Are your savings losing value?

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Introduction

One of the most awaited times of the month must be when we receive our paycheck. You enthusiastically log in to your banking app and satisfactorily gaze at your revised bank account balance. But although you may be richer on paper, the value of your wealth may still be decelerating. Truth be told, if you hold the majority of your wealth in currency and not in assets, then your savings are losing value.

Inflation is commonly described as the increase in the price of goods, services or assets over time. It is not unusual to hear people complain that “food prices have gone up!” and that “gas prices have increased again” or claim that “property prices always go up over time” and that “there is a bubble in the equity market.”

Although these statements may indeed be factual, it rarely crosses our mind whether prices are actually going up, or whether the currencies we use to transact are losing value!

In this article, we will explore the concept of purchasing power and how it can change over time:

Working to earn currency that is losing value?

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Why do we spend, save and invest using fiat currency? Think about it. Why are we so obsessed with hoarding paper notes and witnessing our banks account balances increase with time?

The paper money system was not always as we know it today. Before 1971, money was representative, meaning that its value was backed by an asset which had a true value. In fact, paper money was backed by gold, meaning that people had the right to request banks to swap their paper money for gold on demand.

But under this representative system, credit growth, which is an essential ingredient for economic growth, was constrained by the fact that newly issued currency had to be backed by gold. But there was not enough gold to cater for the demand for new money. Therefore, in 1971, President Nixon removed the requirement that the US dollar needed to be backed by gold.

This essentially meant that the US dollar became legally backed by Government, and the system could only work as long as the currency retained the trust of its citizens.

If you think about it, currency does not have intrinsic value, but it is rather a means of acquiring value. We derive no utility from accumulating currency, but we do so because we trust that the currency can be used to increase our utility by allowing us to buy goods and services, or to pay taxes and repay debt.

All tradable goods, services and assets have value. A currency is a measure of such value, so all goods, services or assets are quantified in terms of a generally acceptable currency, which can be dollars, pounds, euros, yen etc.

This means that the price of a good, service or asset is reflective of two distinct components:

The actual value of the good, service or asset, and
The value of the currency the good, service or asset is priced in

Thus, any fluctuations in the price of the items of value can be the result of one of two things:

A change in the intrinsic value of the goods, services or assets which is backed by fundamentals
Characteristics which give backing to the value of a good, service or asset
, or
A change in the value of the currency;

To illustrate, let us say you own a house. In an attempt to mitigate the economic contraction caused by the pandemic, the Government handed out money to the people. The demand for houses increased because people could now afford assets like real estate. In response to the larger demand, house prices increase, and the market price of your house does so too. But it is ultimately still the same house. You did not make any structural improvements to your house or added to its value. Yet your net worth increased because your house is worth more in currency terms.

However, your actual wealth did not improve because you do not own more houses, but the market value of your wealth has improved. The house did not become more valuable, but since there is more money chasing the same number of houses on the market, the currency has lost value relative to the real estate asset class.

We can illustrate this concept of currency devaluation using a basic demand and supply framework under three scenarios:

Scenario 1

Let’s say you have €1000 sitting in the bank, and you will be leaving it there for 10 years, growing at a fixed rate of 2%. Assume that economic output (a.k.a. total production of goods and services, a.k.a. GDP

) is €1000000 and will also grow at a fixed 2% rate.

When currency and production grow at the same rate, this means that the initial €1000 in my bank account today will retain its value in 10 years’ time. Today, I can buy... \frac{€1000000}{€1000} = €1000

...worth of output with my money. In 10 years’ time, if currency and production both grow at 2%, I will be able to afford the same €1000 worth. To calculate the value of an amount at some time in the future, we can use the following formula:

A = P (1+r)^t ... where A is the final amount which the initial amount P will become after growing at a rate r for t years.

To calculate the final value of the initial €1000: P=€1000, r=2%, t=10. Therefore:

A=€1000(1+0.02)^{10}=€1219

To calculate the final value of production after 10 years, P=€1000000 ,r=2% ,t=10. Therefore:

A=€1000000(1+0.02)^{10}=€1218994

Thus the amount of production which can be bought with the money you would have in 10 years time is:

\frac{€1218994}{€1219} ≈ €1000

Therefore, while in nominal/value terms, you may feel wealthier by having €1219 instead of €1000, because output grows at the same rate as the currency, your purchasing power has not changed. You can afford €1000 worth of goods and services today, and will continue to afford the same €1000 worth in 10 years time.

