I remember hearing about inflation as a kid and I remember asking “Why are my savings worth less each year?” What I was really asking was “What causes inflation?”
I might have gotten an answer about rising prices or more dollars in circulation but I didn’t understand. When I got older I did my own research and now understand the mechanics and causes of inflation.
Today I Explain What Causes Inflation
But before I do I want to make sure we’re on the same page regarding what Inflation is.
Inflation and Price Inflation are often used interchangeably, but it makes more sense to separate them out because one is the cause and the other is the effect.
Let’s define some terms:
Inflation: An increase in the money supply. An increase in the money supply is a fancy way of saying there are more dollars in existence than before.
Price Inflation: Rising prices as result of an increase in the money supply.
Inflating the money supply causes rising prices
An Example of the Effects of Inflation
Imagine everyone woke up one morning to find their bank account balances had doubled. The money supply had been inflated by a factor of 2!
Some people would choose to buy goods and services with their new-found “wealth”. But there aren’t more goods and services in the economy. Thus, consumers will bid up prices.
Basic laws of economics tell us that when demand increases and supply does not, prices rise.
Prices would then be higher as a result of the increase in the money supply in what is properly called Price Inflation.
What Causes Inflation?
Inflation is caused by creating new dollars. But who is creating these new dollars and how do they do it?
New dollars are created by banks.
The main bank responsible for inflation is the US Federal Reserve. But virtually all other banks also cause inflation via Fractional Reserve Banking.
The Federal Reserve Inflates the Money Supply
The US government spends much more than it brings in via taxes. To make up the difference the US treasury borrows money by issuing debt in the form of bonds.
This debt, these bonds, are then bought by investors, foreign governments, pension funds, and the central bank of the United States called the Federal Reserve.
If the debt was purchased with existing money this would not be inflationary. However, the US Federal Reserve conjures money out of thin air to buy US bonds. How do they conjure money?
They simply create deposits in the Federal Reserve accounts. Imagine if you could go into your bank account and type in that you now had 1 million more dollars. You’d be creating money out of thin air! That is what the Federal Reserve does.
The Fed has inflated the money supply. The Fed caused inflation by creating new dollars.
Using this this freshly minted money the Fed buys US government bonds. The US government then takes the dollars it got from the bonds it sold and spends it on tanks, government employee salaries, national parks, welfare, social security payments, you name it.
This new money that was created out of thin air by the Fed flows through the government into the economy and bids up the prices of goods and services for everyone else.
This resultant rise in prices is one of the effects of inflation.
A Second Cause of Inflation: Fractional Reserve Banking
Another cause of inflation is fraction reserve banking.
Fractional reserve banking means that banks do not have to keep all of their depositor’s funds available for withdrawal. Banks only have to keep a fraction (or portion) of their clients funds in reserve.
When you despot $100 into your checking account it doesn’t go into a vault and sit there. The bank loans that money out to other people or uses it to buy stocks, or bonds, or other investments.
Now banks aren’t allowed to loan out and invest all of their depositors money. After all, if you were to go to an ATM, you need to be able to withdraw cash, or when you write a check to pay your mortgage, the bank needs to send that money to your landlady.
Banks estimate how much money people will spend and withdraw over a given time and they keep that amount in reserve.
There are also regulations in place that dictate the amount of liquid dollars a bank must have in reserve. This is known as the reserve requirement. The reserve requirement is set by the Fed.
If the reserve requirement is 10%, that means that for every $100 in deposits, a bank can loan out $90. So, if you deposit a $100 bill into your checking account, the bank will loan out $90.
The person who received that $90 might spend it on a new pair of shoes. So they give $90 to the cobbler (shoemaker). The cobbler then deposits the $90 back into the bank, which can then be loaned out again. So the bank could make an additional $81 loan. This process repeats itself again and again and that $100 deposit, with a 10% reserve requirement, could become nearly $900 floating around the economy with only $100 in reserves in the bank.
So that little $100 bill has now become $1,000.
If you’re a more visual person you can check out this handy fractional reserve calculator.
So by not holding 100% of deposits in reserve, banks increase the money supply and cause inflation.
Do you have a better understanding of Inflation now?
The actions of the Federal Reserve and Banks cause inflation. I personally don’t like that my dollars are worth less each year because banks only hold fractional reserves and because the Fed prints money out of thin air.
