As you walk through your lifetime, you’ve probably noticed that prices for goods and services are rising steadily. This phenomenon is called inflation. But why does inflation exit? Who profits from it and how can you protect yourself against it. To answer these questions, we explain to you all important basis and connections.

Definition of money

First the question of what is money actually? Money is a generally accepted means of exchange and payment. There are different forms of money, especially cash (coins & banknotes) and the payment claim of a non-bank to a bank (book money or bankroll). The money earmarked as legal tender in a country’s monetary constitution is called the currency.

In our today’s market economy, money also serves as a steering and rewarding function. You can see money as a kind of right to buy goods from the society based on value you did give to society. Work that is better paid should attract people to do it. Companies that earn money can grow and companies that lose money, shrinking or disappearing altogether. The state uses different tax rates and tax breaks to promote certain sectors of the economy and penalize others. Consequently, money has a big impact on people’s lives.

Value of money

There are many currencies in the world. However, the value of these currencies are very different. For a few dollars you can buy food, medical care, entertainment and much more. But for many million Zimbabwean dollars you get nothing. Why is this? The reason lies in the main functions of money. These functions must be fulfilled, so that a large group of people accept the currency as a payment method. The main functions of money are briefly described in the following chapters.

Medium of exchange

A medium of exchange is a something that can be easily traded for any good or service. For this it need to have many important properties to be useful. These properties are common and accessible, liquidity, low cost of preservation, transportability, divisibility, high market value in relation to volume and weight, recognisability and resistance to counterfeiting.

Measure of value

A measure of value is a reference you can use to compare the cost of different services and products. The most important properties for this are stability of value and practicality. A currency is convenient to use when the most common numbers are of a size that is easy to calculate with.

Store of value

A store of value is anything that retains its purchasing power in the future. Consequently, in should have a useful future function for humans and will be short in supply. A good historically store of value is backed by something useful. Like a house, country, food, wine or something that you can trade.

Medium to take on debt

The function that is mostly forgotten is the possibility to take on debt. Without money or a currency, it is difficult for private individuals, companies or the governments to take on debt. Companies and states in particular are taking on a lot of debt, On the other hand individuals save it. Of course, debtors have little interest in the fact, that the dept still be of great value in the future.

Generation of money

In our current market economy there are two processes to create money:

Cash generated by a central bank by coin milling and banknote printing.

Commercial bank money is created by private banks by taking out loans as deposits of borrowers. The commercial bank need to have some small ratio of own capital to do this. Normally around 2 to 5 %.

In most countries, most of the money is generated by commercial banks that lend. Consequently, commercial banks do not simply act as brokers and lend deposits to savers. They are not dependent on central bank money to create new loans and deposits.

Banks have been around since the 6th century BC. During this time, however, the monetary impact of banks was rather low compared to the state. In the past, money-printing was much more difficult for the state, as metal commodities such as gold, silver and bronze were necessary. Although sneaky kings and emperors have repeatedly lowered the alloy content of the metals in the coins, but this was only possible to a limited extent. Thus, the money was covered by the raw material and limited in the multiplication. This has given people over thousand years security that their money was worth something tomorrow.

Fiat money

Nowadays, money can be generated simply by acouunt banking. The money itself is not based on any asset, commodity or security. Today’s money has its value solely on the basis of the Government’s demand that the chosen currency be used as a legal tender. Making it unlawful not to accept the currency as a means of repayment for all debts, public and private. Normally, all wages and salaries must also be paid in the prevailing currency. This gives the currency increased acceptance because all workers have it. This kind of currency is called fiat money.

Who controls the money?

Practically everyone that uses money and influences the circulation of it. But of course, the influence of one market participant is negligible compared to large commercial banks and the central bank. The can generate, move and trade so much money that all other effects are negligible. Consequently, the organization that generate money.

Commercial banks

Commercial banks are institutions that provides services such as accepting deposits, providing business loans, and offering basic investment products. Their main function are to accept deposits from the public in order to lend money to borrowers. Like discussed before, they need only 2 to 5 % money deposit to lend 100 % to a borrower. They generate much more money than the central bank. So are they more in control than the central bank? Not really, the central bank has much more control mechanism to make the banks docile.

Central bank

The central bank is a state institution that manages the state’s currency, money supply, and interest rates. The central bank surveys and controls commercial banks and has various disciplinary options. Unlike a commercial bank, the central bank has a monopoly on increasing the monetary base in the state and prints the national currency. With these functions, the central bank is significantly more powerful than a commercial bank.



But who controls the central bank?

Theoretically, the central bank is independent, but in reality the state is in control. He achieves this by hiring the central bank employees and defining the legal framework for it. Time and again there are strong state interventions in central banking. The powerlessness of the central bank against the force of the state shows clearly who is in the lead.

Why does the value of money decrease?

To understand why the money value decrease over time we need to understand the interests and activities of the market participants who control the money. These are the commercial bank, the central bank and the state.

Interests of commercial banks

Commercial banks have only one interest. They want to make a profit. For that, an acceptable stable currency is sufficient. Their most powerful tools are loans, whose money they create with the lending. You can understand it that way. The bank generates money from nothing and gets interest on it. The interest less the expenses in labor and building costs are the profit of the bank. Of course, the bank wants to lend as much money as possible to use this effect as often as possible.

