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In last week's post, I wrote about the fundamentals and principles behind banking. I talked about how the primary functions of a bank are storage of assets and lending, and in that way, both local and large banks are able to make money. A key idea was that, through these functions, banks are able to beat average inflation rates, allowing them to make sure the assets owned or stored at a bank retain their value. In this post, I'm going to be talking about why this is so important to understand, even for the average person not very interested in money or finances, especially when it comes to the storage function of banking.

Why talk about Inflation?

I believe that inflation in economics is very often misunderstood. According to wikipedia:

In economics, inflation is a sustained increase in the general price level of goods and services in an economy over a period of time.

If you don't like wikipedia, Merriam-Webster says basically the same thing:

a continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services

These definitions are technically true. When the cost of the same good generally increases over time, this is considered inflation in economics. Additionally, unless something horrible like the Great Recession in 2008 happens, all economies on average inflate over time. But this doesn't actually get at the heart of why inflation has a negative effect on the average person.

Story Time!

Let's dive into this a little. Since I'm a musician, I'm going to use buying a guitar as an example. When I was teenager, there was this guitar that I'd been really wanting for a while. It cost $279.00 USD. I worked hard tutoring kids in math and english and saved enough money to buy it. I purchased it, went home, played with it, and fell absolutely in love with it. In fact, I still have this guitar today.

A few years later, I was looking online, curious about whether they still sold the model guitar I had. They did, but now it was worth around $379.00. Initially, I was ecstatic. I thought, “Wow, my guitar gained in value! If I ever wanted to sell it, I could sell it now for more than I bought it for! I would make a profit!” But then I looked at the other guitars that I had been pining for, but couldn't afford at the time. Those guitars had also increased in price, some more than mine.

This troubled me. The guitars being sold hadn't changed. The parts were all still the same. If anything, the companies who made them probably outsourced those models to cheaper factories over time, so not only were they charging more for the same, but probably making a bigger profit because they were cheaper to build. So the guitars themselves, from my point of view, hadn't changed in value. Rather, as I realized, the money I was using to purchase them had lost value, because I would have to pay more in order to get the same good. The “profit” I would have made selling my guitar is erased, because the goods I wanted to purchase had also increased in price.

Here is a key concept I came to understand: money is simply the agreed upon intermediary for an exchange to happen between someone who desires the product or service, and another who offers it. The value of that good or service is determined by the person who wants it, and how much they are willing to give in order to have it. However, because of inflation, the currency we use to purchase anything actually decreases in value over time in comparison to the good or service. It's normally not that the product is more valuable (providing it hasn't changed in any essential way to the buyer), it's that the currency used is worth less, because more of it is required to exchange for the same thing.

Inflation and Storage of Value

So, as we can see, because of inflation, any fiat currency we hold in storage over time actually loses value when compared to the goods and services we want.

Since the US Dollar is currently still the global reserve currency, I'm going to use the US inflation rate. According to Zacks, over the past century, the average inflation rate in the United States is nearly 4%. So on average, the money we store in our banks loses 4% of its value year after year. If we're going to be our own bankers, this is a problem we're going to have to solve if we're going to keep the purchasing power of what we earned over time.

What about Bank Savings Accounts Interest Rates?

Historically, beating inflation as a service for their customers used to be a primary goal of a traditional or institutional bank. Savings accounts had higher interest rates so that customers of those banks could leave their money safely in them and not worry that their stored asset would lose any value over time. However, presently, savings accounts have such small interest rates that storing money with these institutions and services actually means you're losing value over time.

As I wrote about last week, traditional banks need to pay their money lenders and managers. In light of what inflation really is, by putting our money in one of these banks, we’re actually paying them simply for storing depreciating value, rather than having a service that manages those assets we put in the bank so that their value stays the same (or better) against inflation over time.

This is probably one of the biggest reasons that drove me to begin searching out options aside from storing money at a bank. Of course, I still use traditional banking services. I constantly use my debit card or take advantage of various credit card benefits. But I no longer rely on these things to make sure that my money and assets retain their worth over time.

Instead, over the past few years, I've looked for and found various services and products that perform the storage and lending functions which traditional banks offer, but better. Not only do they offer things like better interest rates, but now I have more control, which means I get to be the primary decision-maker about the worth of my hard earned money.

In this series, I plan to explain and evaluate these various services that I've found. However, for next week's blog, I'll be writing about how money is put to work. Just like how inflation has a negative impact on the storage function of banking, I want to share about how lending has been impacted negatively by typical banking practices, and how we can avoid their pitfalls while still doing what they do, albeit on a smaller scale.

Hope this was a helpful! Until next time!

Index

Header Image was taken from here.

If you haven't read my previous post (it didn't show up in the “New” explore tab in Coil due to a bug), you can read it here.