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Monday, 14 May 2012

Money illusion

Money illusion



Definition: Money illusion is the mistaken belief that money is stable 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 real value day by day and even hour by hour. In low inflationary economies people are vaguely aware that money loses real value over a long period of time. Money in a low inflationary economy is often used as if its real value is completely stable over the short term. That is money illusion.



Money illusion is evident everywhere in low inflationary economies. TV presenters reporting on historical events regularly quote Historical Cost values as the most natural thing to do. For example: ‘Marble Arch was built for 10 000 Pounds’ a TV reporter may state 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 may have been the original cost in historical terms but we live today and absolutely no–one can immediately imagine what the construction cost of Marble Arch is in current terms. It is the same as saying that something cost one Pound 300 years ago. It is impossible to immediately value it now. We live now and not 300 years in the past. We do not know what some–one bought for a Pound 300 years ago. People in the United Kingdom know what a person can buy for one Pound now – and the Pound’s real value changes day by day within the UK economy as indicated by the change in the UK Daily CPI.



Companies report an unending stream of information about their performance and results. Sales increased by eight per cent over last year’s figures, for example. These are normally nominal rates. A person has to remember the inflation rate for last year and mentally adjust the reported figures to real rates to understand what the real rate of increase or decrease was.



Money illusion is very common in our low inflationary economies. Another example: The BBC ran a program about the fantastic E–Type Jaguar. The presenter 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. 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 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 the effect of inflation on the British Pound over the years in question.



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 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. Two per cent annual inflation is not price stability. Two per cent annual inflation is a high degree of price stability. It is some countries´ definition of 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.



In a hyperinflationary economy notes become worthless very quickly. I saw 100 Kwanza notes lying in the street in 1996. The street boys would not even pick them up when hyperinflation in Angola was 3200 per cent per annum while they would fight to pick up a One USD note. In 2010 I held a 100 Trillion Zimbabwe Dollar note which landed up in Portugal via various family connections. It was also worth nothing just like the 100 Kwanza notes lying in the street in Luanda in 1996.



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

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.