When people see the cost of their weekly shop going up almost every week, inflation seems to acquire its own animus and becomes ‘a thing’, moving from the financial to the front pages of the newspapers. The post-Covid cost of living crisis is a case in point.
What is strange though is how people tend to overlook lower, persistent levels of inflation. Perhaps the reason is that inflation is in fact central bank policy, with the Bank of England amongst others targeting a 2% annual increase in the general level of prices. What does this really mean for savers?
Albert Einstein is supposed to have described compound interest as an eighth wonder of the world, and it sometimes seems that one needs a mind as attuned as his to make the calculations.
An investment of £100 yielding 10% makes £10 in year one, £11 in year two and £12.10 in year three, for a total of £133.10 after three years. Doable with a calculator, not quite so easy in your head.
Luckily, there is a heuristic or rule-of-thumb to help out. Using natural logarithms, the ‘rule of 72’ allows us to work out how long it takes to double our money for any given compound level of return.
The process is simple – just divide 72 by the rate of compounding. For a 10% compound rate, 72 divided by 10 means you double your money in 7.2 years. A 5% compounding rate takes 14.4 years, a 2% rate 36 years and so on. If the compounding effect of interest makes us richer over time, the process applied to inflation destroys the spending power of our money in exactly the same way.
One way of interpreting the Bank of England’s 2% inflation target using the rule of 72 is that this goal makes your money worthless in 36 years, all else equal.
To call this a headwind to retirement saving seems like an understatement. In fact, when put this way, it’s a surprise people aren’t rioting in the streets.
The effect of compound inflation isn’t quite the whole story. The economy can grow and wages can rise in real terms, and investing – the manner in which we save – allows us, if we are lucky or clever, to stay ahead of inflation over time.
There are a number of ways to do this. Inflation-linked government bonds (linkers) are one way.
Certain commodities like gold are still seen by some as a hedge against monetary inflation. The popularity of housing as an investment in part reflects the use of the financial leverage resulting from mortgage borrowing to enhance returns over time.
For the majority though, staying ahead of inflation is a tough task, both from an absolute and relative perspective.
Many of the social and economic issues the country faces, such as the build-up of debt, income inequality and unaffordable house prices (especially for the young who want to settle down to start a family), are in part products of this compounding effect.
We tend to think of time passing in a linear way through hours, days and months. Yet the process of compounding, whether in terms of investment returns over time or through the process of inflation,# is a non-linear or geometric process.
One way of looking at the idea of wealth inequality, for example, is to say that time doesn’t pass equally for rich and poor, debtors and creditors. The wealthy get richer over time as compound returns accrue. Those with credit card debt get poorer for the same reason. The effect of inflation on the cost of living, itself a process of compounding over time, also tends to affect the poor hardest.
Social divisions and sluggish economic growth are often the result.
In ancient times, debt jubilees, where loans were periodically written off, eliminated the pernicious effects of the build-up of debt over time. Nowadays though, countries like Argentina, which default on their debt, are treated as basket-cases.
It is perhaps ironic that high inflation, which destroys the real value of debt and capital, has often proved to be the easiest and most convenient way for governments to solve the problem of over-
Indebtedness and wealth inequality. A bitter pill to swallow indeed.
Charles Crowson is the author of Jam Tomorrow? Why Time Really Matters in Economics, published
by Whitefox Publishing.
