Inflation and Thinking on Money (Part I)

(1/03/2010) - Though its so pervasive in our lives, I find that the nature/essense of money is tremendously hard to pin down.  On a physical level it is fairly useless – paper, cheap metal, or more often than not, electronic signals and magnetized ferromagnetic material.  You can’t eat, wear, or sleep in money (note to literalists – you know what I mean).  Yet in the experience of much/most of the world’s population, it provides you all these things and possibly much more.

On a very basic level, we can think of money’s value as a symbol for goods and services it can purchase.  For example, lets say I received this twenty dollars for mowing my neighbor’s lawn.  My neighbor works for Google, and received the money to pay me by working approximately 30 minutes developing web applications.  I can trade my twenty dollars for some apples, milk, a chocolate bar, and a movie ticket.  Each of these products was produced and brought to me by the work of hundreds, if not thousands of people. 

In our everyday experience, money is interchangeable for goods and services.  But at the same time, money is not equivalent to goods and services.  For example, the six dollars in my pocket is not a rain check for 2 gallons of milk or a used shirt.  If a plague kills half of the country’s dairy cows and the price of milk spikes to $10 a gallon, I’ll be out of luck.  Prices change for a huge number of reasons.  And there are hundreds of ways to acquire money.  For many Americans, money is acquired in exchange for paid work.  But there are other ways to acquire money – investing, bank interest, relatives, robbery, etc. 

The value of money within a single country floats, and the values of different currencies change in relationship to one another as well.  In the United States, the value of our money is measured by broad statistics such as the Consumer Price Index, which tracks the average price of consumer goods and services.  While the prices of individual products can vary greatly – a computer that would have sold for $1,400 a few years ago can probably be got at 1/3 of that price, while rents in New Orleans have spiked 40% since Katrina – the prices of consumer goods in general have been fairly steady over the past 30 years, usually rising between 1.5% and 4.5% every year.  This year was the first year that it has fallen since 1955.

(A Note – For a long time I thought and wrote that the CPI didn’t measure the price of important goods like food and energy (gasoline, electricity, natural gas, etc.).  While its true that the so-called “core” inflation index doesn’t measure these things because economists do not believe that monetary policy can be used to control the prices of these goods, the primary measure of inflation does include these price changes.)

On the other hand, this really that steady at all.  Since 1984, the year I was born, consumer prices have nearly doubled.  Money acquired in that year would have bought, on average, twice as much as it would buy today if it had been stuffed under the proverbial mattress and left for 25 years.  But the average American is much wealthier than they were in 1984.  Wages have grown, and technological progress has made many purchases a better value.  A person who stuffed $1,000 in their mattress in 1984 would be able to buy a much, much better computer in 2009 than they would have in 1984, inflation not withstanding. 

Lets take the example of computers one step further.  Let’s say that a $2,000 computer sold in 1984 is (assuming its currently working) about a thousand times slower than a $1,000 computer purchased today (not sure exactly what this is would actually be, but I’m pretty sure I’m being too kind to computers from 1984).  Was the labor and skill of programmers, miners, truck drivers, manufacturers, sales people, and everyone else who worked to produce and sell our Commodore 128 worth one thousandth of the labor performed and materials used in 2009 to produce a Mac Book?  Of course not.  Value can’t be determined in this way.  Instead, value is determined by what people are willing and able to pay at the time that labor is performed or transaction is completed. 

Local Views of Inflation

This flexibility in prices and the value of work isn’t always obvious at a personal level.  Its often hard to remember the details surrounding important events in your life that occurred ten or twenty years ago.  Its almost impossible to remember the price of a gallon of milk or a computer or whatever from fifteen years ago and integrate that knowledge into your life.  And it has been the experience of most people living today in the United States that they have more money than they used to, that their home has increased in value, that they have access to more consumer goods and better services than they did 20 or 30 years ago (the 2000’s were the first decade since the 1930’s where this hasn’t necessarily been the case). 

My fiancé’s parents remember buying their home in Santa Clara, CA (i.e. Silicon Valley) for something like $130,000 in the late 1970’s/early 1980’s (I’m sure they remember the exact amount and year, but I don’t).  Today the home is probably worth $750,000.  On one level, its been a great investment for them.  If they sold their house, it would have earned them $620,000 (this doesn’t include all the interest and maintenance and property tax costs, but for simplicity’s sake lets say that’s the amount they would have otherwise spent on rent had they not owned a home).  Even if you include general increases in the consumer price index (a.k.a. inflation), their home has still “made” them money if you view it as an investment.

But is this really right?  Let’s say that they wanted to sell their home.  Well, they would have a lot of money, but wouldn’t have a place to live.  They would either have to rent, buy a new home, become homeless, or what not.  Let’s say they wanted to buy a home, probably near by because Morgan’s father works in near-by San Jose and they have many friends in the area.  Unless they wanted to take out a new mortgage, they’d probably only be able to buy a modest home, because homes are expensive in Silicon Valley.  The money they “made” on their old home doesn’t really get them anything unless they wanted to move to a place where home prices were lower, i.e. a place where there is a lower demand/greater surplus of homes than Santa Clara. 

If it weren’t for the renovations they made on their home, it didn’t really gain value at all, despite having “made” money.  This is the work of inflation.