CIPPA equals automatic zero erosion in the constant item economy

CIPPA equals automatic zero erosion in the constant item economy

We do not have stable – as in fixed real value – money. The real value of money is generally accepted by the public at large to be stable – as in fixed – in low inflation economies, but this is not true. The belief that we have stable – as in fixed real value – money is an illusion, namely the notorious money illusion.

Central banks and monetary authorities have monetary policies that often create the impression that money is stable in real economic value. They implement monetary policies that include the tolerance of low inflation limits of up to two per cent per annum. Then they assure everybody that ‘price stability’ is guaranteed and assured. The public at large mistakenly assume that this means stable – as in fixed – prices. We regularly read in inflation reports that low inflation targets have been met and that ‘price stability’ is assured.

‘The primary objective of monetary policy in South Africa is to achieve and maintain price stability in the interest of sustainable and balanced economic development and growth. Price stability reduces uncertainty in the economy and, therefore, provides a favourable environment for growth and employment creation.’

South African Reserve Bank

In a low inflationary economy this appears to be true. But in reality it is not true. Yes, money illusion makes us believe that our depreciating money maintains its real value stable, while it actually halves in real value over 35 years with constant two per cent per annum inflation – the generally accepted level of ‘price stability.’ All currently existing bank notes and coins will eventually arrive at a point of being completely worthless in real value during indefinite inflation. How quickly depends on the level of inflation.

Table 2

                               Real Value Table

            Per cent of Today’s Real Value Eroded

                                                                   Hyperinflation*

Annual Inflation     2%        6%        10%        26%

                   Years       %         %          %           %

                     5           10          27          41          78

                    10          18          46          65          95

                    16          28          63          84          99

                    20          33          71          88

                    30          45          84          96

                    35          51          89          98

                    44          59          93          99

                    75          78          99

                  114          90

                  228          99

*Cumulative inflation over three years equals or is more than 100 per cent: for example, inflation at 26 per cent per annum for three years in a row.

In Zimbabwe hyperinflation reached such high levels that the real value of the country’s entire money supply was wiped out when the ZimDollar had no exchangeability with any foreign currency in November 2008.  Towards the end of the hyperinflationary spiral the real value of the ZimDollar halved every 24.7 hours according to Steve Hanke from Cato Institute. There is no money illusion in hyperinflationary economies. People know that hyperinflation erodes the real value of their money very quickly.

Central bank governors aid and abet money illusion by regularly stating in their monetary policy statements that they are ‘achieving and maintaining price stability.’

‘The MPC remains fully committed to its mandate of achieving and maintaining price stability.’

(Mboweni, 2009)

It is not regularly pointed out by governors of central banks that the ‘price stability’ they mention, refers to their particular definition of ‘price stability’. Jean–Claude Trichet, the ex-President of the European Central Bank, was a central bank governor who regularly mentioned that two per cent inflation was their definition of price stability. Absolute price stability is a year–on–year increase in the Consumer Price Index of zero per cent. The SARB´s definition of ‘price stability’ ‘is for CPI inflation to be within the target range of 3 to 6 per cent on a continuous basis.’

The SARB would aid in reducing money illusion in the SA economy by stating:

The MPC remains fully committed to its mandate of achieving and maintaining the SARB´s chosen level of price stability which is for CPI inflation to be within the target range of 3 to 6 per cent per annum on a continuous basis. Absolute price stability is a year–on–year increase in the CPI of zero per cent. Current 6 per cent annual inflation eroded 6 per cent of the real value of every Rand and in total about R132 billion of the real value of the Rand money supply over the past 12 months to the end of March, 2012.

It has to be remembered that the stable measuring unit assumption (not inflation) as implemented as part of the traditional Historical Cost Accounting model used by South African companies unnecessarily eroded an additional about Rand 100 billion of the real value of constant items never maintained constant in SA companies at a rate equal to the 6 per cent (March, 2012) annual inflation rate.

