Introduction: Savings accounts, Banking practice and Inflation.

Who remembers their first savings account? Perhaps Mom or Dad brought you to the bank to open it – each month you would add a bit of your allowance, giving you a sense of pride every time. It made you feel grown-up: your first real handle on wealth management. Then, as you grew older, got a job, and began buying things for yourself, maybe you decided to open up another account; this one came with a card that was magically connected to the money in the bank. This was your first checking account, and I’m willing to bet that felt pretty good too.

But have you ever asked yourself where that money goes when you deposit it? Do banks hold it in vaults like how you see in the movies? No, definitely not. See, banks make the majority of their revenues on interest, the fee they charge for extending you credit. Take this as an example: a $100 loan will require a $110 dollar repayment, $100 being the value of your initial borrowings, known as principal, and the added $10 is the amount the bank charges you for giving you their money, known as interest. The four biggest American banks (Bank of America, Chase, Wells Fargo, Citibank) in total accrue around half of their total income from interest.^[1]

This takes us back to our original question: What does the bank do with the money you deposit? Well, in short, they give it away to other people or businesses and charge a fee for doing so. They repay you for giving them this money by extending you a minuscule portion of the interest income they have earned, which is known as consumer interest or APY (annual percentage yield). This, to you, seems like a pretty good deal: Your money is kept safe, it is always accessible, and you get some reward for leaving it there. Here we can begin to see how banks can create money out of thin air. The $100 you deposited is kept in your name and belongs to you, yet the bank goes out and lends it to someone else. Suddenly the total amount of liquid dollars attached to your deposit is doubled. The bank has created one hundred new dollars to be used in the economy.

Banks will do this into perpetuity, lending and taking deposits until the end of time. They will also consistently lend out more money than they could reasonably give their depositors at any given time. And that is to be expected. It would be an incredible anomaly to have every bank account holder immediately request all their funds withdrawn. To protect against what is known as a bank run, the Federal Reserve requires that banks hold cash on hand to be available in the instance of abnormally high withdrawal requests. This requirement is known as the reserve rate or cash reserve ratio, and as of March 26th, 2020, is 0% for all commercial U.S. banks. It is worth noting that the Federal Reserve eliminated the reserve requirement during the onset of the Covid-19 pandemic, and has not updated it since. Prior to 2020, it was 10%.

So what does this have to do with your savings and checking account, and why did we spend so much time learning about it? To put it bluntly, having large amounts of money in checking or savings at a young age is just about the closest you could get to financial suicide at this point in your life. We have learned so far that the banks create money, turning $100 into $200 without even batting an eye. However, we have yet to examine the long-run effects of this or other monetary supply practices. Eventually, we will end up with an understanding of the key idea of inflation and once we understand this we will see how checking and savings accounts should function and how using them incorrectly will rob you of your wealth.

The year is 1945. World War II just ended. The United States is about to enter one of the longest expansionary periods in its economic history, and a gallon of milk costs about 63 cents. Just like today, savings accounts are common and encouraged – so let’s assume that like every other well-wishing American, you decide to begin saving in one of these accounts. You deposit $1000 and forget about it until 2021. Your $1000 deposit is worth a whole $67.28 this current year. How did this happen? $1000 should still be worth $1000, right? Well in a sense, yes. But every year, the purchasing power of your dollar declines. While hours could be spent discussing theories about inflation – why it happens, why it is or isn’t good for the economy – that is not important at the current moment. What you must understand is that over time, from bank lending, government stimulus, strong economies, and foreign investment, the total amount of dollars cycling through the economy, or money supply, will always be increasing. Whether naturally or by seller’s choice, prices will always follow the increase in dollars, going up over time, often even faster than the rate of new dollars entering the economy. This price increase is called inflation and it averages around 3% per year. Essentially, things cost 3% more every year, or inversely, your dollar buys 3% less.