This knowledge has led me to hold some money in gold. Unlike dollars banks can’t create gold by typing in numbers into a computer.
It also goes to show that if everyone were to try to withdraw their money from the bank at once the system would collapse. Don’t count on the FDIC, which is supposed to back up the banks, because it is undercapitalized. This knowledge leads me to hold some money in physical cash.
As I mentioned in a previous article the increase in money supply has caused dollars to be worth half a much since the year 2000.
Another one of the effects of inflation is the creation of bubbles (like the housing bubble of 2008) and the misallocation of resources. But that is a topic for another article.
Five Tax Strategies I use to Keep More of My Hard Earned Income
You work hard for your money and you deserve to keep it! Today I share five US tax strategies that allow me to keep more of what I’ve earned.
I don’t know if these tax strategies are suitable for you. You need to make your own decisions with the input and advice from a licensed tax professional and investment advisor.
I have a Master’s Degree in Human Resources and have studied employee benefits but I’m not a CPA or tax advisor. What I’ve written below is accurate and lawful to the best of my knowledge as of posting this article but I can’t guarantee that my understanding of the tax code is complete, accurate or up to date. Tax laws do change and in the future the below information could become outdated and/or incorrect.
I’m sharing what has worked for me!
Tax Strategy 1: Contribute to a 401k
A traditional 401k allows you to save money for retirement using pre-tax dollars. Your contributions are exempt from state and federal income tax. You do still have to pay social security and medicare taxes on 401k contributions.
Trivia: a 401(k) plan is the tax-qualified, defined-contribution pension account defined in subsection 401(k) of the IRS code.
When you retire and are eligible to make 401k withdrawals you do pay taxes on your withdrawals but your money will have (hopefully!) grown and if you’re retired you might be in a lower tax bracket then when you were working.
If my employer offers a 401k plan with company matching I contribute as much as I can to get the full company match but no more. That’s because the investment choices most companies offer are very limited. I do max out the company match so I’m not leaving money on the table.
I go with a Roth 401k if my employer offers it but they’re less common. With a Roth 401k you pay taxes up front but when you withdraw the money in retirement that income is tax free. I think taxes in the US are going to go up so I think it’s better to pay taxes now at the lower rates and get tax free retirement income later.
If your tax rate is the same during retirement as when you contribute to the 401k there is no advantage between a Roth 401k and 401k.
Two of my employers have offered Roth 401ks and company matching. When I left those employers, I rolled my Roth 401k into a Roth IRA and any 401k contributions into an IRA.
Tax Strategy 2: Contribute to an Individual Retirement Account (IRA)
The Roth IRA is one of my favorite tax strategies. Like 401k’s you get to pick your “flavor” of IRA: Roth or traditional. I favor Roth IRAs for the same reason I favor Roth 401k’s: because I believe tax rates will be going up in the future. Whether your employer offers a 401k or not you can open up an Individual Retirement Account (IRA) on your own.
To open a Roth IRA you just need some money and a custodian like Vanguard or TD Ameritrade. Once I’ve maxed out my employer matches for my 401k (if offered) I contribute additional retirement savings to my Roth IRA.
Through Vanguard I’m able to invest in many more securities and mutual funds than any employer offered investment options I’ve seen.
With a Roth IRA I will be able to enjoy tax free income during retirement, and it grows tax free while I wait. I’ve had a Roth IRA since I was 16 and it has been a great way to save for retirement.
If I gave investment advice I would implore everyone with $1,000 they could afford to set aside to open a Roth IRA today. I posit it is the most powerful of all five of these tax strategies.
Tax Strategy 3: Contribute to a Flexible Spending Account (FSA)
This is my second favorite of the five tax strategies. Your employer might offer a Flexible Spending Account. All of my employers have. Like a 401k, you use pre-tax dollars to set aside money for eligible medical expenses like doctor visits and prescription drugs.
In addition to the tax benefits are three nice perks to an FSA.
1) You can spend the money right away as long as it is an eligible medical expense
2) Not only do you not pay state or federal income tax on FSA contributions, but you don’t pay social security or medicare taxes either
3) If you stay at the company but don’t spend all the contributions you’ve made they roll over to the next year
One NOT so nice feature of the FSA is that if you leave your employer you lose it. You can’t take it with you.