This leads to a higher supply of money every time the bank does so. Of course, this process has not increased the amount of goods or service offered. As a result, a larger amount of money faces the same number of goods and services. Based on the supply and demand rule, a larger amount of money is now needed buy a good. Consequently, this lowers the value of money.



From a moral point of view this is more than questionable. Why has the bank or bank customer a right to buy goods from society based on value he did not give yet? The answer to this question is not easy. See it as system that did perform well over thousand of years. Or more technical, this give new hungry people a chance to generate value for society and them self, even when the old people don’t want to give them a chance. Of course, this brings commercial banks in a strong gate keeper position. Maybe we will find long term a better solution.

Interests of the central bank

The interest of the central bank is to maintain the 4 basic function of money. Like the commercial banks their money generation leads to decreasing value in money. But why does the central bank do this? In my eyes the central bank is only an extended arm of the government or state. Its interest are aliened to the state. Consequently, lets look at the interest of the state.

Interests of the state

The state has the interest that his currency is the accepted legal tender. For this the currency need to perform well for its 4 basis functions. Consequently, the state will most likely do nothing to thread this functions. This means he has an interest in a “relative” stable currency.

But the state use his currency most likely to go into debt. Mainly because politician want to spend money they don’t have. Instead of raising taxes, what is not popular, they borrow it with the intent to never pay it back. And if they don’t find a debtor, they borrow directly from their own institution. The central bank that will print it for them.

In the past countries could not print gold or silver. Which has made the currency more stable or led to state bankruptcy. This can also happen if the stats own currency is not accepted and the state has to use foreign currencies. Nowadays it is more likely that a currency cut happens. Witch delays only some zeros from your money numbers. Great for the debtors and bad for the loan holder.

True inflation vs stated Inflation

In the last 10 years the stated Inflation is in the western industrial countries around 2 %. Compared to the inflation in years after WW2 where the inflation was around 5 to 8 %, this is quite low. The main reason for this is the globalization of labor. With the removal of tariffs and the creation of a global supply structure the worker pool for companies did grow dramatically. Higher supply did lower wages and consequently lower prices. I think with the Trump administration and their more tariff orientated trade policy the Inflation will come back.

But there is another reason why inflation looks low. It’s highly beneficial for the government to report lower Inflation numbers compared to the real ones. Mainly because unreported inflation shows in the GDP statistic as economy growth. GDP growth is based on inflation growth and economy growth. Consequently, if the GDP did growth by 5 % it can be by 4 % inflation and 1 % economy growth. If you only report 2 % Inflation it looks like the economy did growth by 3 %.

Based on the M1&M2 money growth and my own measurements I would estimate that the real Inflation is about 50 to 100 % higher than the reported Inflation. Yes you read correct 50 to 100 % higher.

What does this mean for you?

First holding large sum of cash is a worse idea than you think. The purges power lose is more than you think. Second, Investing in interest based securities (Bonds) gives you little chance to beat the true Inflation. For example, you by a bond with 5 % annual interest. 2 % Inflation you could beat but 3 or 4 % with playing taxes and some risk loses is not likely anymore. Thirdly you income growth most likely slower than the true inflation. Fourth the Asset prices like houses and stocks are not so unrealistic as you may expect.

Investing in money, a currency or cash

As an investment side, we of course speak more about investing in cash. For your better understanding of investments we need to go shortly to the basics. There are three things you can own.

Some resource you own that generates a regular cash flow to you. The biggest asset normal people have is their job. But there are many others like that a house you rent or stock that pays regular dividends. A alternative definition is something that it will provide a future benefit. Like a good education, gold or some paintings.

A liability is something that most of the time only cost you money. Like food and the apartment or house you live in. Yes! Your hobby to go every Friday evening to a bar and so much more. Of course, these goods can give you peace of mind, concentration and confidence. In finacial terms these are still the ones that cost you money and therefore a liability.



Cash or money

Cash is the exchange medium with which you pay for assets and liabilities. Aside from investment terms you use cash to pay for services, consumer goods, debts or other things of your daily life. Money has no use in itself except to pay for other things.

Conclusion for investing in money

As an investor you collect assets and try to have as few liabilites as possible. Consequently, to invest in the medium of exchange and not in an asset is an unusual behavior for an investor. Of course not for a speculator, they can do whatever they want. But please understand that normal people are very bad speculators. So why is investing in cash a bad idea for an investor? Because the historical performance, like shown above, is terrible. The state, the king or who generated the currency, has always inflated it. Why? They use the currency to get into debt and need to wipe it out.

As an investment, you want to buy something valuable. Something is valuable when it is backed by an asset that will generate a positive cash flow in the future. This should be a high selling price and a passive regular income. One example is a stock certificate. Its only paper or digital data record. In itself almost worthless. However, it is backed by the ownership of a part of a company. With this ownership you are entitled to the dividend payments of the company and the voting rights in the annual general meeting. Something very valuable, that you can sell at high prices in the future, if you desire.

Summary

Money loses its value through the expansion of the money supply by commercial and central banks, as well as the state’s concern to get rid of its debt. To protect against this don’t hold a lot of cash and don’t invest in cash based securities like bonds. Because the true inflation is 50 to 100 % higher than the reported one. With taxes and risk based loses you have nearly no chance to beat inflation with this investments. Invest in assets that generate a regular passive income and you can hold for a long time.