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I have to admit that I derive some pleasure in taking on hoary old myths. For example, some economists assert that the interest rate you see on the Treasury bond is not real. You see, it’s only nominal. To calculate the real rate, they say you must adjust the nominal rate by inflation.
Real Interest Rate = Nominal Interest – Inflation
It seems to make sense. Suppose you have enough cash to feed your family for 2,000 days. Then the general price level increases by 15%. You still have the same dollars, but now you can only buy groceries for 1,700 days. You’ve been robbed, some of your purchasing power stolen. Therefore you want to earn enough interest to overcome this loss.
This view is flawed.
Normally, you don’t spend your savings, only the income on it. In ancient times, people had to hoard a commodity like salt when they worked. In retirement, they sold it to buy food. Modern economies evolved beyond that, with the development of interest. Retirees should not have to liquidate their life savings.
Inflation and Retirement Savings
Now, let’s examine this idea of correcting the interest rate using the Consumer Price Index, or CPI. We’ll skip over the problems in trying to measure prices, and avoid the controversy over whether CPI does a good job. We’ll just compare two retirees from two different eras.
Clarence was retired way back in 1979. Suppose he had $100,000 saved up. According to the St. Louis Fed, the CPI was 68.5 on January 1, 1979 and it rose to 78.0 one year later. This means prices rose by about 14%—what most people call inflation. Also according to the St. Louis Fed, a 3-month certificate of deposit offered 11.23%. There are many interest rates, but let’s use this one for simplicity.
The popular view focuses on his lost purchasing power. He begins the year with $100,000. That amount could buy some meat and potatoes. Clarence ends the year with $111,230 in principal + interest. Liquidating that larger amount buys less hamburger and fewer fries at the higher prices at the end of the year. Therefore Clarence had a loss, and the loss is interest – CPI, or 2.77% of $100,000, which $2,770.
Interest and Wealth
I suggest another view. The interest afforded Clarence $11,230 worth of food. According to the U.S. Census Bureau, the median income in 1979 was $16,841. Clarence made 2/3 of his former income. That’s about right for a retiree without a mortgage or commuting expenses. He could eat pretty well. Although the falling dollar did erode his wealth, we’re focusing on how Clarence experiences interest in the real world.
Now, consider Larry, a recent retiree. Larry has $1,000,000 in savings. CPI actually fell over the past year. Interest on a 3-month CD is negligible—0.03%. Again, we’re not focused on whether CPI is accurate. Just grant for the sake of argument, that some prices dropped and this was matched by a rise in others.
In the standard view Larry appears to be better off than ol’ Clarence. Larry lost no purchasing power, unlike Clarence’s loss of almost 3%. This is deceptive and misleading.
The stark reality is that Larry earns a scant $300 in interest. He can’t afford groceries on this paltry sum, so he is spending down his savings. The median income was $52,250 in 2013 (the latest year available). To earn 2/3 of that—and match Clarence—poor Larry would need over $116 million.
Purchasing Power vs. Yield Purchasing Power
The notion of nominal interest paints a misleading picture of Clarence losing purchasing power and Larry keeping even. If you look at what they can buy with the interest on their savings—Yield purchasing power—you see that Clarence was living well while Larry is quickly spending down his life’s savings.
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Additional Resources for Earning Interest on Gold
If you’d like to learn more about how to earn interest on gold with Monetary Metals, check out the following resources:
In this paper we look at how conventional gold holdings stack up to Monetary Metals Investments, which offer a Yield on Gold, Paid in Gold®. We compare retail coins, vault storage, the popular ETF – GLD, and mining stocks against Monetary Metals’ True Gold Leases.
The Case for Gold Yield in Investment Portfolios
Adding gold to a diversified portfolio of assets reduces volatility and increases returns. But how much and what about the ongoing costs? What changes when gold pays a yield? This paper answers those questions using data going back to 1972.
Keith,
Isn’t this analogous with saying that real interest rates have largely been negative since the mid-80’s?
Mark
Keith: Very interesting metric. Fits in with a recent meme “Many of us are rentiers now — whether we want to be or not” kicked off by Thomas Piketty…
That is an excellent observation. However, I prefer the chart not inverted to show the loss in purchasing power. In the link below I added what could be labelled Gold Purchasing Power, i.e., gold/10-year yields. Interesting.
https://stockcharts.com/h-sc/ui?s=%24TNX%3A%24%24CCPI&p=M&b=1&g=0&id=p71453674262&a=406127784
Thanks for the comments.
miamonaco: The discussion of “real” vs. “nominal” interest rates is based on the idea that the dollar is 1/P (P is the price level). If prices double, then that means the dollar has lost half its value. This is wrong on several levels and for many reasons. One, per the first graph in this article, companies are constantly cutting real costs. Two, there are many nonmonetary forces that push prices up including: taxes, California water mismanagement, environment restrictions, regulation, permitting, labor law, litigation, etc. Anyways, in this view, the interest rate we see is not real. To calculate the real one, subtract the CPI.
This isn’t what I am saying, above. I am saying don’t think of selling your assets to buy food. That is to consume your capital. I am saying thinking of the return you get on your portfolio, and buying food with that.
Phil: I looked at the graph but I don’t understand. What did you do with gold? Thanks.
This is an insightful article, Keith, and it’s the first time I’ve seen both currency debasement and increases in efficiency both taken into account in an assessment of the damage. Here’s what I tell people: You know (or may not know) that the dollar is only worth 4% of what it was worth in 1913. What happened to the other 96%? That value was stolen through currency debasement. But what about all the incredible increases in efficiency, economies of scale, etc. that have come about since then? Shouldn’t prices be MUCH LOWER than they were in 1913, all other things being equal? Shouldn’t the dollar buy much more now, rather than less? THAT VALUE WAS STOLEN TOO! It’s akin to Bastiat’s “Things not seen” argument.
Sorry. The link mangled the chart. All I did was to divide gold by the CPI and got interesting results.
davidnrobyn: The dollar was worth 1505mg gold in 1913. Today it is worth about 26.25. This is a loss of 98.3%. I agree it’s theft. And that theft of value is the *least* of the harms done to us by the fiat dollar regime.
Keith, I think this is a very nice and appropriate chart. But why not have another line drawn, giving the development of earnings? That is as an example average hourly earnings adapted to inflation?