A one per cent decrease in inflation (disinflation) would maintain about R22 billion per annum of real value only in the SA monetary economy as a result of the decrease in the level of inflation. At the same time, an additional R20 billion would be maintained in the SA constant item economy as a result of the reduction in the level of erosion by the traditional HCA model in the real value of constant items never maintained constant in consequence of the implementation of the stable measuring unit assumption; i.e. financial capital maintenance in nominal monetary units during low inflation in South Africa.

All that has to be done to completely stop this erosion of constant items by the stable measuring unit assumption is for all entities to freely change over to IFRS–approved financial capital maintenance in units of constant purchasing power during low inflation (CIPPA) in terms of a Daily CPI and the SA real economy would automatically be boosted by about R100 billion per annum for an indefinite period of time as long as the SARB maintains its chosen level of price stability at 6 per cent inflation per annum. This would require complete co-ordination although any individual company can start any time it wants since it was authorized in IFRS in 1989.

The SA economy would continue to suffer the erosion of R132 billion of the real value of the Rand money supply per annum – ceteris paribus – but would be boosted by the maintenance of about R100 billion per annum in the constant item economy for an indefinite period of time at continuous 6 per cent inflation when everybody is SA change over to financial capital maintenance in units of constant purchasing power (CIPPA).

The SA economy would be boosted by a further R132 billion per annum for an indefinite period of time at continuous 6 per cent inflation when SA inflation-adjusts the entire money supply.

As the Deutsche Bundesbank stated:

‘The benefits of price stability, on the other hand, can scarcely be overestimated, especially as these are, in principle, unlimited in duration and accrue year after year.’

(Deutsche Bundesbank, 1996)

All SA entities changing over to CIPPA would mean automatic zero erosion of constant items´ real values for an indefinite period of time in the SA economy in all entities that at least break even during inflation and deflation – ceteris paribus. The same principle applies to all other economies.

Gill Marcus, the current (2012) governor of the SARB, would have to bring inflation down to zero per cent per annum on a permanent basis to have the same effect in the constant item economy. Financial capital maintenance in units of constant purchasing power (CIPPA) in terms of a Daily CPI would do this automatically at any level of inflation or deflation. Zero per cent inflation is not currently advisable in the monetary economy because governments and central banks still do not know how to run an economy at sustainable zero per cent annual inflation. It is relatively easy to automatically run the constant item economy in any country or monetary union at sustainable zero per cent erosion in constant items for an indefinite period of time: just choose the other option: real value maintaining financial capital maintenance in units of constant purchasing power (CIPPA). It is compliant with IFRS and has been authorized by the IASB in 1989.

Financial capital maintenance in units of constant purchasing power (CIPPA) is a basic accounting model that results in the automatic maintenance – without additional capital contributions or extra retained profits – of the real value of constant real value non–monetary items in the constant item economy for an unlimited period of time in all companies that at least break even in real value during inflation and deflation – ceteris paribus. The principle applies when any economy changes over to financial capital maintenance in units of constant purchasing power (CIPPA).

Nicolaas Smith

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

Items with an underlying monetary nature

Items with an underlying monetary nature

Utility, scarcity and exchangeability are the three basic attributes of an economic item which, in combination, give it economic value. All economic items are exchangeable and money is generally the generally accepted medium of exchange. All economic items thus have monetary values in an economy using money as the monetary unit of account. Both monetary items and non–monetary items are expressed in monetary terms; i.e., in terms of the monetary unit of account. The monetary unit is used as the unstable medium of exchange, unstable unit of account and unstable store of value. Variable real value non–monetary items, constant real value non–monetary items and monetary items are all expressed in terms of money and have monetary values.

There is, however, a difference between having a monetary value and being a monetary item. All economic items have monetary values, but, only money and items with an underlying monetary nature which are substitutes for money held are monetary items. Non–monetary items have monetary values: they have their economic values expressed in terms of money, but they are not monetary items.

Houses, cars, mobile phones, raw material, etc. have monetary values, but they are not monetary items. They are variable real value non–monetary items whose real values are expressed in terms of depreciating or appreciating money depending on whether the economy is in a state of inflation or deflation.