So what do you say? The likelihood that you will keep $1000 in a savings account for 76 years is small. You will need that money to buy a car, a house, or maybe even a plane ticket. I would agree, you will probably use that $1,000 along the way for something no doubt. So let’s run the same numbers in a new example: You are putting $1000 away this year in order to buy a car in 2027. We will assume the same 3% inflation rate. If the car costs $1000 in 2022, by 2027 it will cost $1159, and your $1000 will still be worth, well, $1000. Suddenly the car you wanted costs $159 more, and you are left scrambling to come up with the extra dough. Each year you keep your money in that savings account, things get more expensive, and your money’s worth decreases. Now enter the bank’s solution.

Earlier we touched on the idea of APY (annual percentage yield) and consumer interest. This is the amount a bank will pay you in order to take your money and use it for loans. That sounds sweet – you’re not doing anything better with the money, and getting paid to do nothing is awesome. To begin this process, you are given three options for the type of account you can open up to earn this interest: a traditional savings account, a Money Market account, or a CD (certificate of deposit). Below is a brief overview of what you could earn from each.

Now that you are familiar with the different forms of saving vessels, we should return to the idea of inflation. Taking our new knowledge of the APY earned from various accounts, it is clear that this interest may ease the sting of inflation. Assuming our traditional savings account yields .75% a year, our money market savings account yields 1.25% a year, and our 5-year CD account yields 2% a year, we can see that they lessen the impact of inflation by their respective yields. However, we can also see that even in the best-case scenario – the 5-year CD account – we will still lose 1% of our purchasing power each year.

I would be remiss if I did not mention the fact that savings, money market and CD rates are constantly in flux. At the time of writing this book, deposit rates across the board are at multi-decade lows. So however, is inflation, and therein lies the paradox. Deposit rates and inflation are, and always will be, engaged in an infinite tango. This dance has been occurring since the inception of modern central banking. Thinking about it intuitively, it makes good sense. If inflation was running hotter, say above 10%, as it did in the 70s and 80s, nobody would even consider a bank account if it didn’t offer something comparable. While I have no way of knowing what the state of price stability is during your period reading this book, I can assure this relationship persists. If you are seeing deposit rates higher than the numbers I have quoted above, I would encourage you to go look at recent inflation data. The correlation speaks for itself.

With that out of the way, once again we return to the car scenario. Say we decide to put our $1000 in a 5-year 2.0% APY CD this time. As we know, the real cost of the car in 2027 will be $1159, but we do not yet know what the real value of our savings will be with the new CD account. Using the 2.0% yield, we can calculate that our initial $1000 deposit will have grown to $1104 by the time our CD has ended its term, in 2027. This may not seem so bad, as we, in real dollar terms, have only lost $55. We have essentially paid the bank a $55 dollar fee for holding our money for these five years. But how is this possible? Wasn’t the bank paying us to hold our money? Hopefully, it has now become apparent that the savings account is just one large scam, in most cases. If you remember only one thing from this introduction, let it be this: Never, ever will your savings account keep pace with inflation. With every year, your money will lose its value.

Maybe this doesn’t bother you – that $55 hidden fee is something you are willing to pay, or maybe you plan to make enough money that none of this miserly inflation nonsense will affect you. If that is all true, I wish you the best of luck. I would not recommend you read any further; you have no need. If you are like me and think $55 might be handy for gas or to take your mother out to dinner, or you would like to save for your first house in a smarter fashion, this is the place for you. Through lots of minimum wage work, conversations with peers and colleagues, personal mistakes and confusion, hours of correcting these mistakes, and a partially earned finance degree, I can assure you that the average young person is woefully financially illiterate. I hope, in some way, to change that for you. I firmly believe that the right financial education, planning, and mindset are key to enjoying all that life has to offer. I have a younger brother who is turning 16 this coming year, and even if he is the only one that reads this, I will be immensely happy to know that someone his age is getting the financial education I never did. With him in mind, the specifics and theory of this book will be kept simple, to be read fully in an afternoon, or over the course of a few nights. I wish the best of luck to everyone choosing to embark on the journey of financial independence and sincerely hope this helps you along your way.