But one crazy loophole that an HR representative once told me about was that you can spend all the FSA contributions you would have made for the year, even if you leave the company.
For example, lets say you’re set to contribute $20 per month to your FSA. That is $240 per year. Lets also say the company’s fiscal year starts on January 1 and you get paid on the first of each month. If you enroll in the FSA program and are set to contribute $20 per month, and you leave your employer at the end of March, before your last day of employment you can spend up to $240 on eligible expenses using your FSA, even though you’ve only contributed $60. Crazy!
If you have recurring medical expenses like prescription drugs, dental cleanings, doctor visits or eye exams an FSA is a no brainer if your employer offers one. Some employers will even match FSA contributions.
I’ve had an FSA at my last three employers and it’s a great way to save on medical expenses.
Tax Strategy 4: Contribute to a Health Savings Account
Not everyone qualifies for an HSA. The IRS tells us you’re eligible to open an HSA if you meet the following:
- You must be covered under a high deductible health plan (HDHP)
- You have no other health coverage except what is permitted under “Other health coverage”
- You are not enrolled in Medicare
Plans with the following deductibles qualify as High deductible Health plans:
- Self-only coverage minimum annual deductible $1,300 / Maximum annual deductible and other out-of-pocket expenses* $6,450
- Family coverage minimum annual deductible $2,600 / Maximum annual deductible and other out-of-pocket expenses* $12,900
Having recently gained the status of unemployed and having bought a high deductible healthcare plan, I opened up an HSA through a company called Select Account. My very good friend who is self employed recommended them to me. Assuming I remain eligible for the HSA, I should be able to deduct my HSA contributions on my taxes.
I like HSAs because unlike FSAs they stay with you. What I don’t like about them is that you can’t invest the HSA contributions, so you’re stuck in depreciating dollars. The IRS is also very particular about who qualifies for an HSA, so when I start my next job, and that job offers health insurance, I might lose my eligibility for the HSA.
If you want to torture yourself you can read more about HSAs over at the IRS website.
Tax Strategy 5: Stop Getting a Tax Refund!
I don’t understand why people get excited about tax refunds. A tax refund means you overpaid on your taxes, you haven’t had that extra money all year and now the government is giving your money back to you that you loaned to them interest free.
I calculate/estimate what my taxes are going to be and then tweak the allowances and deductions on the W-4 worksheet so that I will owe about $900 in federal taxes at the end of the year.
Depending on the state you can do something similar for state income taxes.
By owing a small amount of money to the IRS on April 15 I’ve essentially got the refund through the year in the form of slightly higher paychecks. I’ve also held onto my hard earned money for as long as possible.
You do have to be careful with this because if you underpay by over $1,000 on your Federal taxes you get penalized. States that allow this will probably also penalize you if you underpay by too much, I know Illinois does.
Again I’m no CPA so consult a competent tax advisor before you try something like this. You can read more about the underpayment penalty over at the IRS website.
What do you think of these Five Tax Strategies?
These are five tax strategies I use to keep more of my hard earned income. I will say if you don’t have a Roth IRA you’d better have a darn good reason.
Do your own research, determine what is suitable for your situation and ask your tax advisor if one or more of these strategies is right for you.
If you’re interested in saving more money from the “inflation tax” consider keeping a portion of your savings in gold. Create and fund an account over at Goldmoney using this link for free bonus gold: Goldmoney.com/r/1HWLl0.
If a frog is placed in boiling water, it will jump out, but if it is placed in cold water that is slowly heated, it will not perceive the danger and will be cooked to death.
– Motto of the Inflation Bandit
There is a thief called the Inflation Bandit. He steals YOUR money every year. The ‘Bandit has been robbing and plundering since 1913. He has never been caught and he has never been stopped.
The Inflation Bandit Stole Half Your Money Since 2000
He is a terrible scoundrel and has robbed Americans of millions and billions of dollars but he’s also clever in an evil sort of way.
He doesn’t break into banks and steal money directly–after all that would be dangerous and he’d be caught.
How the Inflation Bandit Operates
The dastardly Inflation Bandit just prints up new money that looks exactly like all the other real money and spends it.
By spending his fake money into the economy he causes prices to go up for everyone else.
So while he doesn’t take your money directly he accomplishes the same thing by stealing the purchasing power of your money.