Assuming that you have no other assets and liabilities, a simplified personal balance sheet would look as follows:

money-growth-equal-to-production-growth

Takeaway 1: Every time the currency and economic output grow at equal rates, the purchasing power remains unchanged.

Scenario 2

Now let’s assume that the currency supply will remain fixed, but as the economy becomes more productive, economic output (i.e. goods and services) will grow at 2% annually. In this case, a fixed amount of currency will be chasing an increasing supply of goods and services. Therefore, the amount of goods and services available for each unit of currency you own increases, so your purchasing power improves.

With money remaining fixed, here is how the value of goods and services evolves after 10 years: Using P=€1000000 , r=2% , t=10:

A=€1000000(1+0.02)^{10}=€1218994

Thus the amount of production which can be bought with the money I would have in 10 years time is:

\frac{€1218994}{€1000} ≈ €1219

money-growth-lower-than-production-growth

Takeaway 2: A currency which has a fixed supply appreciates in value as the supply of goods and services increases. The currency becomes more scarce relative to the amount of output, so prices fall in real terms. Therefore, you simply leave the €1000 in the bank and still end up wealthier in the future, as you will be able to buy more goods and services.

Scenario 3

Now let’s assess the opposite situation, which is a better manifestation of the financial system we live in.

For simplicity, let us assume that the economy will grow at an average rate of 2% a year. Furthermore, the rate of annual currency growth over the next 10 years will be 12.5%. Why 12.5% you may ask? The 12.5% is the average money growth of all Central Banks since the start of the Covid-19 pandemic.

Central Banks have been relentlessly growing their balance sheets without any sign of tapering. Given that the economic scarring from the pandemic is still far from being repaired anytime soon, 2021 will be another record money printing year. At such high levels of debt, global economies are so fragile that Central Banks are likely to continue to accommodating at record rates for the foreseeable future. Besides, the economic recovery will not be the same across the globe. Therefore, a 12.5% rate of money growth seems to be a reasonable assumption.

Using the initial values for stored wealth and economic output, the above exercise can be repeated:

With money growing at 12.5% per annum, using P=€1000, r=12.5%, t=10:

A=€1000(1+0.125)^{10}=€3,247

Using P=€1000000 , r=2% , t=10, after 10 years growth at 2% the total value of goods and services will be:

A=€1000000(1+0.02)^{10}=€1218994

Thus the amount of production which can be bought with the money you would have in 10 years time is:

\frac{€1218994}{€3247} ≈ €375

The initial purchasing power of €1000 has been diluted to €375! The currency has been devalued, because the growth in the money supply surpassed the growth in production of goods and services. There is too much money chasing too few goods and services, so the currency value declines relative to the value of goods and services.

money-growth-greater-than-production-growth

Takeaway 3: If you leave €1000 in your bank account when money supply growth outpaces production, the purchasing power of this €1000 will dilute with time.

Is my currency losing value?

Since the Great Financial Crisis (GFC), Central Banks have been artificially 'creating' currency to keep the economic engines running. The 2020 pandemic caused Central Banks to take their money printing powers to the extreme. Quantitative Easing (QE)

has not been the only unconventional tool in policymakers' arsenal however. With banks unwilling to lend in such an uncertain environment, Governments made sure that the money trickled down to the real economy by providing direct liquidity support to consumers and firms.

They did this by joining forces with national Central Banks to finance their budget deficit. As, the above chart shows, in 2020, the broad money supply increased by over 19.1% in the USA, 9.1% in the UK, 8.8% in the Euro Area and 5.4% in Japan. And it is surely likely that this above-average growth will go on for much longer.