Likewise salaries, wages, rentals, pensions, interest, taxes, retained earnings, issued share capital, capital reserves, all other shareholder equity items, trade debtors, trade creditors, deferred tax assets and liabilities, taxes payable and receivable, etc. have depreciating or appreciating monetary values, but they are not monetary items. They are constant real value non–monetary items whose constant real non–monetary values are expressed in terms of depreciating or appreciating money. Constant real value non–monetary items´ real values are maintained constant with financial capital maintenance in units of purchasing power during inflation and deflation, i.e., with Constant Item Purchasing Power Accounting or with measurement in units of constant purchasing power.

Examples of items with an underlying monetary nature

Money loans

Mortgage bonds

Government Bonds

Commercial Bonds

Treasury Bills

Consumer loans

Bank loans

Car loans

Student loans

Credit card loans

They are monetary items lent or borrowed, normally payable or receivable in money.   Variable and constant items to be paid or received in money remain variable and constant items. Money is simply the monetary medium of exchange used to transfer the ownership of a variable item or constant item from one entity to another.

Items with an underlying monetary nature have exactly the same attributes as money held with the exception that they are not bank notes and coins.

Nicolaas Smith

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

Trade debtors and creditors are not monetary items

Trade debtors and creditors are not monetary items

Monetary items are defined incorrectly in IAS 21 The Effects of Changes in Foreign Exchange Rates, Par. 8:




‘Monetary items are units of currency held and assets and liabilities to be received or paid in a fixed or determinable number of units of currency.’



The capital amounts of all capital inflation-indexed bonds are monetary items. However, they are non-monetary items according to the above definition because they are not to be paid or received in a fixed or determinable number of units of currency during inflation. No-one can determine the final nominal payback value of a capital inflation-indexed bond during inflation at the date of issue. TIPS and other sovereign inflation-indexed bonds with a guarantee of a capital payback at least equal to the original nominal principal value if it should be lower than the issuance amount due to deflation, are thus monetary items only during deflation according to the IASB´s definition in IAS 21, Par. 8. The capital amounts of inflation-linked bonds are obviously not non-monetary items during inflation no matter that they could be defined as such according to the IASB: they are always and everywhere monetary items because they are items with an underlying monetary nature. They are substitutes for local currency held during inflation and deflation.



Not all assets and liabilities to be received or paid in a fixed or determinable number of units of currency are monetary items – per se. Non–monetary items are often paid in a fixed or determinable number of units of currency. Fixed salary, wage and rental payments do not transform these constant real value non–monetary items into monetary items. Salaries, wages, rentals, etc. are constant real value non–monetary items. They are not monetary items. They are simply paid in money as the generally accepted mutually agreed medium of exchange. They are, however, sometimes paid in a fixed or determinable number of units of currency because they are measured in nominal monetary units under the current Historical Cost paradigm under which the stable measuring unit assumption is implemented during inflation and deflation (and often even during hyperinflation). This does not transform them into monetary items simply because they are paid in fixed nominal historical cost values. They remain constant real value non–monetary items.



Trade debtors and trade creditors are defined incorrectly by the FASB and by PricewaterhouseCoopers (amongst most probably all others except (1) in Chile, (2) during hyperinflation in Brazil and (3) during 1995-7 in Auto-Sueco (Angola) where I worked) to be monetary items. Trade debtors and trade creditors are items with an underlying non-monetary nature; e.g., finished goods, stock, raw materials, plant, equipment, services rendered, etc. They are constant real value non–monetary items.



I posed the question whether trade debtors and trade creditors are monetary or non-monetary items in 2007 to Dr Gustavo Franco, former governor of Brazil’s Central Bank in 1997-99. He was one of the architects of the Unidade Real de Valor by which Brazil finally conquered hyperinflation in 1994.



I asked him: ‘> Were trade debtors and trade creditors treated as monetary items under the URV and not updated or were they treated as non-monetary items an updated in terms of the URV?

>

> What are trade debtors and trade creditors in your opinion? Are they monetary or non-monetary items?’



