Despite the practical impossibility of real comparisons we know perfectly well that the value of a dollar or a pound, shekel, rouble or euro isn’t what it used to be…This fact, however, doesn’t stop us from almost exclusively focusing on how much money we have today rather than what it can purchase for us: we think about money in nominal terms rather than real ones [- and that is what is known as money illusion. Let me explain.]
So says Timarr (www.psyfitec.com) in edited excerpts from the original article* which Lorimer Wilson, editor of www.munKNEE.com (Your Key to Making Money!), has further edited below for length and clarity – see Editor’s Note at the bottom of the page. (This paragraph must be included in any article re-posting to avoid copyright infringement.)
Timarr goes on to say, in part:
What is Money Illusion?
Money illusion is the trait that causes people to focus on the amount of money they possess rather than it’s worth to them. A hundred dollars a hundred years ago is obviously worth much more than a hundred dollars now: prices have inflated and the value of the hundred dollars is far less than it used to be…
[The money illusion trait has] spawned a range of measures that are more or less (usually less) useful to us in everyday life leading us to various predictable, albeit unpleasant, consequences such as believing that “you can’t go wrong with property” or that storing cash in your mattress equates to sensible financial planning …
Money Illusion and Inflation
People hoard cash in low interest savings accounts or get excited about huge multiples of value increases in their house prices without really thinking through what this means in real terms. The brutal reality is that most asset classes lose you money when inflation is taken into account. Money illusion really matters and striving to ensure that we’re not victims of it is a fight well worth picking.
Money Illusion and Deflation
It’s not just savings and investments where money illusion causes a problem. Just as we don’t easily take into account the effect of inflation neither do we readily come to terms with its opposite, the dreaded deflation…
It is not entirely obvious why everyone gets quite so anxious about deflation, because it would generally seem to be a good thing to be able to buy a new car tomorrow for less than you can today…but what gets politicians and bankers all nervous and edgy is the experience of deflation in the Great Depression [which evolved into a time of] mass unemployment. This left a generation of workers deeply scarred and central bankers worried about the social problems that arise from such situations. If it was a golden age of anything it was labor disputes…
Money Illusion and Unemployment
Sadly, money illusion has its part to play in this going wrong. If prices are falling then profit margins are also decreasing so, assuming that wages are a significant part of a company’s expenditure [and, as such,] it makes sense to reduce their wage bill. Rationally they should achieve this by cutting wages – after all, if prices are deflating, then a wage cut doesn’t mean you’re any worse off because you can still buy just as much as you used to be able to. Unfortunately, driven by money illusion most people react violently against such proposals, employers feel unable to make such requests and to cut their wage bills they adopt the more “socially acceptable” method of firing workers. Thanks to money illusion people would rather risk losing their jobs and earn nothing than taking a pay cut…
Money Illusion and “Higher” Company Profits/”Higher” Wages
Money illusion also explains why many companies can actually increase their profits when inflation is on the rise. When inflation is low people still want pay rises and corporations find it difficult to resist this, ultimately having to raise wages in real terms – i.e. over and above the rate of inflation. When inflation is high people are often satisfied with wages that increase only with the rate of inflation – they still get a nice big pay rise, and happily ignore the fact that they’re no better off than they used to be.
Money Illusion and Investor Returns
Money illusion seems to be indicted in:
- house price booms, according to Brunnermeier and Julliard, who concluded that:
A reduction in inflation can fuel run-ups in housing prices if people suffer from money illusion. For example, investors who decide whether to rent or buy a house by simply comparing monthly rent and mortgage payments do not take into account the fact that inflation lowers future real mortgage costs. We decompose the price-rent ratio into a rational component meant to capture the “proxy effect” and risk premia and an implied mispricing. We find that inflation and nominal interest rates explain a large share of the time-series variation of the mispricing, and that the tilt effect is very unlikely to rationalize this finding.
- and in the stock market according to the Modigliani-Cohen hypothesis that argues that:
If inflation is high then people think that increases in stock prices include the excess returns that stocks offer over other securities, and systematically undervalue them.
That is simply money illusion, again…Higher periods of inflation seem to be great times for long term investors, as stocks are on offer at a discount due to the effects of money illusion. Lower inflation seems to be more indicative of over-pricing in the markets. Basically everything’s governed by money illusion – revenues, earnings, stock prices and, of course, valuation ratios. This is yet another reason why it’s hard to compare the value of stocks between the decades – a price-earnings ratio in a decade of low or reducing inflation will be more real than one in a time where inflation is rampant. Repeat it one more time: price is what you pay, value’s what you get.
Editor’s Note: The above article has been has edited ([ ]), abridged (…) and reformatted (including the title, some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. The article’s views and conclusions are unaltered and no personal comments have been included to maintain the integrity of the original article.
Lorimer Wilson – MunKNEE.com