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What to Expect from the S&P 500

February 13th, 2018 at 07:39 pm

Many people are counting on an 8% compound interest to get them to retirement. Dave Ramsey’s book “Total Money Makeover” even claims a 12% return! Where on earth did these numbers come from? Are they at all a reasonable expectation?

What is the Long-Term Return on the S&P 500?
To start, I plotted the S&P daily opening values since 1871 (when they started tracking) and added a trendline. I choose to use a trendline to back out all of my expected returns so that all of the data within the range count towards the return. Because the odds of buying at the beginning and selling right at the end are astronomical, I think this trendline method gives a better idea of what people actually experience.

Looking at the equation of that trendline, I could conclude that the S&P 500’s annual return is 4.49%. That is a lot less than 8%.
As you can see though, we need to look a lot closer at the data to see if it actually matches in the trendline. With this zoomed out view, it is impossible to tell if the first 100 years are skewing the trendline down away from the 8% people expect. Because we are seeking the exponential return, a logarithmic graph should show us the data more clearly.

There! Now you can actually see the data. As suspected, the old data is very different from the new data. We are going to have to consider this data in pieces based on historical changes.

I’m going to walk you through several historical periods to get you adjusted to what is historically normal. If you want to just skip to the current period, be my guest and scroll down to 1995.

1871-1914: Industrializing World before the World Wars

During this exciting 38 year period where we experienced serious industrial expansion, urbanization, and erected the brand new Statue of Liberty, the annual S&P 500 return was only about 1.9% growth. Yup, definitely skewing the data down.

1914-1945: World Wars and The Great Depression

During this 31 year period the overall return was only about 1.32%: -1.1% during WW1, 2.14% between the two wars, and 4.83% during WW2. I find the cycle between the wars particularly important to look at as we are currently going through massive build ups followed by devastating crashes. The difference here is that we were still on a global gold standard so the recovery didn’t involve a boost from printed money (inflation).

1945-1971: Tense Global Cooperation

This 26 year period the US experienced several civil rights movements and the major world powers fought the cold war and indirect wars though Korea and Vietnam. This is our first period to yield high S&P 500 returns at 8.9%! Yay!

1971-1995: Goodbye Gold Standard

In my opinion, this is the most important dividing line in our financial history, the flight to

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fiat currency. In 1971 we got the "Nixon Shock" and the US Dollar decoupled from gold. Since 1971, the very essence of what money is has changed. All major currencies have abandoned any physical backing and floating exchange rates emerged. I don’t know that we can really count any data prior to 1971 towards identifying trends. (see
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fiat currency).
During this again profitable period of 24 years, the S&P 500 grew by 8.5%, but it lost some ground in the monetary policy switch and shifted to the right before resuming the growth.

1995-Present: Federal Reserve Induced Oscillation

In the piloting world, there is something called PIO, pilot induced oscillation. This is caused by a pilot pulling up, but the airplane delaying its response. The pilot’s instinct is to pull up harder, but when the plane finally starts responding, it is too hard of a pull, sending the plane towards a stall. To correct the error, he or she will quickly nose over and try to dive. Again, the delayed response of the plane intensifies the action as it convinces the pilot to keep pushing down. If the pilot doesn’t fight the instinct to recover, the rollercoster motions will increase in intensity until it suddenly stops and the plane lay in pieces on the ground.

I fear we are experiencing the same phenomenon in the financial world:

Since entering this increasing rollercoaster of crashes and bailouts and bubbles, we’ve dropped back down to, a 4.4% annual return on the S&P 500. That’s just under the all-time historic average of 4.5%, but this time we aren’t gold backed.

That 4.4% might actually be a little high. The graphed data includes 2.5 full cycles: three ups, but only two downs. The next bear market will push the trendline down.

Now I understand that I'm looking at much less data now making the numbers somewhat cherry picked. It is over 20 years though. 20 years is definitely significant in a 40 year career path. I don't really care if I can count on a 100 year return of 8%. I don't plan on working 100 years!

I can't use more data because things probably won't work out the way they did over 20 years ago. Can we really pull numbers to predict the future from before Bill Clinton and Greenspan (former Chairman of the Federal Reserve) started playing with money? I'm worried we can only really expect the 4-5% overall return until money game shifts again. When it does shift, who is to say it will be back to the 8% we got for only 50 years out of 147 or the 8% we got for only 24 of the 47 non-gold backed years?