He replied:



‘Two observations are in order. First, for spot transactions the existence of the URV is imaterial, sums of means of payment are surrendered in exchange for goods, all delivered and liquidated on spot. Second, the unit of account enteres the picture only when at least one leg of a commercial transaction is defferred. In this case, the URV serves the purpose of defining the price at the day of the contract. The same quantity of URVs are to be paid at the payment day, though this should represent larger quantities of whatever means of payment is used.



It was essentil, in the Brazilian case, and this may be a general case, that the URV was defined as part of the monetary system. It has a lot to do with jurisprudence regarding monetary correction; URV denomiated obligation had to be treated as if they were obligations subject to monetary correction. In the URV law it was defined that the URV would be issued, in the form of notes, and when this would happen, the URV would have its name changed to Real, and the other currency, the old, the Cruzeiro, was demonetized.’



(Franco, 2007)



It is clear from Dr Franco´s reply that trade debtors and trade creditors are non-monetary items that have to be measured in units of constant purchasing power during inflation.



In principle, all fixed payments over time under HCA are regarded as monetary items because of the implementation of stable measuring unit assumption. When it is assumed, in practice, that money is perfectly stable during low and high inflation and deflation, then the classification of an item between being a monetary or non-monetary item depends on whether it is paid or received in a fixed nominal amount over time or not. Fixed payments are then assumed to be monetary items under HCA. In reality they may not be.



The stable measuring unit assumption means that changes in the purchasing power of money are regarded as not sufficiently important to require financial capital maintenance in units of constant purchasing power during low inflation and deflation. In practice the stable measuring unit assumption means that the real value of money is assumed to be perfectly stable during low and high inflation and deflation. The stable measuring unit assumption is simply an economic and accounting assumption. It is not based on fact. The fact is that the real value of money is never perfectly stable under inflation and deflation. The stable measuring unit assumption is thus based on a fallacy, namely the fallacy that money is stable in real value during low inflation and deflation. A fact will always eventually prevail over an assumption regarding that fact.



Trade debtors and trade creditors are constant real value non–monetary items but are treated like monetary items under the Historical Cost paradigm. Brazil measured trade debtors and trade creditors in units of constant purchasing power in terms of a daily index value during 30 years of very high inflation and hyperinflation.



I measured all trade debtors in units of constant purchasing power in terms of the daily US Dollar parallel rate in Auto–Sueco (Angola) in 1996. All our trade debtors accepted that and paid the updated amounts in Angolan Kwanzas. They knew that the underlying nature of their debt to us was non-monetary, namely, the new spare parts that were installed in their trucks in our workshops and the services of our mechanics installing those parts and servicing their trucks.



Trade debtors and trade creditors are incorrectly treated as monetary items in practice in terms of IAS 29 Financial Reporting in Hyperinflationary Economies. All calculations done since 1989 in terms of IAS 29 of net monetary losses and gains as well as profit / loss calculations are thus, in principle, wrong.


Nicolaas Smith

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

Legal tender

Legal tender

Money derives its nominal value from being declared by government to be legal tender. It does not mean economic entities will accept it as money. Zimbabwe declared 100 trillion Zimbabwe Dollar notes as legal tender, but the population in Zimbabwe refused to accept them as legal tender after a very short time because hyperinflation in the hundreds of millions per cent per annum made the notes almost worthless. The Zimbabwe Government withdrew the ZimDollar from circulation when the Zimbabwean economy dollarized spontaneously with multi–currencies after the Reserve Bank of Zimbabwe wiped out most of the real value represented by the Zimbabwe Dollar in their economy by printing excessive amounts of extremely high nominal value bank notes till the currency had exchangeability with only one foreign currency, namely the British Pound via the Old Mutual Implied Rate. This happened on 20 November, 2008 when the Reserve Bank of Zimbabwe closed the Zimbabwe Stock Exchange and with it the trade in Old Mutual shares which led to the end of the last form of exchangeability with a foreign currency for the Zimbabwe Dollar.

