Here’s a riddle: when is $100 worth $97?
The answer: when you put it in the bank a year ago.
Being frugal and being money-savvy are actually two very different skills. The former requires discipline, planning, and a strong sense of the relative importance of resources. The latter relies more on understanding how to take advantage of existing financial systems, economic regulations, and mathematical quirks.
Think of it this way: a frugal person packs their own lunch, whereas a money-savvy person itemizes it.
Depreciation expense is one of those mathematical quirks. It sounds tricky, but it’s really not! And if you know how depreciation works, you can make it work for you.
The price of donuts in Straightsville
In the classic 1944 moralistic exploitation film I Accuse My Parents, there’s a scene toward the end where golden-boy-turned-wanted-man Jimmy Wilson is at his darkest point. He enters a small town diner, intending to rob it. Luckily for him, the diner is run by a street-wise, burger-flipping, blue-collar Christian who offers Jimmy redemption—and a brief glimpse of the life he could’ve led if only he had wholesome, sober, churchgoing parents.
There’s a large sign hanging in the background of this scene, which reads, “Donuts and Coffee, 10¢.” I had to google “cent symbol” just to transcribe it.
At the Dunkin Donuts closest to my house, a donut costs $1.21. Two of them, plus a small black coffee for $1.94, would run me $4.36. After taxes and abandoning my change into the employee tip jar, let’s say I’ve spent $5.00.
Why were coffee and donuts $0.10 in 1944 but $5.00 today? What accounts for a 5,000% price increase over a scant seventy-three years?
How inflation works
The answer is inflation. Inflation is the term used to describe a usually steady rise in the cost of goods and services. I say “usually steady” because war, economic upheaval, and other disruptive changes can make it jump up or down. A healthy average is about 3%, but we’ve gone as high as 13% in a crisis. Please see: The Vietnam War was Not Our Brightest Idea, Part 17 of 39.
The coffee that cost 10¢ in 1944 would’ve cost 15¢ in 1950, 20¢ in 1960, 25¢ in 1970, 45¢ in 1980, 75¢ in 1990, $1.96 in 2000, and $2.70 in 2010.
If you’re like me, looking at those numbers fills you with a creeping sense of dread. “The price of everything is skyrocketing up!” my simple, over-caffeinated brain tells me. But that’s not really what’s happening, because the purchasing power is the real metric by which you gauge money’s value. Remember that context always matters, even in straightforward math.
Think of it this way: the average household income for 1944 was under $3,000. So if it took about ten minutes’ wages to pay for a cup of coffee then, the same is (theoretically) still true now. These values are meant to rise and fall in concert with wages and maintain a seamless purchasing power despite inflation.
But why tho?
Our government works very hard to control the pace of inflation by releasing a strategic amount of new money into the marketplace every year. If they didn’t, inflation would slow to a crawl. And it goes without saying that constantly changing prices is a great bother to businesses, consumers, and Uncle Sam himself.
So why do they want prices to inflate?
Controlled inflation is a tool that strengthens economies by forcing entities to invest their wealth, rather than board it up in their chicken coops or convert it into gold and sit upon it like dragons.
The cost of depreciation
Let’s return to our riddle at the top of the article. If you put a crisp, fragrant $100 bill into a safe-deposit box at the bank in 2017, and take it out one year later, it can only buy $97 worth of 2018 goods and services because inflation has pushed the price of those services up by 3%. This is known as depreciation.
If that makes you think, “Man, then what’s the point of keeping money in the bank?” then congratulations! You’ve figured out why a controlled inflation rate works.
Imagine if there were no inflation. Imagine if instead of investing their money, every millionaire and billionaire in the world kept their millions and their billions in a bank vault somewhere. That money isn’t participating in our capitalist market economy. It’s not being affected by depreciation, either. If stasis was safe, everyone would be a lot more static.
Investing is a risk, but the government incentivizes you to take that risk by making purely liquid cash a guaranteed loss. It’s healthier for the market overall. Or that’s the theory, anyway! Please don’t screenshot this paragraph as evidence of my buffoonery in a future timeline with runaway inflation or an economy ruined by bad investments. Side-eyeing you, unicorn bubble.
A tragic example of depreciation expense
By now you’ve come to a horrifying conclusion. And yes, it’s true.
Harry’s inheritance would’ve been a lot more substantial if his parents had invested it.
Instead, they just let it sit in Gringotts collecting fairy dust. Thirteen years of accrued interest is a lot of damn money, James slash Lily! Now, it’s true that the wizarding world seems to still be on the gold standard, but come on! They come from a reality in which wizards can just make stuff. It’s illegal, of course, but it must happen. If anything, I bet inflation in the wizarding world is worse than in the muggle world!
Guys, I’m not playing around here. If you think a charismatic dark wizard is coming to ethnically cleanse your asses, you need to make some plans. Fill out your wills. Email a copy of your advanced directives to Dumbledore. And buy some fucking bonds for your kids! I mean it. There was a war going on, and they just kept their money in gold bars at a bank somewhere? Jesus Christ. Hogwarts arithmancy classes clearly do not cover the topic of compound interest. Deliver me from all this bad parenting.
Erstwhile Hogwarts students, allow us to fill the gaps in your education:
- Dafuq Is Interest? And How Does It Work for the Forces of Darkness?
- Dafuq Is a Down Payment? And Why Do You Need One to Buy Stuff?
- Dafuq Is Credit and How Do You Bend It to Your Will?
What does this mean for me?
One of the reasons we’re kinda meh about large cash emergency funds is that your money is losing value year over year. The $10,000 emergency fund you set aside in case of catastrophe is worth $300 less in its first year.
In the context of $10K, $300 may seem like small potatoes—but you’re also missing out on the opportunity to reap the rewards of investing that money. The stock market performed pretty damn well last year. For example, the S&P 500 in 2016 gained an average of 9.5%.
So if you kept a $10K cash emergency fund in 2016, your money is worth $9,700 today. But if you’d invested it across the S&P 500, you would have $10,950. That’s a $1,250 split that makes a very big difference.
If you’re saving up for a big-ticket purchase like a home, investing that savings is a great idea… with a caveat. Investments are risky. I invested my $50K home down payment and lost $3K of it when China’s markets decided to randomly poop their pants. But it was my mistake to keep the funds in high-risk, high-reward investments. When I was fully-funded and ready to start searching seriously for a home, I should’ve moved it into stabler funds or a high-yield savings account.
Oh well! You live and you learn. And then you write a blog so that other people don’t do the same dumb shit you did.
Hopefully now you understand a little bit more about the relationship between inflation and cash depreciation! Depreciation is a broad umbrella that accommodates far more than cash, of course. Assets, like a vehicle or a computer, depreciate too. The fridge you bought for $1K six years ago is not worth $1K today. But that is a topic for another day.
In the meantime, I implore you to add the legendary MST3K episode I Accuse My Parents to your Netflix queue posthaste. You’ll never win the essay contest of life until you’ve seen it.