Unfortunately, one of my hypothesis is that it will actually be a lot worse. If you recall the PIO example, it doesn’t just oscillate forever, expect a catastrophic collapse:

Dotcom boom and bust
With the excitement of the internet, new companies popped up all over and investors poured money into anything ending in “.com”. No one cared how much a company earned, only how many views they received. The Dotcom bubble had formed and the S&P 500 spent 5 years shooting up at a rate of 24.8% annualized.

Eventually, it became clear that many of these companies had failed business models and were going bust and there was a major sell off. The S&P 500 plummeted for two and a half years at a rate of -18.0%. The Federal Reserve slashed interest rates and encouraged investing.

Housing Crash
With the slashed interest rates and incentives, it became very easy to buy a home. With the extra buying of houses, the sticker prices of the houses increased. At first, the increased price simply offset the decreased interest rate, but then people started noticing trends and got greedy. With the house prices shooting up, people started buying houses and using them as banks. Some would buy as big of a house as they could with special interest only loans. The assumption was that they would sell it in a few years for much more than they were in debt for and turn a huge profit. Others took out home equity lines of credit on the appreciation they received on the home they already owned. With this buying frenzy, prices continued to shoot up, and paper wealth abounded. The S&P 500 again shot up for 5 years, this time at an annualized rate of 11.0%. People had thought they found the secret to unlimited wealth. That is, until some people started realizing they couldn’t actually afford the payments that the bank was so willing to sign them on.

Banks began to receive house keys as people walked away from their mortgages. As the buying frenzy reversed, house prices plummeted, destroying the crazy dream of living off home appreciation and putting many families “under water” owing more than their home was worth. The S&P 500 dropped at an annualized rate of a whopping -38.5% for one and a half years. Again the Federal Reserve slashed interest rates, but this time to unprecedented levels. In the dotcom aftermath the interest rates were slashed from around 5% to 1-2%, but this time they went all the way down to 0.1% for years. In addition, the Federal Reserve bought up securities, increasing the money supply.

Dollar Crash?
Again the Federal Reserve is fueling a crash by creating a “bailout bubble”. Each one getting larger than the one before. The interest rates stayed at experimentally low levels low for a full decade. For some reason, people are again thinking this can go on forever and the S&P 500 has grown at a rate of 12.1% for almost 9 years. Investors have become complacent knowing that the Fed refuses to let the market slide and will bail them out in the case of disaster. That’s what it did all through Obama’s administration, but who knows where the new Federal Reserve Chairman and Trump have their priorities: normalizing or market stability?

I worry the next crash will actually break confidence in the US Dollar. I don’t see any way the Federal Reserve can avert the oncoming crisis. I see two options:
1. They could continue to raise rates and shrink their balance sheet (sell the securities acquired after 2008). This would send the stock market into a crash and increase the price of servicing the debt to levels we can’t pay, causing countries to drop the dollar. The dollars would all find their way back home and become worthless.

2.They could reverse rhetoric and start easing to save their struggling economy, but sacrifice the dollar in inflation, also triggering countries to not want the dollar or dollar securities.

Luckily, I am not the one choosing the options. My hope is that there is a third option that those in power will come up with once they notice the cliff they are running towards.

It is hard to know what this will do to the S&P 500. The hundreds of years of data is somewhat useless since we have never had a market like the one we have today. My personal guess is it will crash, then grow but mostly due to inflation.

It all comes out in the inflation wash
If you read my explanation of
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what inflation really is, you understand that we are really hovering around a
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5% inflation! In other words, unless the stock market starts beating its 4% growth, your gains are just adjusting your money to inflation (or pent up inflation). If you have a mixed portfolio with bonds, you're losing to inflation. By all means, that is much better than losing the full 5% to inflation, but it does make retiring a challenge.
I re-ran my retirement numbers with the following grim assumptions:
1. Any money I gain in the stock market will be negated by inflation
2. Any pay increases you gain will be negated by a higher cost of living and taxes

In effect, it is as if we just kept replaying today over and over until retirement.