Fiat money´s nominal value is determined by government fiat or decree. Fiat money’s real value is determined by all the underlying value systems in the economy. Changes in fiat money’s real value over time are indicated by the rate of annual inflation or deflation.

Money has the legal backing of being legal tender. Legal tender is an offered payment that, by law, cannot be refused in settlement of a debt. Credit cards, personal cheques and similar non–cash methods of payment are not legal tender. The law does not relieve the debt until payment is accepted which explains the practice in some economies of making out receipts for most payments. Bank notes and coins are defined as legal tender.

Nicolaas Smith

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

Correct definition of monetary items is critical

Correct definition of monetary items is critical

Updated on 4 July 2013

Definition: Monetary items constitute the money supply.

The correct definition of monetary items is critical for the correct classification of monetary and non–monetary items since the latter are defined as all items that are not monetary items. If the definition of monetary items is partly wrong – as it currently (2013) is in IFRS – then some constant items are incorrectly classified as monetary items. This happens mainly with the incorrect classification of trade debtors and trade creditors as monetary items under IFRS. This affects the correct valuation of these items, the accounting of the net monetary and constant item gain or loss and consequently the profit or loss for the reporting period which influences the correctness of the financial statements in terms of IAS 29 during hyperinflation. The accounting of the net monetary and constant item gain or loss is an essential part of the CIPPA model while these two items are not required under the HCA model during non-hyperinflationary periods. Only the accounting of the net monetary gain or loss is required in IAS 29 during hyperinflation.

The incorrect treatment of the constant items trade debtors and trade creditors and other non–monetary payables and receivables as monetary items is mainly due to the incorrect definition of monetary items in IFRS.

It is generally accepted and taught at university that there are only two distinct economic items in the economy, namely, monetary and non–monetary items and that the economy is divided in the monetary and non–monetary or real economy.

Monetary items are defined by the IASB in IAS 21 The Effects of Changes in Foreign Exchange Rates, Par. 8.

‘Monetary items are units of currency held and assets and liabilities to be received or paid in a fixed or determinable number of units of currency.’

Monetary items are also defined in IAS 29 Financial Reporting in Hyperinflationary Economies, Par. 12.

‘Monetary items are money held and items to be received or paid in money.’

The FASB and PricewaterhouseCoopers also define trade debtors and trade creditors incorrectly as monetary items.

The second part of the IAS 29 definition is not correct. When a non–monetary item, e.g., a raw material item, is bought on credit, the trade debtor amount in the supplier’s accounts is not a monetary item just because it will be paid in money or because it will be paid in a fixed or determinable number of units of currency. It can be paid in strawberries or diamonds too, if the supplier will accept strawberries or diamonds as a medium of payment. That will not make the non–monetary raw material a strawberry item or diamond item, just like payment in money does not, necessarily, make a non–monetary raw material item, a monetary item. Money or strawberries or diamonds are simply used as the mutually agreed medium of exchange. The constant real value non–monetary trade debtor amount relates to the sale of a non–monetary item, namely the non–monetary raw material. That is the fundamental factor: what is the underlying nature of the trade debtor or trade creditor? The trade debt for the payment of a raw material item has an underlying non–monetary nature. All items – monetary and non–monetary items – are normally received or paid in money.

The buyer did not decide or agree to borrow money – exactly equal to the amount of the trade debt – from the supplier of the raw material item the moment the buyer decided not to pay the purchase cash on delivery or even if it was beforehand agreed that the buyer would not pay cash on delivery, but would be granted credit. The supplier did not decide or agree to lend the buyer money– exactly equal to the amount of the trade debt – the moment the buyer did not pay the purchase cash on delivery. The trade debt relates to a non–monetary item: raw material. The trade debt is thus a constant real value non–monetary item the moment it comes about. The underlying non–monetary nature of the debt (raw material, furniture, vehicle, etc.) results in it being a constant real value non–monetary item the moment the debt comes about which has to be measured in units of constant purchasing power – over time – during inflation  and deflation. Street vendors in hyperinflationary economies – some of whom have never been to school – know this instinctively from plying their trade in the street.

