"Where?" Part III: Inflation, Deflation, Real, and Nominal Prices

Our goal in writing this blog was to educate more people on money and markets. How they function and how not to be fooled by what is probably about to occur.

In the first discussion on this topic, we focused on what the economy is and what the main questions are that we are going to try and answer, notably "where" we are in the economic cycle. This was the beginning of a series that focuses on where we are.

This has turned out to be a more difficult undertaking than originally conceived. The answer is straightforward, although surprising to most, but to really prove where we are, there are many facets of economics and terminology to go through. Of course, it's simply not possible to teach a complete economics course here, but hopefully we can shed enough light on the situation to both prove our point and encourage you, dear reader, to learn more about the topic yourself.

In Part I of "Where?" we looked at economics and markets, notably the stock market, as a means of understanding our current financial crisis. We introduced the concept of charts, and as a reinforcement, please note that if you do not have a comfort level in what you are viewing and what it means, you simply must focus on understanding it. While putting the entire economic situation into context through fundamentals is necessary, in order to really get a sense of what's going to happen next and when we're through all of this requires some practice in viewing the charts.

Most notably in Part I, we reviewed the Dow Jones Industrial Average (DJIA) as a familiar means of viewing the economy in both linear and logarithmic charts (please study the logarithmic chart and burn it into your brain!). People tend to think "stock market is up, so the economy is good." This is not necessarily true, but to prove this point, we have to understand that most charts are denominated in dollars. The DJIA is, by default, in dollars. So understanding money, at least to some reasonable degree, is required to continue.

In Part II, we looked at the definition of money a bit. Since we look at the stock market, which is priced in dollars (money), then we need to understand a bit of what money is and is not. In summary, most people understandably think of money as a constant in the same way they perceive time. As an example, you have a sense of how long one minute is. A minute is always a minute. It's a stable, predictable thing. But from the standpoint of physics, time is not constant, though in most cases, it's close enough for us on a day to day basis. Money is similar. You think of how much your home costs in dollars (or euros, yen, krona, whatever) and you believe that the home is becoming more expensive or falling in price. In most cases, that is simply not true. The value of your money itself fluctuates, and that is a critical issue that most people do not really comprehend.

We also addressed the concept of capital vs. money. Please review Part II and make sure you get the difference.

We followed up with a supplemental piece on money. It has tipped our hand a bit as it shows our bias toward an honest money. In truth, we have some mixed feelings on a pure gold standard. There are advantages, and there are risks. The situation is similar with floating exchange rates, which we have today globally (with the exception of some countries that peg their currencies to the value of other currencies). We will delve into this topic in more detail at another time.

Here's the important takeaway from those money discussions. Your money changes value over time. In fact, it is largely constantly being inflated away (which we will describe in detail below). So your money, with almost no exception to any currency on the Earth, is generally losing its "store of value" attribute. Your currency functions primarily as a "medium of exchange" only. Given that, then you must realize that if you hold currencies exclusively, the value of your labor is being eroded away. This has an effect on the price of things around you because those things don't change--your money does.

Now we're going to put all of this together, with some concepts like inflation and deflation in order to make sense of our current situation and determine where we're likely to go from here.

Currencies and Inflation/Deflation

Modern currencies are an interesting study in the concept of money. First, the currencies are a medium of exchange simply because the governments command that they be used for exchange via legal tender laws. Governments are in a unique position in that they have a monopoly on force You will either use what they say is money, or you will not be able to buy things. Try trading your gold jewelry or a bunch of eggs for a buggy full of groceries at the store and see if the store accepts it as payment. Unless you've got a special relationship with the seller of the items, it won't be accepted. Those things do not meet the "medium of exchange" definition and are not money.

So, is money whatever the government says it is?

Absolutely not. And this brings us to the crux of our modern problem.

Currencies are subject to the laws of supply and demand like everything else. The more units of a currency that are supplied, the more the demand is negatively affected. Said another way, the government can force its currency to be used through legal tender laws (which makes the currency a medium of exchange), but if it creates a lot more of that money, then the currency starts to fail the store of value test as the supply rises.

Folks, this is what inflation is. Inflation is not about rising prices. Inflation is about increasing the supply of money, which has effects later on down the road. Modern financial commentators and economists speak about inflation meaning rising prices. However, if you think about inflation like this, you'll always be fooled as to why the prices are rising. Inflation, when viewed as rising prices, ignores the cause of price increases. It is about supply and demand--nothing more. So for our purposes, we will use the term "inflation" to mean a rise in the supply of money and "deflation" to mean a decrease in the supply of money. Keep in mind that when you hear of inflation and deflation in the media, they mean price increases and decreases. This is one reason that they often get it wrong when predicting what is going to happen next.

To illustrate this concept, let's look at a recent example. Suppose you bought a house in 2003 for $400,000. Your neighborhood hasn't changed, the local area hasn't really grown, you haven't remodeled and generally things have been the same. However, in 2006, you find that the house is worth three times ($1.2 million) what you paid for it in 2003. This was not at all an uncommon occurrance a few years ago.

The house does everything now that it did in 2003. Nothing's changed. Why is it worth more?

Guess what. It's not worth more. The supply of money (ie, inflation) has been increasing. Truth is, the money has lost its value. It takes more units of the money to buy the house. The house wasn't getting more valuable, the money was simply not maintaining its store of value property as the supply of it was rising (inflation).