The good news is with these assumptions, we expect to be millionaires in today's money before I'm 50! The bad news is my husband will have to work till he's 69 before we can retire. Luckily, I should eventually be able to help him out, so I doubt it will really be that long. The numbers are still sobering though. Even maxing out our 401K ($18,000/year) isn't necessarily going to cut it.

If you want to run your own numbers with these depressingly conservative assumptions to see what could be ahead,
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here's a simple and free spreadsheet.

Bottom line:
If anyone is telling you long term rates (especially Dave Ramsey's crazy 12% expectation), ask how they derived those numbers. The data can be cropped, skewed, and made to tell anything you want. When it comes to something as important as retirement planning, you've got to do your own thinking and figure out what makes sense to you (and don't forget inflation!).
Good luck!

Disclaimer: I am not a licensed or certified financial coach, planner or adviser, just an enthusiast. Anything I recommend should be personally analyzed and discussed with your financial adviser.

Inflation - A Tax on your Savings

January 29th, 2018 at 10:38 pm

You get taxed on your income, you get taxed when you spend it, you get taxed on your property, you get taxed when you visit other properties (hotel tax), and you get taxed when you die.  Americans are subject to taxes in every form.  What most people don't realize is that the government taxes savings as well.

Yep, after you put in your hard effort earning at a discount, buying at an increase and trying to make those ends meet, the government steals away a significant portion of the money responsible people and businesses set aside.  The money is taxed as you earn it, then anything unspent gets taxed repeatedly until it is reduced to nothing.  

What really drives my crazy is there's an old economic saying that you get more of what you subsidise and less of what you tax. The government is taxing the very behavior that prevents individuals and companies from needing bailouts and welfare programs. What does that lead to? More dependency, less freedom.

How are they stealing savings?
One word: Inflation

How is inflation the government stealing savings?
It should be fairly obvious that inflation causes the buying power of your savings to go down.  You might be able to buy milk today for $3.  In a few years, it might cost $5.  In other words, if you put your money into a stagnant account it lost 40% of its buying power.  By setting it aside for your future, you just made your $3 worth $1.8.

Even with an inflation as the current target of 2%, prices will double 2.3 times in the average lifetime. Increase that to 5% and you're looking at almost doubling 6 times! Even normal inflation levels can drastically reduce your wealth.

What is less obvious is how this puts it into the government's pocket.  Imagine you are in severe debt.  Wouldn't it be nice if dollars were worth less?  With a government as in debt as the United States, it is pretty easy to see why they might like inflation.

Inflation is a socialist.  It takes from the prudent and prosperous to benefit the reckless and failing.

But wait Milly, inflation has been near zero for a decade and hasn't been high since 1981.
I guess it all depends on how you measure inflation.

When you look at inflation data, it is usually represented by the CPI (consumer price index).  What is the CPI?  Supposedly it represents the price of household goods.

A tricky method many economists use is the

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"Core" CPI, a CPI that excludes energy and food.  The justification is that energy and food costs are much more volatile and large moves in those prices don't necessarily indicate true inflation.  The truth is that CPI isn't that great of an indicator unless you are averaging over a long time anyways, negating that argument.

The problem with "Core" CPI is that it is held artificially low by more heavily weighing items that rapidly decrease in price as technology develops.  Remember buying a 1G thumb drive a few years ago?  What does a 1G thumb drive sell for today?

Often they'll even take it a step further using hedonics. With the hedonic regression, they break items down past their unit price into their constituent parts. In other words, TV screens might be much more expensive than they were in 2000, but maybe the per pixel price has gone down, so they announce deflation. Who knows what formulas they use for completely new features on smart TVs. I can buy an amazing smart TV today for a few thousand dollars, where as in 2000, I would have had to pay a team of computer engineers to research it first. With that mentality, a smart TV's price has come WAY DOWN! Just look at the communications portion of 2017's CPI. Did your phone costs go down
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Now look at your own expenses from groceries to electricity to toys.  You know prices are going up.  When prices do go up, what is the first thing you start trying to adjust to meet your budget?  Probably energy and groceries, exactly what "Core" CPI doesn't include.  Energy and food matter a lot to the consumer!

