Friday, 1 July 2011

Money illusion and Historical Cost values

Money illusion and Historical Cost values

(The following is adapted from a live–event on US TV. 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 years ago completely falsified the example he gave. 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 updated in units of constant purchasing power for real value erosion in the US Dollar during the fifty or more years of his working life till the date of his comments on TV, 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 nominal terms and start thinking in real value terms. As long as there is inflation in an economy, the national currency created and used in that inflationary economy is not a store of perfectly 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. 2% inflation is not price stability; 2% inflation is a high degree of price stability. It is some countries´ definition of price stability. It is not absolute price stability. All currently existing bank notes and coins will actually be completely 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, other monetary items and constant real value non–monetary items that are mistakenly considered to be monetary items under the Historical Cost paradigm; for example, trade debtors, trade creditors, dividends payable, dividends receivable, taxes payable, taxes receivable, etc.

Nicolaas Smith

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