Inflation is term we use to describe the fact that currency is a poor yardstick to measure things with. Imagine if your tape measure changed the definition of an inch continuously, and unpredictably! This is the situation that all of us live in every day with our finances. Those of us who live in developed countries get reasonably accurate measuring tapes, while the poor sods who live elsewhere get measuring tapes that disintegrate or stretch wildly, on average, every 7-10 years.

However, once one starts digging into the concept of inflation, one quickly realizes that the correct answer to “What is the current rate of inflation? is:


CPI, CPI-U, CPI-E, PCE. Digging into inflation soon gets you lost in a maze of acronyms, all of which claim to be “the one true inflation.” In fact, the real situation is even worse! Each person has their own personal rate of inflation, based on the things that they personally buy, down to the specific home they live in!

However, inflation measures generally come in two basic flavors: those that measure the price level of things, and those that measure the supply of a kind of currency. These are related, but they can be persistently different by several percent for decades! Let’s go over the different kinds of inflation.

The first kind of inflation is the easiest to understand: monetary supply inflation. This is how fast new dollars (or yen, or yuan, or BTC, or whatever) are created. For the dollar, currency is created whenever the Fed buys something, or a new loan is taken out by a consumer, business, or government (both our government, and also foreign governments that borrow in dollar denominated debt.) Dollars get destroyed when debt goes into default, gets paid back, or when the Fed sells something.

This kind of inflation generally runs around 7% a year! The difference in this rate, and the other, lower kinds of inflation, gets paid to the folks who are doing the lending (or in the case of the Fed, gets paid to the Treasury Department). The specific word for this difference is “seigniorage.” In economic terms, seigniorage is a kind of “rent,” or value that gets paid to someone for doing nothing useful. Typically, this rent gets paid to the richest folks, or the people who need it the least.

Our work here at Coinbase in building Finance 2.0 could go a long way towards eliminating this continuous drain on the productivity of the world. Since there is about $100T worth of debt-money in the world, and seigniorage runs about 4%-5% above the price inflation rate for the largest currencies, this represents a drain on the world’s productivity to the tune of $4T - $5T a year! Eliminating that waste is very motivating to me every morning when it’s time to come to work!

The second broad kind of inflation is price inflation, and this is where things get sticky. When the price of eggs goes up, we call that a change in the price of eggs. But what happens when all food goes up? What about food and energy? Wages? Rent? Houses? Stocks? It all gets very complicated very quickly. Here are some of the different measures of inflation, from simplest to most complicated.

CPI-U (sometimes just called CPI) stands for “consumer price index for urban consumers.” It generally runs 2% to 3% a year, these last few decades, although in the 70s it spiked to double digits. It measures a “basket” of goods. To calculate this, the Fed literally sends out teams of secret shoppers to go see how much things cost online and in stores. However, this gets complicated because the goods and services that people purchase change slowly over time. Sometimes that’s because preferences change, but sometimes it’s because prices changed. What should stay and what should go? What percentage of the basket should cell service and smart phones take up? How about ride sharing or robot butlers? These are the sorts of questions that keep economists employed.

Core CPI strips out energy and food prices, because these are high volatility, and we don’t want our measure of inflation swinging up and down wildly all the time. However, if food and energy get consistently cheaper or more expensive over time, core CPI can get out of whack with CPI.

CPI-E is “consumer price index for the elderly.” It has more healthcare and less education, as well as some other changes to the “basket.”

PCE, or “personal consumption expenditures,” is complicated because it’s what’s called a “chained inflation measure.” This means it not only measures the changes in prices, but also the changes in preferences for things. So if people stop buying beef and start buying chicken because beef is too expensive, PCE won’t reflect that. If they later switch to soy, and all the red meat carnivores are miserable because beef is too expensive, PCE won’t reflect that either. PCE is important because it’s the measure the Fed uses. When the Fed says “inflation is running at 2%,” they mean PCE is running at 2%.

Another problem with inflation is that it is an average. In America, for the last few decades, inflation has been running much higher than the headline number in many of the big cities, and much lower than the headline number in many rural areas. So while “inflation remains moderate,” to quote the Fed, that’s not necessarily awesome for either the people in SF who now have to pay $7 for a loaf of bread, or the folks in 2 hours outside of Modesto who are stuck in a deflationary spiral that could easily be right out of the Great Depression.

In my next post, I’ll talk about how inflation affects the economy, and the good and bad kinds of both inflation and deflation, and in the final post, I’ll talk about how you can tell how it will affect you and your investments, and how to protect yourself from those effects, and even profit off of them!




Go read the top disclaimer. Remember how I’m not a lawyer, or a CPA, or anything like that? I’m also not an economist! However, since that isn’t a licensed profession, I feel free to pontificate as if I were one. Woe upon you for listening to me. After all, it isn’t called the “dismal science” for nothing.