The bottom line is that by using different indicators and clever math, inflation can be carefully crafted to whatever the Federal Reserve wants it to show and that means low inflation.  They've even kicked their game up a notch and are making a huge show to try and increase inflation, as if that is a good thing.  If they can get us excited about avoiding deflation, their job gets a lot easier.

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Latest CPI data broken down into subcategories and months
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Weighting of categories and locations for the CPI (in 2014).  

I ran the numbers against my personal spending percentages for 2016 and the weighting they give each category (at least in 2014) seems reasonable.

Why are they concealing the true inflation?

Every time the Federal Reserve adds dollar, money  already distributed decreases its share of buying  power.  The United States depends heavily on borrowing.  If they let the rest of the world know what they are doing to the value of the dollar, who would loan us money?  At a minimum, they would demand interest to adjust with real inflation, something we simply cannot afford.

Officially low inflation also keeps domestic benefits cheaper.  If they released what the true inflation was, they'd have to also increase Social Security benefits.  Tax brackets would raise as well, limiting the money we give them.

Economists' Plea for More Inflation!
Just hiding inflation won't work forever though. On June 9, 2017, a group of 22 prominent economists including former Federal Reserve President Kocherlakota, wrote a letter urging then current Federal Reserve President Yellen to raise the target inflation rate above 2%.  The
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argument is that with only 2% of room to play, there will not be enough "ammunition" in an economic downturn to raise up employment with near-zero interest rates (closely tied to inflation).  In other words, if the expected inflation was at 5%, near-zero interest rates would be closer to 5% lower than expected and produce a much faster recovery than a 2% lower than expected interest rate.

Kocherlakota also states, "periods of zero nominal rates are likely to "
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be more frequent".  With the current 2% inflation target, the rates will need to be at the "zero lower bound about 30 percent to 40 percent of the time."  It is clear that Kocherlakota sees that the economic times have changed and drastic measures must be used.

What is crazy is the Fed's are saying it is great that we are on track and even above our target 2% inflation as if that is good news. They also say that 3% is okay since inflation has been so low for so long. Three problems with that thought:
They are acting as if their target 2% is a benchmark to beat. Shooting an arrow a yard above your target isn't a good thing.  They are making it sounds like we don't need to worry about anything, we are already exceeding our annual goals!

It hasn't been near zero for long. It  averages pretty close to 2% since 2008.

Even if we were near zero for a decade, that mind-set is very hard on the consumer. Imagine going years of near zero inflation. In your perceived prosperity, you load up on all forms of debt.  Then, suddenly prices jump in one year. Between higher living costs and adjustable interest debt (such as credit cards) your budget becomes VERY tight.

Note: the other way they could achieve these results is to toy with Europe's idea of
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NEGATIVE interest rates.  In other words, paying someone 3% for them to hold your money for you.  This idea could only work if money is trapped in the system.  Like in [href="]India[/url], we could see a situation where paper money is forced to be converted to digital money, where Uncle Sam can see, track, and tax it all.

So how should we be measuring inflation?
Good question!

You could think of inflation as having two components, the supply of money and the velocity (how frequently the money is passed from person to person in a year) of that money. One is formed by monetary policy, the other by the behavior of the people within the economy. Let's start with money supply:

M3 - Broad Money

Money supply is measured in several categories.  The most useful in this case is
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M3, or broad money.  This includes cash as well as assets easily liquidated into cash (savings accounts, money market accounts, CD's, repurchase agreements, etc.)  If you look at a historical chart of this number, it has been steadily increasing until 2006, when the Federal Reserve announced they would no longer provide M3 numbers (
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When my daughter is about to do something she knows she'll get in trouble for, she shuts the door or asks me to go into a different room.  If broad money was increasing like it was when openly disclosed, what do you think has happened since 2006? If you check out 
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Note: to learn more about where money originates look here:
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What is Money? and the US Dollar Machine

This component seemed strange to me at first. Why would exchanging money make it worth less? Try thinking about it this way. If twice as much money passes through your hands annually, but there are still the same number of products, the product will have to cost twice as much to prevent a shortage.

The Federal Reserve doesn't seem to be worried about inflation because they believe in a "
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goldilocks economy" that is not too hot and not too cold which is easily tuned with economic easing/tightening if something does get a little out of balance.

