It's time to get your head around inflation
What got me thinking about it was weird. It’s because I’ve just bought a new car - a Mini. They’re made by BMW now but they're still cute, just like the original Minis made in the 1960s. I’ve always liked them since my uncle had one years ago. In fact, in 1965 when my uncle bought a Mini Cooper it cost him about £600, which was a fortune then.
I’m not exactly sure what National Average Earnings were in 1965 - I could look it up if I could be bothered - but I think it was somewhere around £1,100 a year. So £600 must have been a fair percentage of National Average Earnings in those days.
The Mini I’ve just bought also cost a fair percentage of National Average Earnings as they are today. I paid a little over £15,000 for it and National Average Earnings are at around the £25,000 mark. The thing is, if someone had set out in 1965 to save up to buy a new Mini in 2003, nearly a 40-year saving period, how would they have gone about it?
It would have seemed amazing to my uncle in 1965 to be told he’d need to save up something like £15,000 to buy a new Mini in 2003, particularly as he was probably only earning around £800 a year at that time. The three bedroom semi-detached house he’d just bought in those days had meant he’d had to take out a mortgage of £2,500 and he regarded that as a bit of a millstone around his neck as it was. If you’d told him he would need to put nearly six times as much aside to buy a Mini he would have thought you were mad.
The trouble is, we put the same pound sign in front of numbers to denote value today as we do in front of numbers that are meant to denote value in the future. We should use a different symbol, but we don’t. And that’s where the confusion comes in. A ‘pound’ in 1965 had a completely different and much higher value than a ‘pound’ does now. But we have it caught up in our heads somewhere that they are both the same.
Its almost as if we are able to accept that we know rationally they can’t be the same, but a part of us still seems to think they are anyway. If you don’t believe we all think in this weird and irrational way, just think back to your own private thoughts when you read in the last paragraph that my uncle only paid £2,500 for his house.
I’ll bet you thought “Wow, that was cheap”, or “I wish houses still only cost that sort of amount now”, or something similar. Most people think that way - you, me, all of us. It’s a hard habit to kick. I notice I’ve even referred to it as ‘only’ £2,500 in the last sentence or so. It’s so caught up in the way we use language. No wonder we find it so hard to think sensibly about things like this.
Pension saving is a 40 year hike, just like the hypothetical 40-year savings plan to buy a Mini I’ve just used to illustrate a point. How many 'pounds' should we save now to produce a pension of a certain number of ‘future-pounds’ in years to come? What do we think those two ‘pounds’ are in any case?
The variable value of money is hard to get the hang of. With pension savings, though, there’s a lot more to it than just the change in the value of the ‘pound’ over time. The cost of buying a ‘future-pound’ of pension also appears to be increasing. This is because it looks like, on average, we will all live longer than we previously thought we would.
That’s great news, of course, but if we do and want to spend those extra years in retirement, rather than working, then we will need more savings to live on. That simple fact translates into an ‘increase’ in the cost of a ‘pound’ of pension. There are loads of tricky concepts tied up in that last sentence, all compounded by the fact we seem to be conditioned not to understand the effects of inflation anyway.
What we need to be wary of is a kind of reverse reaction to the one that makes us think £2,500 in 1965 was cheap for a house. The reaction to an illustration of pension benefits that goes along the lines of “Is that all?” or “I thought I’d get a lot more than that!” is an understandable one if we don’t first realise that the pound signs in front of the numbers are practically meaningless. To understand them properly we first need to understand what we’re looking at.
First published in Bloomberg Money, May 2003