I like to divide inflationary pressures into four categories: “good inflation,” “bad inflation,” “good deflation,” and “bad deflation.” Most economists don’t divide out good from bad, but I’ve noticed there are forces which help the economy on both sides, as well as those that hurt it on both sides.

“Good” inflation is all of the things which create new money or increase prices for reasons that will help the economy grow. So when people take out a loan to buy the smallest house they need, new money is created, and that is “good” inflation. Similarly, when people take out a loan to start what will end up being a successful business, it’s good for the economy, and simultaneously increases the money supply and the price level. Borrowing for student loans is also often good for the economy, because it will increase people’s earning potential in the future. Population growth and immigration is, within reason, also “good” inflation, because people’s earning potential increases as soon as they cross the border into the USA, and existing residents benefit from the increased size of the trading network within the country.

“Bad” inflation is all of the things which create new money or increase prices for reasons that don’t help the economy grow. So every time someone takes out a home equity loan to go on vacation, that’s “bad.” Vacations, while they may be great for the soul, make us all poorer (unless they energize us and improve our productivity later!) Similarly, we may appreciate the fact that Canada can’t invade and enslave us all (this is a joke!), spending on tanks probably doesn’t directly increase our future income, so it’s “bad” for the government to borrow money to pay for tanks or bombers. (If those bombers make the world a safer place for investment and improve rule of law, then that borrowing is “good” inflation.) It gets complicated pretty quickly.

“Good” deflation is all of the things that destroy money or decrease prices for reasons that will help the economy grow. Every time a new, cheaper, and more efficient computer chip or solar panel comes out, that’s “good” deflation. When silicon valley “killed” the profits of the music industry with the mp3 and the iPod, that was great for the economy in the long run, because it eliminated a whole class of “rentiers” (people who extract economic rents) who were basically economic parasites on the music industry.

Hopefully, cryptocurrency will similarly destroy entire classes of obsolete ways for existing people and companies to make money. Several kinds of fraud will be impossible, so those fraud detection/mitigation jobs go away. We talked about seigniorage yesterday, and several kinds of jobs in banking, finance, and insurance should all get eliminated. While this isn’t good for the people losing their incomes, they will mostly retrain (or their children will), and the entire planet ends up richer in the long run. This is “good” deflation, because the cost of goods and services drop for everyone. In fact, creative destruction (or if you want to sound snooty and economically literate, “Schumpeterian growth,” after the inventor of the theory), is the only thing on Earth that really moves the needle on wealth creation.

“Bad” deflation is all of the things that destroy money or decrease prices in ways that hurt the economy. If the Fed had not bailed out the banks in the last recession, people who had invested prudently might have lost their retirement anyway, causing them to cut their spending. This would have put lots of people making important contributions to the economy to lose their income, and cut their spending as well, which would have put even more people out of work. This kind of feedback loop is called a “deflationary spiral,” and we last had one in America in the Great Depression, although Greece has been living this for the last decade or so.

Weirdly, even “good deflation” can be bad in the short run, however. It isn’t the coal workers' fault that solar panels are cheaper and better ways to make power now, but that doesn’t stop them from cutting back on groceries and education for their kids. The poor grocers and children of coal workers end up with permanently lower incomes as a result of this “good” deflation, and it can take generations for a community to recover from this kind of change, even if they all end up richer in the very long run.

Even weirder, inflationary and deflationary forces can be simultaneously good in one way and bad in another. So population movements from rural America to urban America is “good inflation,” overall, because it increases people’s wages and expenses, and also makes the economy more efficient by improving trade networks. However, the towns that people are leaving are losing population, and setting off deflationary spirals there, so the person who moves from a suburb of Modesto to Oakland is simultaneously causing both “good inflation” in the bay area and overall, and also some offsetting “bad deflation” in their old hometown.

As you invest for retirement/getting rich, start to pay attention to inflationary and deflationary forces around you. There’s a saying in investing, “Don’t fight the Fed,” but even the Fed doesn’t isn’t omnipotent in the face of many of these forces. You will be better off (and help those around you be better off!) if you have a vague idea of what the current forces are, even if you can’t say for certain how they all balance out.

Tomorrow, I’ll go over how inflation affects your portfolio, and even a bit on how to profit by it!


The last two posts have been pretty academic. This one is intended to be practical. Obviously, no one can predict the future. However, we can look at how inflation affected various asset classes in the past and let you draw your own conclusions. It’s really important with this post that you remember that I’m not a financial advisor, and I can’t tell you what to buy.

It’s also really important to remember that if you attempt to position your portfolio for an inflationary episode that never materializes, you can end up losing money. On the other hand, you can also lose money if you are not positioned for an inflationary episode and one does show up. A huge part of investing is emotional; it’s just getting comfortable with risk and uncertainty, and staying focused on the long term.

Another thing to learn about inflation and investing is that it’s often not the absolute level of inflation that matters for various asset classes. Instead, it’s about how much the inflation rate changes over time. This led economists to invent two new technical terms: disinflation, and reflation.