You can see the phenomenon in many assets. Oil prices, food prices, price of gold and silver, etc. The price of any item in the world has two components that must be considered: the supply and demand of the thing itself, and the supply and demand of the money it's priced in.

So the first thing you need to do is stop thinking about how many dollars (or euros, francs, yen, pesos, etc) you have and start trying to recognize the value of something. If the supply and demand fundamentals of the thing you're looking at aren't improving but the price is rising, you should be taking a look at your money and see if its supply and demand fundamentals are improving or not.

But, you may ask, isn't the demand for money infinite? After all, who doesn't want more money? Therefore, if the government produces more of it, won't it all be demanded?

Money is unique in that there is no bit of money in the world that's isn't owned by someone. People don't actually care about money, the care about what money buys. Money itself is useless. Its value is only recognized when it is exchanged for something at some point. Thus the demand for money is all time based. People hold money for some time if they have stuff they need now, in anticipation of using that money later on (and in hopes that it maintains its "store of value" well). Otherwise they exchange it for things they need in the short term.

There are many other different and interesting "tendencies" of money that we will discuss over time. But for now, understanding that when money is inflated, it loses it weakens its store of value property is enough.

So, to summarize this bit on inflation and deflation, we need to think about supply and demand of the thing itself and the inflation/deflation (supply) of the money. For purposes of simplicity, we've skipped the idea of credit for now, but credit is very central to where we are today and where we're going. We'll come back to credit another time.

Asset Prices Adjusted for Inflation/Deflation

With all of that behind us, let's go back to the original DJIA logarithmic chart we posted in Part I.

And let's adjust it now for inflation (and pretend inflation started in 1982, like the government calculations for most things pretend):

What you are seeing is that inflation makes the magnitude of the run up of the stock market much smaller. For a moment, just ignore that most of the government numbers used for CPI (which is their measure of inflation) are doctored for political purposes, and focus on how even these underestimated number make the the top of the DJIA look more like just over 6000 versus 14,000.

Similar charts, using the log scale for more visibility:

Ok. Let's have a little fun. Let's adjust the inflation rate and interpolate what it was back when the DJIA began back in 1896.

Ouch. Think about what this means. If we had no inflation, the DJIA would be around 2000 today. That's the real value of the stock market adjusted for inflation. So think about your house value. The value didn't change--or didn't change much--in most cases. But the price went up. This chart is the exact same illustration, and it even uses fudged government numbers to calculate the inflation and make it seem lower than it really is.

The Grand Finale: Prices in Gold

So, it's taken several major parts of this series to get here, but we're finally up to the first major point we want to show to give you an idea of where you are in this economic cycle. Fasten your seat belts.

Instead of pricing the DJIA in terms of dollars, which it is, by default, priced in, we could theoretically convert dollars to euros and see what the DJIA looks like. We could convert it to most anything and look at a chart--and they're all valuable to review. But, perhaps the most interesting chart to review is the DJIA priced in gold, for it is very telling and will be the subject of more discussion as this series continues.

There's a saying that gold holds its value over time. A nice man's suit costs about an ounce of gold today, just as it did 100 years ago. If you think about prices in the manner we've discussed, then you realize that gold doesn't change its value, but the money changes in price. As currencies inflate, gold tends to hold its value better. After all, gold doesn't have much of a function in the world except as an alternative to currency, so its value is largely constant.

Let's look at the DJIA priced in ounces of gold instead of dollars.

The blue line is the DJIA in log form. The green line is the DJIA divided by the price of gold over time. This is a very different view of the DJIA, right? What is it telling us?

At certain points in history, the stock market often drops or generally underperforms. These are called secular bear markets because they last for long periods of time and are characterized by either stock market crashes, as in the 1930s/Great Depression era, or flat periods like the staflation of the 1970s. During these periods of turmoil, people flock to gold. These periods last a long time, typically around 15 years, during which time the financial system and economic system are in great distress. The stock market peaks, and gold rises. Note that this trend has started in 2000 and we are still in it. So that's the "where"--we're in a secular bear market. Note that they end when the DJIA is worth around 2 ounces of gold.

As of this moment, the DJIA is around 9038, and the spot gold price is 938.80. In other words, it takes about 9.6 ounces of gold to buy the DJIA.

Does this mean that the DJIA is going to drop to around 2000? Probably not. From the inflation-adjusted charts, you can see that DJIA is always much higher than its "true value." This is called the nominal price--which is the DJIA in inflated dollars. That's the price you always hear quoted. Then there's the real price--the price with the inflation pulled out. Of course, that's a tough one to get because it's a formula controlled by government based on a lot of assumptions. But if we believe that gold always holds its value over time (not every second of every day, but over long periods), then we can measure the real value of things in terms of gold to see what they're worth. Often, the gold-adjusted price is better than the inflation-adjusted price, but we'll have to use both of them now and again to get a sense of the real price.

We may be in a short term bull market with the price moving up, but the fact is our economy is not good and not healing. At some point, the DJIA and gold will meet. We do not yet know if that means the DJIA falls to 2000 and gold stays still, or if the DJIA rises to 20,000 and gold rises to 10,000. That, of course, is based on inflation, confidence, global currency flows, and lots of other things we have to take into account. We will touch on those over time.

Study that chart closely. We're going to pick up right here next time, and look more closely at what that chart is telling us. We'll dig deeper into real and nominal prices. We'll discuss secular and cyclical bulls and bears. We'll define periods of history by secular bull and bear periods. There's a lot of ground to cover and the hour is late.