If I could pick one financial or economical topic that does not get enough attention it would be inflation. Very few of us ever question why prices of goods and services go up over the years and even fewer of us question the long-term effects inflation has on us as workers, consumers, and investors. To understand what inflation is and why it happens a quick history lesson is very helpful.
During the 16th century the Spanish monarchy financed several expeditions to the new world. The voyages that landed the conquistadors in present day Bolivia were the ones that proved most consequential. It was here that they discovered (or stole, depending on how you look at it) vast quantities of gold and silver. As the ships sailed back to Spain with unimaginable amounts of portable power, many people around the world believed that Spain would drastically expand its empire and increase the living standards of its people. But the newfound wealth of Spain had the exact opposite effect. Over the next 100 years their power and influence in the world would decline precipitously.
Historians and contemporaries sometimes refer to the time period following Spain’s conquest of South America as the Price Revolution. For the first time in human history, long term, consistent inflation was observable. Over the 150-year period starting in the mid-16th century prices of all goods and services in and around Spain rose about 1-1.5% per year. That amount seems negligible today but at the time it caused great economic disruption. The link between price stability and the money supply had not been given any significant thought prior to this time period. Today it is one of the most important factors that must be considered when running an economy.
For an economy to run smoothly its money supply must accommodate for the number of households in it. If the supply is not increased concurrently with population growth, a game of economic musical chairs ensues, money becomes more valuable and prices decline. (Deflation is just as bad, if not worse than inflation.) The arduous task of balancing a country’s money supply is usually bestowed upon a central bank. In the US, the Federal Reserve has a “target inflation” of 2% per year, essentially guaranteeing that your dollars will purchase less goods and services every year.
Whether inflation is good or bad is an interesting question but not a useful one. Rising prices are a part of the modern economy for better or for worse. The important thing is to ask how inflation impacts you. Without any appreciating assets (stocks, real estate, businesses) or income growth that does not outpace inflation, it is easy to see how individuals can get “pinched”. For most Americans, the only way to “get ahead” is to invest in appreciating assets. If you do not have the risk tolerance to own a business, stocks, or investment property, then at the very least you need to own your own home.