What they fail to realize is how behavioral based the velocity component is. Right now, as businesses and families feel economic strain, they look towards securing their future and save money as best as they can.

What happens if inflation breaks out even just a little? Suddenly, analysts will advise corporations to spend on upgrades, inventory, and raw supplies while their money has more power. With the increased corporation spending, prices will rise and individuals will catch on. With a subtle shift, that saving could turn to a spending frenzy that grows exponentially.

I think we are sitting on a situation even more volatile today than in any of the historical hyper inflation stories. On the corporate level, companies rely on computer data and analysts more than ever. With this data and statistical analysis, the strategy has become operate on the tiniest margin possible to capture the largest market share. What happens when a company as large as Walmart or Amazon notice a bad inflation trajectory? Dollars will pour into the economy as fast as the companies can wisely manage it as they scramble to protect their tiny margins.

On the individual level, social media can create massive behavioral movements in just a few days. As each move is made, more parties will catch on and the more aggressive each party will have to become.

What can we Do about it?
There really isn't much we can do to stop the problem except spreading awareness and electing officials brave enough to stand against the Federal Reserve.  Luckily, you can protect yourself from the effects.  When you are storing your economic resources, don't leave the bulk of it exposed to inflation.

The commonly advertised way to do remove the effects of inflation is by investing in TIPS (Treasury Inflation Protected Securities).  When inflation increases, so does the payout.  One major problem, the official inflation tracks CPI, not the money supply/velocity.  Your savings will still get eaten by the dying power of the dollar and you are back where we started.

Here's what you should do.  Keep your emergency funds liquid and ready, but diversify your deep savings such as retirement.  Most people think diversifying their portfolio means investing in various stocks and bonds.  But what happens if it is the dollar that crashes?  All of those deals and obligations become worthless regardless of how diverse they were.  Instead invest in some domestic stocks, some foreign stocks, some real estate, some
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precious metals, some in long shelf-life food storage, and most importantly invest in your own personal education and skills.  With a diverse portfolio like that, you can weather any depth of economic crisis and make it out just fine.

Further reading:
Peter Schiff's
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Crash Proof 2.0
Text is What is your money? and the US dollar machine and Link is
What is your money? and the US dollar machine
Upcoming US Economic Collapse - How and Why (coming in a future post)
How NOT to Prepare for the Economic Crisis (coming in a future post)

Disclaimer: I am not a licensed or certified financial coach, planner or adviser, just an enthusiast.  Anything I recommend should be personally analyzed and discussed with your financial adviser.

What is Money? and the US Dollar Machine

January 25th, 2018 at 10:24 pm

Why do we have Money?
The purpose of money is to store our economic value (time, efforts, resources, etc.)  Without money, a carpenter would have to find a chicken farmer that needed a new table if he or she ever wanted eggs.  Because of monetary systems, the carpenter can produce a table, sell it to anyone, and use the money over time to buy groceries from various sources.  Money greatly increase the efficiency of an economy.

Commodity Currency

Money comes in various forms.  Commodity currency is money that has value in of itself.  Salt has been used in Eastern Africa, tea bricks in Central Asia, Parmigiano cheese in Italy, cocoa bean in Central America, and pemmican in North America.    Cattle, knives, and even potato mashers have been used as well.  The most obvious example of commodity money is precious metal.

A lump of gold has substantial value no matter where or when you live.  It is easily worked, carries a current, and is stunningly beautiful.  To further ease transactions, the metal currency is often minted into coins or bars that are recognizable, standard in size, hard to counterfeit, and noticeable if shaved or clipped.  This allows it to be exchanged without a scale and without fear of purity issues.  The advantage of commodity currency is it will always be worth something.  The disadvantage is that it is less portable and cannot be transported digitally.

Representative Currency

Another type of money is representative currency.  This is a certificate that can be redeemed for a commodity (something of value).  Effectively, the object stays in place, but the title of ownership changes hands.  The United States operated under this form of currency for nearly a hundred years.  The United States’ paper money used to be exchangeable for actual silver at the Federal Reserve.  An advantage to this method is the commodity doesn’t have to be continually packed by the owner and it doesn’t get worn or abused.  A disadvantage is it masks the commodity and puts it in someone else’s control.  If there is doubt that the certificate can be redeemed, the purchasing power of the certificate will plummet.

