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Thursday, December 5, 2013

Think in Real Terms

Back in '73-'74, OPEC, at a time when  the U.S. was a big importer of oil with our gas guzzlers and wasteful energy practices, quadrupled the price of oil overnight.  Economists, in thinking through this type of event, tend to get away from prices and dollars and think in real terms.  Thus, in effect pre-embargo, we would trade x number of autos versus a given number of barrels of oil and after the embargo OPEC wanted 4 times as many autos for the same number of barrels!  Putting the oil price rise in these terms clearly shows the extent of the problem.  Specifically, it showed that something would have to give:  either the U'S. economy would get pounded or OPEC would be paid in funny money as inflation pushed the value of the dollar lower.

In fact, in 1980 OPEC doubled the price of oil again a;nd the U.S. experienced spiraling double-digit inflation that led to Volcker slamming the brakes and throwing the economy into a severe downturn. Anyone remember the WIN buttons?

This technique of putting dollars in real terms is useful in financial planning.  For example, sometimes the decision is to take Social Security today or wait 2 years and get $150/month more.  Many people would think that $150/ month extra, on the face of it, isn't worth waiting for and opt for the payments to start today.  But, in real terms, we might observe that $150/month provides a really nice dinner (wine included) monthly for a couple as long as they live.  Perhaps put in these terms the decision might be worth reconsidering!  Or, more broadly, looking at the payments over a 12-month period shows an amount that could go a long ways towards funding an annual trip.

The technique also works the other way.  Working with annuity payouts typically involve higher payments if there are no survivor benefits.  Allowing, for example, for survivor benefits of, say, 90% may lower the monthly payment by $100/month.  Would you give up a monthly eating dinner out to have the peace of mind that the payments will continue to the spouse as long as she is a survivor?  Again, thinking of the payments in terms of real sacrifices can help in the decision process.

Obviously, I like to eat; but the decision can be framed in terms of rounds of golf, traveling to see friends, time between buying a new car, or whatever.  Framing the decision in terms of what you can gain or have to give up can sometimes be a big help in making the right decision.  This is also useful for young people thinking about saving.  What do they get 30 years down the road, in real terms, by saving a relatively small amount today?


  1. This is precisely why I pay a little more every month on my mortgage! It is very little in relation to the mortgage, but extrapolate it to the life of the mortgage, I shave of almost 5 years of the full term!

    Money and time are funny that way! Great job explaining this!