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Economic crisis and inflation: invest or save?

September 30, 2022

10 min

Economic crisis and inflation: invest or save?
Intermediate

Investing and saving are not opposite concepts, but rather steps in the same virtuous process of protecting the value of money. Your money is in fact subject to inflation and interest rates, two mechanisms to be aware of in order to defend your purchasing power (or capacity to spend). We will explore together how saving and investing can be combined to preserve or even create value.

The meaning of savings

Saving money is not simply putting money aside for the future. It is not a passive action, or at least it should not be. Keeping part of your income is only one component of the definition of saving. Therefore, the classic metaphor of stashing ‘money under the mattress’ does not really explain what it means to save, which is actually the first step in managing and putting money to good use.

Saving might be mistakenly recognised in the difference between our income and expenditure, but this measure is not enough. It means preserving the value of our money. The most valuable quality of banknotes is their purchasing power. What kind of products and services and how many can I buy with the capital I have at my disposal?

Purchasing power is not immutable. When prices rise, the same amount of money corresponds to fewer products and services of lower quality. Therefore, in order to save, it is not enough to give up spending, but you must actively defend your purchasing power. In short, this is only possible by putting our money in a position to generate more value.

Investing your savings, so as to generate profit, is therefore a way to at least keep your spending capacity stable. However, what are the mechanisms that threaten the value of our money?

What is inflation: how money loses value

The loss of value of money (hence of its purchasing power) due to rising prices is precisely the definition of inflation. If we really want to understand what inflation is, we have to consider that it is intrinsic to any debt-based economy, such as ours. The mechanisms of fiat money issuance by the European Central Bank (ECB), and the ‘creation’ of digital money, make price increases inevitable.

In fact, within certain limits, inflation is functional to a healthy economy. This is why the European Central Bank has declared its commitment to keep the inflation rate around 2%. Indeed, the ECB monetary policy, being the core of the European System of Central Banks (ESCB) and the whole Eurosystem, has the power to influence the ‘value of money’ by acting on inflation.

The ECB is therefore responsible for the savings of every EU citizen, but the European economy is equally affected by a complex system of other factors. Therefore, it is difficult for the solutions adopted to encompass each of them: modern history evolves quickly and the ECB is called upon to adapt quickly, but the course of events does not wait for our ability to intervene.

The purchasing power of the Euro has decreased by about 34% since it has been in circulation. This is without taking into account the recent combination of the energy crisis, the war in Ukraine and the Covid health emergency. This means that, in the space of 20 years, the purchasing power of 1000€ has decreased to a spending capacity of 660€.

To understand how anti-crisis measures can affect inflation and savings, let’s take 2022 as an example. European governments, supported by the ECB, distributed economic subsidies to households and companies in order to boost the economy. The flow of money is crucial to keep the market ‘moving’ so that national systems can function properly. In a nutshell, purchases support businesses, who can therefore pay salaries and, in a chain reaction, look after the welfare of citizens. The logic here is reduced to a minimum, but the liquidity injected into the states has led to an increase in inflation, beyond the safe threshold.

Harmonized index of consumer prices (HICP)

The economic stimulus was necessary, but it also had consequences for savings. The euro lost some of its purchasing power: one of the effects of rising inflation. To calculate inflation, you should consider the price change of a basket of goods and services, called the Consumer Price Index (CPI). When generalised to the entire Eurozone, the CPI is referred to as ‘harmonised’, as shown in the infographic. This is because it is calculated following the same methodology for each EU country

What tools does the European Central Bank have to calm prices by acting on inflation? Knowing this is important, because from this we can understand how to save money.

Inflation and interest rates: how to save?

Raising interest rates is the tool used by the ECB to try to bring inflation back to around 2%. In order to understand what interest rates are, you have to consider how much it costs to borrow money. Banks lend money expecting an additional fee in return, namely interest, which the borrower will have to pay in addition to the repayment of the principal.

Individuals borrow from commercial banks, which in turn receive and deposit liquidity with national central banks, based on interest rates decided by the ECB. Going back over the economic system, inflation is thus counteracted through the following steps:

  1. The European Central Bank raises its interest rates;
  2. It is more expensive for commercial banks to demand liquidity, so they increase their interest rates for loans to private individuals;
  3. It is therefore more expensive for citizens to take out loans: since they cannot obtain financing for their expenses, they have an incentive to save;
  4. The lack of demand for goods and services should, theoretically, lower supply prices, so that inflation is reduced.

Raising interest rates will have these effects in the long run, but in the short run it already manages to control inflation expectations. This is important because, without the ECB’s monetary policies, workers might consider high inflation irreversible. In turn, this would persuade them to demand higher wages and, consequently, cause the prices of products and services created by their companies to rise. This phenomenon is called wage-price spiral, and is equally prevented by rising interest rates.

According to this mechanism, savings are the primary factor affected by rising interest rates. In contrast to the rising cost of borrowing, bank deposits are rewarded with higher annual interest rates. In practice, banks will return more profit for the savings they take in. However, this side of the coin (or rather, of money) should not be misleading, because this annual interest is equally subject to inflation. To get a concrete estimate of savings, we need to explain the difference between real and nominal interest rates.

Real and nominal interest rates

Rising interest rates encourage savings because commercial banks simultaneously promise higher returns on deposits balanced with higher borrowing costs. However, it is important to assess whether this is a real benefit for savers. On balance, is more interest really generated on deposited savings?

To this end, we have to consider the Fisher effect. Real interest, produced by your deposited savings, is the difference between the nominal interest, promised by commercial banks, and the inflation rate. In a nutshell, if your bank sets an annual interest rate of 4% on your deposits, but inflation is 3%, the real interest generated will only amount to 1% of the initial value of your savings.

Real and nominal interest

  • Nominal interest: rate (percentage) agreed with the bank while opening an account or while contracting a loan, financing or mortgage. It is the theoretical cost of a loan and the theoretical yield on the deposited savings.
  • Real interest: effective interest rate for loans and deposits. It is calculated as the difference between the nominal interest rate and the inflation rate.

It is worth noting that the real interest rate of deposits is often negative: inflation can reduce the purchasing power of your money to such an extent that it cancels out the added value generated by your savings. Let’s take an example: as of August 2022, the UK inflation rate, as stated by the ONS, was 9.9% on an annual basis. Let’s assume that last year the most generous commercial bank gave you a nominal annual interest rate of 5% on your deposits. If you had deposited £1000 last year, you would now have about £1050 in your account. However the real purchasing power of your capital, adjusted for inflation, would be about £946. The real interest rate is in fact 5% – 9.9%= -4.9%. 

In a nutshell, your savings would only lose value by remaining passive, deposited in a bank account. So, if our aim is to understand how to save, we can finally return to what we said in the first paragraph. Investing is one of the ways to truly preserve the value of money by protecting its purchasing power.

Investing savings

Saving is the first effort needed to save some of our capital, but investing savings is equally important. Generating value is essential to offset and overcome the pressure of inflation, so that we can keep our purchasing power intact or even increase the value of our savings.

Where should you start? First of all you need to understand what investing means today, and then find the financial instruments best suited to your profile, taking risks and goals into consideration. Moreover, you will need an investment strategy and finally you will need to constantly monitor the Profit & Loss of your investments.

Before investing your savings you need to do your own careful research on the instruments you intend to use (DYOR) invest only what you are willing to lose, and above all, do not fall into the traps of social engineering: no one has a magic formula to multiply your savings!

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