Fiat Currency

The final type of currency is what almost everyone carries today, fiat currency.  This is currency that only has value because someone says it does.  It is monopoly money when playing a game, tokens when at an arcade, stickers when paying the postage, fancy green paper with historical figures when paying in cash, and a blip on a computer screen when ordering online.  In their own domain, they are each valid currency.  If I were to pull out a checkbook while playing Monopoly, it would ruin the game and if I were to use Monopoly money at the grocery store, I wouldn't have any eggs for dinner. 

If the rules within the domain are unchanging and fully backed, the system works.  I’ve never had a hyperinflation problem while playing Monopoly, because I've never designated an official "game rule maker" who announced midgame that prices would double with each dice roll.  The problem with the real world is there are "game rule makers": the US government, the US Federal Reserve, and other law makers or currency regulators throughout the world.  They constantly play with currency supply, interest rates, commodity prices, taxes, tariffs, and treaties to meet their objectives. Unfortunately, this manipulation has caused the collapse of both the currency and the economy

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dozens of times in the past.

The US Dollar

The US dollar is even one step more convoluted.  They are not owned by the US Government, but by the Federal Reserve System.  If the US Government needs more dollars than what it collected in taxes, it sells
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government securities (government debt) in the form of Treasury bills, Government Bonds, and Government Notes. These are bought by other countries, investors, or the Federal Reserve and will eventually need to be paid back with interest. When the Federal Reserve buys the securities, it creates money out of thin air and is reffered to as "printing money", even when digitally created.

Reserve Currency Status

In 1944, 44 delegates from 44 Allied nations gathered together in Bretton Woods New Hampshire to discus global finances in the WWII aftermath.  At the time of the
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Bretton Woods Conference, the United States was the leading exporter and creditor and the dollar was exchangeable for a fixed quantity of gold (representative currency).  Because of the United States' strong currency, the delegates selected it to be the international reserve currency.  

As the global reserve currency, other nations would have to first trade their money for dollars before exchanging with other countries to settle debts or purchase comodities. Countries also hoarde dollars as their own personal reserves the same way a household would hold some available cash for difficult times. It also serves as some protection against adverse exchange rates with their local currency. No one wants to scramble for dollars when they are needed because that is also likely when they are the most expensive.

Because countries need dollars, it creates an extra demand. This proping up of the dollar and gives the United States a huge advantage in power and prosperity.  As the only legal producer of the US dollar, we also get a discount on transactions by avoiding exchanges.  Much of the prosperity we experience today is directly dependent on holding the reserve currency status.

In 1771, the United States released a series of economic measures known as the
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Nixon Shock.  It was in these monetary policies that the US dollar lost its representative currency status and fell to a true fiat currency.  This should have plummeted the value, but other countries weren't willing to declare their dollar holdings worthless.

The US Petro Dollar

Knowing the dollar had to be backed by something, even if indirectly, in 1973 the United States made a brilliant deal to protect Saudi Arabian oil fields (specifically from Israel) on two conditions. They had to agree to only sell oil in US dollars and invest their excess profits in US government debt securities.  By 1975, this deal was expanded to all OPEC nations, creating the US petrodollar.  These deals forced other nations to buy US goods to obtain US dollars despite the physical worthlessness of the paper money.  The deals also gave artificial demand to US government debt securities, lowering the interest rates significantly.  Basically, the US is able to print money to buy oil, then have the oil producers buy the debt used to print the money!  It is this circular system that allows the US to print nearly as much money as it wants.

In the past, some oil producers have tried to switch away from the petrodollar system and have felt the full force of the US military.  In Iraq, Saddam Hussein traded his oil for Euros, so we searched for an excuse to take him out.  With the 9/11 attacks, we chose to ignore the fact that most of the hijackers were Saudi (our petrodollar ally) and instead drew up plans against Iraq as the answer.  Kaddafi sold oil in Dinars and met the same fate.  Just about every military decision since the Industrial Revolution is oil dependent.  Vietnam, Pearl Harbor, and even the assassination of Archduke Franz Ferdinand (triggering WWI) all have underlying oil motivations.

