creation of the Fed in 1913 ended the free-banking era, finance remained unregulated. That is why I am including the period after 1913.
6. This is one of the root causes of the Great Depression. 10,000 banks failed from 1929-1933. While that in itself is not a major issue, there was no deposit insurance back then. So when a bank failed, customers lost their savings, which led to further reductions in consumer spending, further steepening the recession. 
7.  All average earned income figures are in 2006 dollars. Keep in mind nominal income for bottom 90% increased by 163% from 1979-2006, prices rose 159% using CPI-U RS data set.  Thus average incomes beat inflation by just 1.6%.  Source: UC Berkley Table A4 based on IRS data
8.  Table A6 from same source above in 2006 dollars.  Table A4 excludes capital income,  A6 includes all income.  The same analysis can be found at this interactive chart from EPI.  Same UCB source but in 2008 dollars.

Saturday, February 25, 2012

No, the dollar did NOT really lose 95% of its value since 1913

There is a chart making the rounds lately,  that claims the dollar lost 96.2% of it value since 1900.  One of Ron Paul's fav talking points. Though technically true in a very narrow sense, if you look at average incomes during the same period, it is clear why this is deceptive.  Additionally, the way the line chart is presented is highly deceptive. It makes it seem that there has been higher inflation in the last 40 years.  But if you look at the actual numbers in the chart, that is clearly not the case. See the last 2 paragraphs for more detail.

Let us take at the period from 1913-2006, where we have complete data. So what do they mean, when they say the dollar lost 95.1% of its value in those 93 years? Essentially, an average good/service that cost $1 in 2006,  used to be priced at 4.9 cents in 1913. In other words, the average price level of goods/services increased by 1930% since 1913.  True, but guess what, average earned income increased by 6560% during the same time period. Average earned income rose from  $740/yr in 1913 to $49,300/yr in 2006.  Adjusting for inflation, $740/yr in 1913 is $15,000/yr in 2006 dollars.  Average incomes, not only kept pace, but beat price inflation by 230%.

So does it make any sense all to say the dollar lost value?  In reality, the REAL purchasing power of the average American, has increased by 230% in the past century.  Sure, prices were cheap in 1913, but $740/yr doesn't buy you a whole lot, not anymore than 15,000/yr today.  Even this statistic doesn't fully capture the quality of life gains of the last century.  A household making $15,000/yr today is well below the poverty line, but yet, they are highly likely to have a refrigerator, indoor plumbing, electricity, tv, cell phone and maybe even heating and cooling.  They are highly likely to have government help in making ends meet - food stamps, subsidized housing, Medicaid etc:.  And yeah, thanks to advances in medicine, they don't have to worry about half their children dying before the age of  5.  Their analogue in 1913, making $740/yr had none of these "luxuries".  And that was the average income...  Can you imagine what the poverty line looked like then?

Anyone who says the dollar lost value, is really trying to sell the false point of view, that somehow things were better off in 1913.  Seriously?? Maybe we should send them back in time to live in the slums of New York.  Yeah, we had actual slums back then. Update 3/2/2012:  Yes, technically, in the parlance of mainstream economics, the dollar dropped in value.  But, anytime Ron Paul says the dollar lost 95% of it value, but conveniently ignores the fact that average incomes and average savings beat price inflation, he is deceiving the American public.  The fact the incomes and savings beat inflation, it makes the "fall" in the dollar completely irrelevant.  What I am saying is we need a change in terminology. 

Inflation Adjust Average Income 1913-2006 (2006 dollars) h/t

 Further more, according to the ridiculous logic in the article, the dollar "gained" in value during the great depression.  This must have been a very prosperous time. Maybe we should start another depression so the dollar can "gain" in value. The dollar "gaining" in value is deflation, and that is rarely a good thing, especially for debtors.  Deflation doesn't usually happen in prosperous economic times. The question should not be whether the dollar "gains" or "loses" in value.  The question should be, will incomes beat inflation?  That is the real metric of progress.

