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Friday, 9 October 2009

Money illusion

Definition: Money illusion is the mistaken belief that money is stable – as in fixed – in real value over time.

Money illusion is primarily evident in low inflation countries. In hyperinflationary countries there is absolutely no money illusion as far as the hyperinflationary national currency is concerned. Everyone knows as a fact that the local hyperinflationary currency loses value day by day. In low inflationary countries people are vaguely aware that money loses value over a long period of time. Over the short term, however, low inflation money is used as if its real value is completely stable – as in fixed.

Money illusion is evident everywhere in low inflationary economies. TV channels reporting on historical events regularly quote historical values as the most natural thing to do. “Marble Arch was built for 10 000 Pounds” the TV reporter states with sincere knowledge that his audience is being well entertained with correct facts and figures. It is a figure very difficult to instantaneously value today. 10 000 British Pounds was the original cost in historical terms but we live today and absolutely no-one can immediately imagine what the construction cost of Marble Arch was in current terms. It is the same as saying that 300 years ago something cost one Pound. It is impossible to immediately value it now. We live now and not 300 years in the past. We don’t know what some-one could have bought for a Pound 300 years ago. People in the United Kingdom know what a person can buy for one Pound now – and that value changes month after month.

Companies report an unending stream of information about their performance and results. Sales increased by 5 per cent over last year’s figures, for example. Are these historical cost comparisons or real value comparisons? It is more never than hardly ever stated.

Money illusion is very, very common in our low inflationary economies. An example: The BBC recently ran a program about the fantastic E-Type Jag. It was stated that one of the many reasons why the E-type Jag - the best car ever, according to the presenter - was such a success was its original nominal price of 2 500 Pounds at the time of its first introduction into the market. Towards the end of the program it is then stated that a number of years later these same original E-Type Jags sold at a nominal price at that time of 25 000 Pounds. It is thus implied to be 10 times more than the original price of 2 500 Pounds. In nominal terms, yes. We all agree. Certainly not in real terms and we are interested in real values. We are real people. We live real lives in a real world. Nominal profits - however fantastic they may look - are misleading the longer the time period and the higher the rate of inflation or hyperinflation in the transaction currency during the time period involved.

In this example we are all led to believe that the E-Type Jag was sold at a real value 10 times its original real value. It is the notorious money illusion at work. The real value in a sale like that certainly would not be 10 times the original real value once the original nominal price is adjusted for inflation in the British Pound over the years in question.

Money illusion in Historical Cost values

(The following is adapted from a live-event on CNN. Any resemblance to a living person is purely coincidental ;-)

Let us assume a highly respected 75-year-old grandfather tries to encourage his grandson to accept a low starting salary in a very good company as a good starting point for the youngster’s career. The grandfather may mention that when he started work he earned 25 Dollars per week - meaning that he also started with a low salary and worked his way up. Stating his starting salary at its original historical cost value of maybe more than 50 odd years ago completely distorted the example he was trying to give. He was trying to say - and he certainly did, incorrectly (unintentional though it may have been) create the impression - that he started work at a low salary and had to work his way up. When the original historical cost value of 25 US Dollars of the grandfather’s first weekly pay packet is inflation-adjusted for inflation - in the medium of exchange - during the fifty or more years of his working life till the date of his comments on CNN, we find that he started work at a monthly salary of about 5 000 US Dollars current at the date of his comments. So, at 60 000 US Dollar per year the grandfather had a very good starting salary - which is exactly the opposite of what he was trying to say to his grandson.

That is money illusion at work. Money illusion is so pervasive in our low inflation societies that we do not even notice it any more. It is a complete state of mind - a way of thinking.

We have to stop thinking in money terms and start thinking in real value terms. As long as there is positive inflation in an economy, the national currency created and used in that inflationary economy is not a store of stable real value. It is a store of decreasing real value. Money is losing real value all the time when an economy is in a state of inflation. All current notes and coins will actually be worthless sometime in the future when an economy remains in an inflationary mode for a long enough period of time.

Money developed upon the mistaken belief that it is stable – as in fixed – in real value in the short to medium term in economies with low inflation. The term stable money is seen as meaning that money’s real value stays intact over the short to medium term in low inflationary economies. Money illusion is still very evident today in most economies in money, monetary items and constant items that are mistakenly considered to be monetary items, for example, trade debtors and trade creditors.

Kindest regards,

Nicolaas Smith