Average Growth in Broad Money	USA	UK	Euro Area	Japan
Average (2000-2020)	6.8%	2.0%	5.5%	6.6%
Non-Crisis Average (2000-2020)	5.9%	1.9%	4.9%	5.7%
Dot-Com Crisis (2001:3-2001:10)	8.6%	1.6%	8.3%	10.0%
Great Financial Crisis (2007:12-2009:05)	7.4%	0.9%	9.2%	14.1%
COVID-19 pandemic (2020:2 - 2020:12)	20.2%	5.6%	9.1%	9.8%

The currency excesses created by Central Banks have had irreparable ramifications on the value of our currencies.

Excessive printing of currency infringes on a fundamental characteristic of money: scarcity. If money is freely available, it will not retain its value. The more freely available a currency becomes, the more the value of currency deteriorates, causing goods, services and assets which preserve their scarce nature to increase in value.

But a currency devaluation is very difficult to observe in practice because it is so abstract. If we think of the prices of goods, services and assets as exchange rates, you may be able to conceptualize a currency devaluation better.

Consider an exchange rate, such as EUR/USD. An exchange rate is a currency pair, which compares the value of the base currency on the left, with the quoted currency on the right. The base currency is fixed at 1 unit, so EUR/USD describes the amount of USD which can be bought per EUR. We can express the exchange rate as a fraction to facilitate interpretation:
EUR/USD = \frac{USD}{EUR} = \frac{quoted currency}{base currency}
On 27/03/2021, the EUR/USD exchange rate was 1.17928. Therefore, with €1, I can buy $1.17928.

We can apply this exchange rate interpretation to understand how the prices of goods, services and assets are denominated per unit of currency. Instead of the quoted currency in the numerator we will have a good, service or asset. And the base currency will remain 1 unit of our currency of choice. Therefore, goods, services and assets are priced in the following way:

Price\ per\ unit\ of\ currency = \frac{good/service/asset}{1\ unit\times currency}

Now let us use this currency pair interpretation as an analogy for a currency debasement relative to assets, goods and services. I have chosen a car to represent goods, and a doctor's visit to represent services.

Goods: Assume that a car costs $10000 if I buy it today. This means that with $1 I can buy 0.0001th (0.01%) of a car. If I bought the same car a year ago, it would have cost me $15,000. This means that with $1 I could buy 0.00006th (0.006%) of a car. Since the car is less expensive today than it was last year, this means that my $1 has gained purchasing power.

The reason behind this increase in purchasing power may not necessarily be a stronger currency however. It may be that efficiencies in production made the cost to manufacture a car cheaper. Goods go through a production process from which price is determined based on length and complexity of production and transportation costs. The price of goods increase when:

The production and delivery process becomes more expensive, or taxes are imposed on the goods
There is an increase in final demand for goods
The currency loses value and suppliers require more compensation

Services: A doctor charged $24 per hour last year. This meant that with every $1, I was able to book the doctor for 2.5 minutes ($1/$24 per 60 minutes). The doctor increased the fee to $30 per hour this year. This means that with $1, I can book the doctor for 2 minutes. I now get less value out of the doctor per dollar, meaning that the purchasing power of my dollar has weakened.

The time used to provide a service is always scarce and the value of one's time is reflected in the price. Therefore, more is paid for a service when:

The service provider's time increases in value or the service improves
The service provider values the currency of compensation less and asks more of it for the same service

The following chart shows that US money growth has historically surpassed GDP growth from the mid-1990s, but remained elevated after the 2008 Financial Crisis. This means that there should have been more currency chasing goods and services, and this should have been reflected in higher prices. However, inflation seems to have been exhibiting a declining long term trend. Why is this? Shouldn't a larger currency supply be inflationary?

Certain essential goods and services such as food, health and education did indeed record notable inflation over recent years.

However, these price increases are not reflected in the Consumer Price Index, rendering it an unrepresentative measure of true inflation. This is because certain deflationary components such as technology offset the price increases recorded in other components. Inflation is indeed showing up in certain goods and services, but the official statistics are not adequately capturing it.

But, aside from this statistical reason, most of this currency supply ended up increasing demand for assets.

Asset prices appreciate when:

The fundamentals behind the price of the asset improve, namely the intrinsic value
The actual worth
of the asset increases, which causes more demand for the asset.

For instance, a growing population should increase the price of land as more people demand a fixed supply of land.
A growing economy should drive a higher S&P500 index.