During the pre-depression years (1913-1929) average incomes barely kept up with inflation.  During the market liberalization era (1979-2006),  things were slightly better, but not by much. Average incomes beat inflation by just 22%.  Most of the real income gains of the last century came during the high tax, "big" government New Deal era (1933-1973), when average REAL income increased from $9,980/yr to $40,500/yr. In other words, average incomes beat inflation by 300%.  Had real average income grown at the same rate during 1979-2006,  it would be $97,200/yr in 2006!!  The contrast is even more stark, if you look at average real income of just the bottom 90%. For them, average incomes beat inflation by 400% during 1933-1973, as opposed to 1.6% during 1979-2006![1]

In addition, the line chart showing the price level, is  highly deceptive. It makes it seem like there has been higher inflation for the last 40 years. But, inflation is not a linear dataset[2]. Note that the 2nd highest inflationary period in the chart was 1910-1920, when the dollar "lost" half its value (and yes that was during the gold standard).  In other words inflation was 100% in the 1910s, while it was 33% in the 1990s and 28% in the 2000s  But yet the chart makes it look like the 1990s and 2000s have a steeper slope than the 1910s. If the chart were accurately depicted they would use percentages.  This is how Fox news style propaganda works, take factual data and present it in a deceptive way, to sell a false point of view.

Perhaps the point of view they are selling, is that inflation has been higher due to the termination of gold convertibility in 1971. And it does seem many of the post's commenters perceive it that way.  That is clearly, not the case, inflation was pretty normal for most of the 80, 90s and 00s. Yes, the 1970s was the decade with highest inflation rate at 104% (just beat the 1910s by 4% points). But, the primary reason for high inflation in the 1970's and early 1980s were the twin oil shocks of 1973 and 1979.  If you compare inflation vs crude oil prices from 1973-1984, they track pretty close together.  Crude oil prices nearly tripled within a few months starting in late 1973, and that is not going to affect the prices for other goods?  You know, oil is used for transportation of other goods. What a coincidence that inflation peaked right after the oil shocks, twice.  What a coincidence inflation subsided, right after crude oil prices fell of a cliff in 1982-83.  Nothing whatsoever to do with termination of gold convertibility.

Update 3/1/2012:

Many Ron Paul supporters make the argument that the real value of a dollar saved in 1913, would only be worth 5 cents if spent today.  Yes, that would be a valid point, if we assume, that we live in a parallel universe where everybody holds mostly cash savings.  Let us look at data from the real world, that looks at non-home wealth distribution (mostly financial) from 1983-2007. See page 46 in the pdf.  You see three distinct classes. First, the bottom 40% household with an average net financial wealth of $-10,500(yes negative). Then, the 3rd quintile (40-60 percentile) who have little net financial wealth on average (just $26,500). And finally, there is the 4th and top quintile who have most of US net financial wealth.

Paul's argument is completely irrelevant for those bottom 40%, who have no savings. They live paycheck to paycheck. A little inflation, will actually help reduce their debt burden. Thus real income gains are what matters for these folks, and to enable that we should rollback market liberalization .[3]  For the top 3 quintiles, their non-home investments beat inflation on average by 122%, 83% and 66% in 24 years. Even the 3rd quintile who had no REAL income gains in the same period, gained 66% in their financial investments.

I will grant you, this was in 2007 before the financial crisis. By 2012, at most the cumulative returns were cut by half. They still beat inflation. The point is real people, who have actual savings are clearly NOT holding 100% cash.  If they were the average REAL return would have been negative 52%.  In reality, liquid assets only comprise 6.6% of all assets in 2007. Obviously this category include money market accounts. Hell, even money market accounts and online savings accounts had returns that beat inflation 5 years ago, before the Fed funds rate was cut. Same was true of time deposits. And usually in normal times the FFR is set higher than inflation.


1. All average income figures in chart and rest of blog in 2006 dollars. Source: Emmanuel Saez  UC Berkeley   Table A4 based on IRS data
2. Inflation isn't linear.  If you have 9% inflation/yr over 10 years, the price level doesn't increase by 90%.  It increased by  1.0910 = 2.37 or 137% .  From 1910-1920 the price index rose from 1.1 to 2.2,  while in 1990-2000  14.7 to 19.6.  Which decade shows greater price inflation?  The line chart deceptively makes it seem like it was the 90s.  But, really prices doubled (100% increase) in the 1910s, while it only rose 33% in the 1990s.
3. The main reason the bottom 40% are in this quandary, is due to market liberalization, as more and more share went to top 1%, less went to them. That wasn't always the case, from 1933-1973 the average income of the bottom 90% beat inflation by 400%.