One of the Million ways this Master Thief has stolen from you
If the Inflation Bandit finds a car he wants he prints up fake money and uses it to buy one for himself and maybe even a few for his friends.
He buys up enough cars so that there aren’t enough left on the lot for all the people with real money to buy one.
When buyers can’t get what they want they tend to get upset. They complain to the car dealer. “I want to buy one of those awesome new cars but you’re sold out! Get some more ordered from the manufacturer!”
So when the car dealer orders more cars from the manufacturer, the dealer thinks, “Hey, people really love these cars! I bet I can raise my prices when I get more. That way people who most want the cars will be able to get one and I’ll make more money.”
Plus the dealer doesn’t like it when his customer’s come in and complain because he doesn’t have cars available for them to buy.
So now the price is higher for people who still want to buy a car. Because the Inflation Bandit used his fake money to buy cars he effectively stole from people who now have to pay the higher price for a car.
Don’t blame Business
It’s really not the car dealer’s fault he sold the cars to a thief. He didn’t recognize the Inflation Bandit. The ‘Bandit wears many disguises and his fake money is indistinguishable from real money.
The Inflation Bandit doesn’t just buy cars, he buys eggs, milk, gasoline, houses, movie tickets, iPhones, computers, cable TV subscriptions. He buys everything with his fake money.
And it isn’t like once the Inflation Bandit spends his fake money it is gone. That fake money is now mixed into the economy and bids up the prices of everything else.
The Inflation Bandit gets slowed down
Back in the late 70s the Inflation Bandit got especially greedy and printed up a lot of fake money. This was causing prices to go up by over 15% per year!
The ‘Bandit got away with it for a few years but people were outraged.
The government cracked down on his efforts and by the mid 80s he was on the run and printed less of his fake money so prices rose by about 5% per year.
Not a bad take for this master thief. He was still stealing millions upon billions but people were less concerned when prices rose by 5%. After all they had been accustomed to prices rising by 15%.
The ‘Bandit learned his lesson
The Inflation Bandit knows if he prints too much fake money people will be outraged. People will demand he be stopped or at least slowed down.
So he’s gotten smarter and he’s gotten patient. He knows that as long as he doesn’t create too much of his fake money each year most people won’t notice it and people won’t be motivated to stop him.
The Inflation Bandit also knows that if people do notice the rising prices they’ll likely blame greedy businesses.
He has a good chuckle every time a business gets blamed for his crimes.
Have you heard of Price Inflation?
While the Inflation Bandit might not be a real person. Price Inflation is as real as it gets. Price Inflation is caused by fake money being spent into the economy.
Price inflation means things cost more and your money can’t buy as much. For example, in 2000, a dozen eggs cost $.96. In 2015 a dozen eggs cost $2.75. That is over a 186% increase in price over 15 years.
In the egg example that is a 7% average annual inflation rate.
Since the year 2000 I believe price inflation causes your money to be worth 5% less per year on average. This means when you try to buy things from food to gas and yes even electronics like iPhones and computers you’re paying 5% more each year than you otherwise would have.
Another Way to Understand Price Inflation
Lets say you lost a $100 bill in your couch on New Year’s Eve in 1999 and you found it on Christmas of 2015.
With an average inflation rate of 5% that $100 bill in 2015 now has the purchasing power of about $46 in 2000.
You would be able to buy less than half as much stuff! That means you’ve lost over half your purchasing power!
Don’t get Slowly Boiled Alive!
Imagine if you woke up one morning and someone had stolen half of your money. If you’re like me you’d be outraged. You’d call the police and demand justice.
But because inflation causes money to lose value relatively slowly over time it’s harder to notice.
People have had half their dollar’s value stolen over the past fifteen years and few people complain about it.
Like the proverbial frog in water, if the water is heated slowly enough, it will not jump out and be boiled alive.
Most people don’t think much about inflation and they don’t care. But if you buy things using dollars you’re being robbed blind by the Inflation Bandit.
There are ways to protect yourself from inflation thievery but you first have to realize you’re being boiled.
If you’d like to hear about the ways I put the beatdown on the Inflation Bandit click here.
Update: 2 August 2016 10:53 Eastern
Bitfinex reported it has been hacked. The website is not allowing logins.
Coindesk is reporting that 119,756 BTC have been stolen.