People want to get rid of the currency and hold appreciating assets instead. This is because asset becomes more scarce relative to the supply of money. The currency loses value because money supply growth outpaces the growth in supply of the asset (scenario 3). Since asset prices are denominated in fiat currency like the dollar or euro, an oversupply of currency will weaken the currency relative to the scarcer asset under consideration.

The reverse is true when an asset depreciates. The fundamentals of the asset may deteriorate (think of a car which is released from a showroom – it immediately gets exposed to natural conditions like exhaust and dust), and/or the supply of currency declines sufficiently to make it more valuable relative to the asset supply. For example, consider the unexpected discovery of a gold mine. This would increase gold supply and becomes less scarce relative to the supply of currency, so the price of gold denominated in currency is likely to fall.

The following table illustrates the cumulative percentage increases in several components in dollars over various time periods. Asset returns accelerated after 2008, following Central Banks' unconventional new tool of increasing the money supply to counteract economic recessions.

Cumulative % Growth when expressed in USD	2008 - 2020	2015 - 2020	2020
US M2 Money Stock	157.0	63.9	25.0
US CPI	23.3	11.4	1.1
House Prices	37.0	41.0	10.3
S&P500	172.5	88.3	16.4
NASDAQ	439.3	178.0	40.8
Gold	95.1	44.5	19.4
Bitcoin	28,949,300	13,149.2	209.6

While goods and services inflation in the US (US CPI) only increased by 23.3% since 2008, asset prices increased by a significantly higher magnitude. As shown in the above table, in 2020, Bitcoin outperformed all other assets. This implies that Bitcoin appreciated not only in terms of currency, but also relative to equities and corporate bonds which have increased in supply to help companies raise capital throughout the pandemic.

The actions of policymakers have indeed caused a devaluation of currencies, however this devaluation was manifested in several assets rather than the general goods and services prices. And this had a compounding effect on the price of assets stemming from:

increased demand for assets because of too much currency chasing a scarce supply of assets, and
people's and institutions' unwillingness to hold a devaluating currency.

When it comes to assets, the scarcity property is respected, because assets have value and also produce a cash flow.

How to survive a currency devaluation?

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Now that we know that currencies are indeed losing value courtesy to the manipulative actions of policymakers, what can we do about it?

In truth, these easy money policies can go on as long as citizens do not lose confidence in the currency. Once people lose confidence in the currency, then the currency becomes worthless and inflation may transpire into hyper-inflation such as that experienced in Zimbabwe, Argentina and Venezuela.

What we are witnessing is a modern day application of Gresham's law.

Gresham's law states when there are two forms of money, the less valuable form will be used for transactions, while the most valuable form will be hoarded.

This is exactly what is happening today. People are relentlessly substituting their fiat currency for assets which retain their value, or betting their fiat on completely different systems like cryptocurrencies. Even global governments have become aware that their ability of their currency manipulative policies are getting weaker and are working to implement their own digital currencies to better control the spending and saving decisions of citizens.

In light of these developments, hedges

against currency devaluations are imperative to acquire. Substituting currency for assets which retain value is the only way how to avoid wealth destruction.

Which assets retain their value during a currency devaluation?

Most assets generally do well. Real estate and equities are plausible investments as the larger money supply increases their demand. Gold and other precious metals are time-tested wealth preservers. Bitcoin has recently emerged to be a form of digital gold which is independent of the present monetary system, and cannot be controlled by government, despite the fact that it are not yet widely accepted as a medium of exchange.

However, this does not mean that you should immediately convert all your cash into assets. Some contingency money is always good to have in case an emergency arises. Besides, you need to adequately assess whether it is the right time to buy the asset based on its price today and the prospects which lie ahead.

To gauge whether it is a good time to buy, it you can think of the demand and supply for an asset you are interested in relative to the demand and supply of currency and alternative assets. For example, you can denominate gold or real estate in terms of the S&P500 to assess whether gold is underpriced.

While an evaluation of the scarcity of an asset relative to other assets is important valuation metric, scarcity alone does not determine an asset's value. Therefore, this exercise should be complemented with a comprehensive assessment of the asset's true fundamentals and risks.