How inflation destroys wealth, explained in plain English

Welcome back!

This is the fifth part in a series of articles that are meant to explain government finances and how they affect our investments.

This part will explain how inflation in India affects your wealth.

Reading the earlier articles in the sequence below will be very helpful.

  1. Fiscal deficit of India in plain English
  2. Government borrowing in India explained in plain English
  3. What do the RBI and the Batman movie have in common? – Quantitative easing in India by the Reserve Bank of India (RBI)
  4. Inflation in India explained in plain English

Summary of earlier articles

  1. The Government of India spends more than it earns leading to persistent fiscal deficits.
  2. It borrows from the market to feed expenditure which is greater than income.
  3. The market may by be unwilling to fund the government at lower rates of interest.
  4. The RBI engages in quantitative easing, creates money out of thin air, and purchases a portion of the government bonds in the market.
  5. The government is able to meet its borrowing needs using the RBI as a crutch.
  6. Excess money supply chasing goods and services in the economy causes  price inflation.

Inflation – the silent tax

Take the example shared in the earlier article. I will provide a quick recap. With two cycles and Rs. 200/- in the economy the price of one cycle was Rs. 100/-. When there was Rs. 250/- in the economy because the central bank injected Rs. 50/- the price of one cycle increased to Rs. 125/-. Money supply inflation caused price inflation.

For a moment look at it from the reverse angle. Initially Rs. 1/- could buy you 1/100th of a cycle. After money supply increased it could buy you 1/125th of a cycle.

This simply means that the worth of one rupee came down. Each rupee in the economy lost its purchasing power.

Who is affected?

The above example was simplistic. In the real world it takes time for extra money flowing into the economy to percolate down to all the businesses and citizens. It is only after months or sometimes years, that all the participants sense the increased money supply. When businessmen see their customers flush with cash and haggling less they tend to increase the prices of their output products and services. This chain continues through the economy till prices rise in most industry sectors and goods and services.

The salaried class is usually the last to benefit. Wages usually increase last when the rise in prices is clearly visible in the economy.

How does the government benefit?

The interesting part is that the moment there is extra money supply (greater than the goods and services present in economy) there is bound to be inflation down the line. Which means that the money is practically debased anyway on the day that it is injected.

Who is the first spender of debased money in the economy? The government.

At what prices do they buy goods and services and pay salaries to government employees? The existing prices and salary levels.

If the receivers of government spending were aware of the extra money supply would they have not adjusted their prices upward? Yes.

But this is theoretical!

Practically, it takes time for prices to move upwards to match the increased money supply.

By then, the government has already bought goods and services and paid salaries at the old prices.

The government has actually underpaid everyone with debased money.

How does inflation destroy your wealth?

If you understood the above explanation, it should be easy to see the impact of inflation on your investments.

Say you have cash at home worth Rs. 1000/- for the last 1 year. Consumer Price Inflation (CPI) in India is close to 10% today for the year gone by. It means that the purchasing power of cash has decreased because of the rising prices.

Take another example.

Assume you have been holding a one year maturity fixed deposit since the last year which gave you 9% interest. With price inflation of 10% you have in fact had a loss of around 1%. Your investment has not even kept pace with increasing prices.

What is the solution?

Inflation is a monster that ravages savings and investments with the government being one of the prime beneficiary. Think of it like another wealth-destroying tax on the citizens.

Except that this one is stealthy and most people are unaware of how it even hit them.

To start with be aware of the following:

  • Know that Real returns = Nominal returns minus inflation
  • Example Real return is -9% – 10% = -1% in the example given above.
  • Cash is eaten away fastest by inflation.
  • Next come savings accounts which are also a loss-making proposition. Most banks give 4% interest. You can now do the arithmetic. It gets worse when you consider that there is tax on interest too.
  • Next come fixed deposits and bonds. They may or may not beat inflation but will be better than normal savings accounts.
  • Usually over the long-term well-chosen stocks of good companies and good diversified equity mutual funds yield capital appreciation that beats inflation. Wise equity investments will grow your real wealth.
  • Real assets (gold, agricultural land, non-agricultural land, real estate) have comfortably beaten inflation over the long-term if we see past trends.

This should not be taken as a formula to be followed blindly. Real estate bought at the peak of a wild boom can destroy your capital as I explained in an earlier article. Companies like DLF which were considered “good” at a certain point in time have thoroughly disappointed investors in the stock market.  I urge you to go through the disclaimer.

India has been a high-inflation economy. It does not look like things will change as I explained in the last article on inflation.

The key to protecting and growing your wealth lies in being aware of the what happens in the background in the economy in which we make our investments.

Coming soon

In the future, Capital Orbit will cover different investment options including stocks, bonds, savings schemes, mutual funds, real estate and gold.

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Comments

  1. says

    Bank of England head honcho Mervyn King gets his K (OBE) but, one worends, what for? I mean, where was he during the credit crunch and what did he do then or has he done since? He got a salary while he was there, didn’t he? It’s commonly known there’s an even bigger crunch coming anytime soon because the people supposed to be in charge (arise, Sir Melvyn, for instance) resolutely refused point blank to address any of the real issues involved, so what’s he getting his gong for? Not leaving the tribe all the way maybe, remembering he said of all the banking systems possible the one we have is the worst? Was this his fee for keeping shtum about more contentious issues?

    • says

      I agree with you that prominent central bankers have been overlooked problems that were building up. Politics and the world of money, at the top, is a dirty place indeed.