Disinflation is when the inflation rate falls over time. This has been the general trend for pretty much my whole life so far, since the late 70s/early 80s. Reflation is when the inflation rate rises over time. People have been predicting reflation for years, but so far that hasn’t happened, although we are seeing some small signs of it this past year.

Let’s start with what high absolute levels of inflation do. To see this at the extreme, we can look at Venezuela, or for a more moderate example, Argentina. At the absolute highest levels, inflation is devastating to an economy. The main reason is that it becomes impossible for the human mind to comprehend inflation rates of a few percent per day or more, so people freeze up on investment, and rush to spend any cash they get their hands on as quickly as possible. They consume rather than invest, which means that the future is going to be worse than the present. However, far more damaging that high absolute levels of inflation is high levels of reflation.

Reflation totally messes up all lending. Imagine if you take out a 30 year mortgage today for $500K, and then the inflation rate spikes to 50% a year tomorrow. You start getting massive raises at work. (Perhaps they don’t keep up with the new inflation rate, so you still get poorer, but still, massive raises.) Your house increases in value by over 50% a year. In 5 years, the price level has risen by 1.5 ^ 5 = 7.6. Another way of saying this is that the real value of how much money you owe has dropped by a factor of 7.6, to around $66K. The bank’s share price crashes, along with every other bank. Lenders panic, and a “stagflationary crisis” sets in. You, however, are sitting pretty, with a house that you basically received for 87% off. Wheee! Well, unless you lost your job in that crisis. Returning to Venezuela, their high level of inflation is bad, but what is worse is that the reflation rate is high as well. It’s only a matter of time before the currency collapses entirely, and becomes nothing more than a curiosity to be purchased on ebay as a novelty item.

More mild reflation, like what we will inevitably experience someday here in the USA, although possibly not this year or even this decade, is still damaging to the economy. Companies which have purchased short term loans at low rates and were expecting to pay off that debt with more debt (a practice called “rolling” the debt) are going to end up under a pile of unpayable loans, and will probably see their share prices collapse, and possibly go bankrupt. Homes are typically purchased not for their total cost, but for their payment, so some prices will fall as well. If we saw inflation rise to 12%, we might see 18% mortgages, like we had when I was little. A $1.5M home might need to fall in value by over half (in real terms) to leave the payment constant. On the other hand, the nominal value of the house would go up, which would mean the poor homeowner would be left paying a massive capital gain tax when they sold the place, even though it lost value! During reflationary episodes, you want to have long term fixed rate debt going in. If the inflation rate is 9%, and your mortgage is 4.3%, you are getting paid 4.7% a year to borrow money!

Reflation should be thought of as “falling confidence in currency,” so things which have value independent of that currency tend to do better. Land at least keeps up with inflation, typically (because it is hard to get loans on), as well as gold, other commodities, and art. However, these same investments tend to do poorly at other times, so watch out! I personally hope that cryptocurrency, because of increased adoption, will not only keep up with inflation, but far and away outperform it as people flock to it as an alternative root of trust to central banks. However, one could just as easily say that cryptocurrency is likely to perform like high tech stocks, because of the primary investors. It’s hard to say.

During disinflation, stocks, bonds, and developed real estate all do amazingly. As the cost of borrowing falls, companies, consumers, and governments borrow money, and pay those loans off with more and cheaper borrowing. Obviously, this isn’t sustainable in the long run. Eventually, interest rates hit 0%, and the money supply balloons, which causes reflation. Some very smart people (most famously Ray Dalio) believe that we are at this point of transition today, in 2019. However, bond rates (and therefore inflation) tend to move pretty slowly in the developed world. It might be 3-10 years before we can say for sure whether this was a turning point.

Conversely, during reflation, long term debt, stocks, and developed real estate often don’t do as well. Although this episode is not nearly as famous, between 1968 and 1981 stocks did worse, after inflation, than they did after the great crash of 1928 and the subsequent Great Depression! To make matters worse, their prices went up, even as their real world value fell, so the government taxed your losses! However, for folks who were working from 1968 and 1981, and just kept buying the whole stock market, they would have experienced amazing returns. Stocks went on to skyrocket from 1982 to 2001 as disinflation set in, and people who had kept the faith in the economy and the markets were rewarded with a very rich retirement.

So how can you position yourself to do well? I personally take a few lessons here. Firstly, and primarily, stay focused on the long term. Secondly, take some small asymmetric bets to go with your broad market index funds, where if you are wrong you lose a little money, but if you are right you gain a lot. Choose those bets very wisely, because you will probably lose all your money on most of them, even if you are very prudent.

Lastly, and most importantly, remember that smart and hardworking folk are always a good investment. Grow your personal skills, your health, your ability to be frugal, and your knowledge, get an absurdly large savings rate, and invest in others who do the same. You will probably come out better than the vast majority of people, even if you don’t position your portfolio ideally for reflation or disinflation.