The hacking of Bitfinex brings up an additional risk that needs to be considered when investing in any type of Bitcoin enterprise. Even if the person or entity running the bitcoin exchange or bitcoin service is honest and trustworthy there is aways the risk of hacks.
Margin funding is a very exciting investment opportunity. It is offered by Hong Kong based crypto-currency exchange Bitfinex. Bitfinex allows investors to fund margin traders and earn passive income in return.
Why am I planning on growing my wealth through loans to margin traders? Because it is low risk, provides a great return, and is passive.
Brief Background on the Concept of Margin
Trading on margin means borrowing money to buy or sell a security. This increases risk and reward. For example, a trader borrows $100 and buys a share of a company for $100. The price of the share goes up to $110. The trader sells the share and makes $10 minus trade fees and the interest paid to borrow the $100.
Margin funding is simply lending the funds traders are borrowing. In exchange for loaning traders capital the lender is paid a percentage return.
Margin Funding has Limited Risk
Lending funds to margin traders is much less risky than actually trading on margin. There are three mechanisms that protect lenders: an initial equity requirement, equity maintenance requirement and finally traders can’t withdraw the borrowed funds.
1) Initial Equity Requirement
Bitfinex has a minimum initial equity requirement for margin trading. The trader must first have equity in their account equal to 30% the size of the trade they are making if the collateral is USD. The requirement is 33% if the collateral is BTC.
For example, if the account value is equal to 1,000 USD a trader could open a position equal to 3333.33 USD. [1000 * (1/.3)=3333.33]
Assuming a BTC price of 250 USD, a trader would be able to open a long or short margin position of 13.333 BTC. [3333 / 250 = 13.333 BTC]
2) Margin Maintenance Requirements
Once the trade has been made and the position is open Bitfinex enforces a margin maintenance requirement.
Lets say the price of bitcoins goes DOWN. Bitfinex doesn’t just let the trader ride the price of Bitcoin down to $0. If they did the trader would owe $2333.33 [$3333.33-$1,000].
Bitfinex has a margin maintenance requirement equal to 15%. So, for a 3333.33 position, the account value must be greater than $500. [3333.33*.15=500]
Continuing the previous example say the price Bitcoin were to reach $212.50. The trader would be sitting on a paper loss of $500. [$212.5*13.33-$3333.33]
The trader’s total account value would be down from the initial value of $1000 to $500. So the trader has reached the minimum margin requirement of 15%. The trader would then receive a “margin call” (actually an email and alert on the website) from Bitfinex and their position would be force liquidated.
This prevents a trader for losing more money than they have, so they aren’t in a situation where they owe money.
3) Traders can’t withdraw the funds borrowed
Bitfinex does NOT allow the borrowed funds to be withdrawn by the trader.
For example a trader can’t borrow $500 and then just withdraw the money and disappear.
The funding lent to a trader serves only to open margin positions. The actual funding always stays in either the funding provider’s account or on the exchange as part of a position.
Margin Funding Provides a Great Return
Most bank accounts pay less 1% if they pay anything at all. It’s paltry and it doesn’t even keep up with the rate of inflation.
As you would expect market rate for margin funding on Bitfinex fluctuates. I’ve made between .05% and .07% per day lending. Although .05% (.0005) daily interest might not sound like a lot, compounded on a regular basis it is very good. If one were to invest $100 it would be worth about $120 at the end of the year or a 20% annual return. [11 December 2016 Update: Bitfinex charges a 15% fee on interest earned via margin funding, that is not included in this calculation.]
If you know a bank that will pay 20% let me know.
Margin Funding Provides Passive Income
You can setup Margin Funding on Bitfinex and walk away. I check up on it every now and again but it is passive income. Passive income is one of my five investment goal categories.
Bitcoin Price Fluctuations
There are several options when funding margin traders on Bitfinex. You can fund them in USD, BTC, LTC (Litecoin) or ETH (Ether). Funding in USD eliminates bitcoin price fluctuation risk (and the potential for reward if the price of Bitcoin appreciates).
Lending in USD makes the most sense to me right now for three reasons.
1) The large run up in Bitcoin price in 2016
If Bitcoin were to sell off I might be tempted to start loaning in BTC. Right now BTC seems a little rich and could be due for a correction.
2) I have exposure to Bitcoin elsewhere
I already have exposure to Bitcoin and I don’t want to increase my exposure to BTC price fluctuations more than I already am.