Basically, the United States of America, knows that oil rules the world.  If the petrodollar system is threatened, the economy will collapse.  Even President Franklin D. Roosevelt once said, “I hereby find that the defense of Saudi Arabia is vital to the defense of the United States”.

Unfortunately, China has a growing thirst for oil and is now Saudi Arabia's biggest customer.  At the same time, the US oil orders are declining.  Saudi Arabia feels somewhat betrayed by our relaxing of policy against their enemy, Iran, and is questioning the need to maintain the petrodollar system.  In 2010, Russia and China struck a deal and now will exchange oil directly, skipping the dollar.

If oil is bought without the US dollar, nations will have much less tendency to hoard dollars and they may find their way back to the US, quickly.  Countries will want to cash in on their US debt holdings and the dollar value will tank as the domestic money supply skyrockets into hyperinflation. The US dollar is in trouble.

Good luck!

Disclaimer: I am not a licensed or certified financial coach, planner or adviser, just an enthusiast.  Anything I recommend should be personally analyzed and discussed with your financial adviser.

A Penny Saved is 1.57 Pennies Earned

January 23rd, 2018 at 10:53 pm

There is a long standing understanding that a penny saved is a penny earned.  I submit that the statement is false.  Here's why:

When you save a penny by substituting out cheaper alternatives, using coupons, or other means, you become one penny richer.

When you earn a penny, it must enter a pool of tax piranhas before you can take a fraction of it home.

Let's start at the Federal Income Tax

When looking up my effective tax rate of 2% on my federal tax return, I really don't feel that bad about taxes.  To make me even happier, it has been going down every year since we were at 7% in 2013 (before we had 3 tax credits, I mean children).

Since we are talking about the marginal level, we will ignore the effective tax and look only at the tax on that last penny earned.  For most Americans, this is a 15% tax ($18,550-$75,300 taxable income for 2016).

Social Security & Medicare Tax
Also taxed at the federal level and collected by the IRA are the Social Security Tax (6.2%) and the Medicare Tax (1.45%).  This is a flat tax with no brackets or caps until $118,000.  These taxes are in addition to the federal income tax and neither one is deductible from the other.  The vast majority of Americans pay the sum total of a 7.65%  tax towards these funds.

State Income Taxes

Each state has its own income tax and tax brackets ranging from 0-13.3%.  I'm going to use California as an example.  The average Californian household income was about $64,500 in 2015 (

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source), If they don't have a $4,522 worth of deductions, that puts them in a 6% tax bracket ($59,978-$83,258).

Running Total: 28.65% tax

Unfortunately, that's not the end of the story...

Invisible Taxes
Yup, we have those too.  It turns out businesses must also pay additional Social Security and Medicare taxes when they pay you.  Your employer sends off both portions before you see any money.  Although one is "paid by company", the company sends both portions out of your wage by simply paying you less.  This adds another 7.65% tax, bringing you up to a running total of a 36.3% tax.

Corporations also pay an "income" tax.  Economists debate as to how much of that tax is actually transferred to the workers and how much is "paid" by the share holders, but 20% of the 15%-35% tax is a pretty good estimate (
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source).  Because I have no clue how to estimate how much earnings per employee is a good estimate, I'm going to leave off this tax in my numbers. Just know that your income is taxed even higher.

A Penny saved is 1.57 Pennies earned

With a tax of 36.3%, you would have to work the equivalent of a 1.57 cent wage to take home 1 penny.

$0.0157 * (1-0.363) = $0.01

There you have it, while earning extra money is really nice, much of it disappears long before you see it.  Dollar for dollar, saving is a more powerful tool.

Obviously, there are limits to this thinking.  There is only so much money you can save and infinite money you can earn.  It is also true that there is infinite money you can want to spend.  You can have a million dollar salary and still be broke.

It is also important to note that saving money isn't really saving money if it leads to a more costly alternative.  Ignoring the oil changes and being forced to buy a new engine, is obviously a bad idea.

Where to focus your efforts, depends on where you are on your financial journey.


Disclaimer: I am not a licensed or certified financial coach, planner or adviser, just an enthusiast.  Anything I recommend should be personally analyzed and discussed with your financial adviser.