3) USD margin funding pays a much higher return
Do you want a higher return on the funds you lend out and lower risk of Bitcoin price fluctuations, or do you want a lower return on the funds lent in exchange for the possibility of Bitcoin appreciating (while accepting the risk Bitcoin could drop)? I favor the higher return.
I’ve already made my first loans, or as Bitfinex calls it Margin Funding. The user interface of Bitfinex is a little confusing, and it seems like you have to move money around three different wallets several times to go from BTC to USD then provide margin funding. I highly recommend reading the step-by-step Bitfinex lending guide over at bitcoinpassiveincome.com. [11 Dec 2016 Update: Lending guide seems to have been removed.]
Do your own research and make your own decision if Margin Funding on Bitfinex is right for you. I’ve determined it is a solid investment that is suitable for me.
If you do decide to sign up for Bitfinex you can support this site by signing up through my affiliate link: https://www.bitfinex.com/?refcode=IuO4E6gXkj.
On the Fourth of July the United States celebrates Independence Day. Just a few days ago, on 23 June, a majority of British voters elected to initiate the exit of Britain from the European Union in what some are calling Britain’s Independence Day. Coming up on 15 August is India’s Independence Day.
Make 4 July 2016 the day you declare Financial Independence!
While the United States, Britain, India and many other countries around the world celebrate their independence days, it’s an opportunity to reflect on one’s own personal financial situation, and if necessary, make a Declaration of Financial Independence.
My notion of Financial Independence means making enough money via passive investments so that I don’t have to work a traditional 8-6 job. Financial Independence means I’m free to pursue my hobbies and interests full time and I’m not reliant on my employer to sustain my standard of living. Financial Independence means the freedom to choose what to do with my time.
What does Financial Independence mean for you? What is your “why” for growing and protecting your wealth? Is it to go on a dream vacation? Be able to retire before age 112? Volunteer full time? Spend more time with family or friends? Have more control over your own life? Be able to support your favorite charity?
Progress to Goals
What does Financial Independence look like for you?
I lead a modest life. I live in a single bedroom apartment in a safe but not very glamorous part of town. I drive a 14 year old car with over 200,000 miles on it. Not very flashy or impressive at face value.
What else do I have?
- Zero debt
- Steadily growing investments
- Several months worth of income in an emergency fund
I’m reliant on my job and money from my employer to maintain my standard of living. So I don’t consider myself to be financially independent but I am well positioned to become so. How have I done it so far?
- Specific savings goals
- Dogged commitment to paying down non-productive debt (such as my student loans)
- Living below my means
- Continual Financial Education
By paying off my debts, saving in smart investments, and living below my means, I’m confident that one day I will achieve financial independence.
When the American Colonies Declared Independence from Britain they still had to fight and win the Revolutionary war in order to BE an Independent Country. Just Declaring Financial Independence doesn’t GET you there. You need actionable goals that you work towards every day!
Friday 1 July marked the beginning of the second half of 2016.
The second half of 2016 is your time to pay down debt, save more (or start saving!), and working towards living the lifestyle that empowers you to pursue your dreams, whatever they may be.
It’s not easy. It does take sacrifice and discipline.
What can you start doing today to start working towards Financial Independence? Here are some ideas:
- Create a Budget and get an accountability buddy to help you stick to it
- Include a reward for sticking to the budget
- Set a realistic monthly savings goal you want to reach by 31 December 2016
- Research a new investment for the money you save
- Create a realistic plan for paying down debt
- Find recurring discretionary purchases and cut a few of them out
- If you have Netflix and Amazon Prime perhaps you cancel one. Maybe you cancel your cable or satellite TV plan and just pay for Netflix. Perhaps you buy a coffee maker and thermos instead of going to Starbucks each day.
Choose 1-3 financial goals that will lead to Financial Independence and write these goals down on a piece of paper. Post the paper in a prominent place in your home where you’ll see it ever day. The second half of 2016 is when you’re going to work for and achieve these goals.
Money Can’t Buy Happiness
Money certainly can’t buy happiness, but having enough to meet your needs is important for a happy life. Use the second half of 2016 to Declare Financial Independence and then take practical steps to work towards the life of freedom that you desire.
One of the ways I increase my financial liberty is through passive income.