When inflation erodes the real value of the monetary medium of exchange at two per cent per annum, two per cent more money has to be paid over a year to pay off the constant real value non–monetary item, the trade debtor amount.

Inflation is always and everywhere a monetary phenomenon per Milton Friedman. Money is only the monetary medium of exchange used for payment. Inflation can only erode the real value of money and other monetary items – nothing else. Inflation has no effect on the real value of non–monetary items. The debt is for the constant real non–monetary value of a non–monetary item mutually agreed and generally accepted to be paid in money: not for a monetary item. Money is simply the medium of exchange. No–one lent any money to anyone else. There is generally no money loans involved with trade creditors and trade debtors.

Nicolaas Smith

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

Fiat money has real value

Fiat money has real value

The actual materials the physical representation of our money, bank notes and coins, are made of today have, for practical purposes, no intrinsic value in themselves. Our monetary unit is fiat money that is created by government fiat or decree. The government declares fiat money to be legal tender. In the past monetary coins were made of, for example, silver or gold which were valuable in themselves. The actual metal of which the coin was made had a real or intrinsic value supposedly equivalent to the nominal value inscribed on the coin. Today fiat money is a government decreed and legally recognized unstable medium of exchange, unstable unit of measure and unstable store of real value in the economy.

The actual material fiat money is made of has no intrinsic value as fiat money is the natural product of the development of the concept of money through the ages. In the beginning a monetary unit was a (supposedly) full value metal coin. Later it was not a full value metal coin but it was the next best thing as far as economic agents were concerned: it was 100 per cent backed by gold. Today the material fiat money is made of has no intrinsic value and the monetary unit is not backed by gold but is backed by the combined macroeconomic real value of all the underlying value systems in a particular economy or monetary union. These underlying value systems include, but are not limited to, sound governance, a sound economic system, a sound manufacturing system, a sound industrial system, a sound monetary system, a sound political system, a sound social system, a sound educational system, a sound defence system, a sound health system, a sound security system, a sound legal system, a sound accounting system and so on, to name but a few.

The daily change in the real value of an unstable local currency – which is also the unstable accounting monetary unit of measure – is indicated by the change in the Daily CPI or monetized daily indexed unit of account in non-hyperinflationary economies. It is generally indicated by the change in the daily US Dollar or other relatively stable foreign currency parallel rate or a Brazilian-style Unidade Real de Valor daily index rate in a hyperinflationary economy.

The actual materials used to create physical bank notes and coins have almost no intrinsic value. The unstable real value of the total fiat money supply is, however, backed by all – the sum total of – the underlying value systems in an economy, namely sound governance, sound economic policies, sound monetary policies, sound industrial policies, sound commercial policies, etc. Positive annual inflation indicates the excess of fiat money created in the banking system within an economy.

Fiat money is used every day by seven billion people to buy everything in the world economy. Fiat money thus has real value. All monetary units in the world are, generally, fiat money. Every person knows, more or less, what he or she can buy with 1 or 10 or 100 or 1000 units of fiat money in his or her economy – today. The real value of fiat money is eroded over time in an inflationary economy and increases over time in a deflationary economy.

Yes, the special bank paper that fiat bank notes is made of and the metals that fiat bank coins are made of have almost no intrinsic value as compared to the real value of the actual gold or actual silver in gold and silver coins of commodity money in the past. That is not a logical reason to state that fiat money has no real value. Every fiat monetary unit´s real value is determined by what it can buy today in an average consumer basket of goods and services. That generally changes every day.

Fiat money is money which generally has a daily changing real value. Only the actual bank notes and coins have insignificant intrinsic values.

All fiat functional currencies within economies have international exchange rates with the fiat functional currencies of other economies.

The fact that fiat money is not legally convertible into gold on demand as it was done in the days of the gold standard, is made irrelevant by the indisputable fact that fiat money is legal tender. Fiat money is used every day to buy gold and silver and almost everything else in the world economy. The fact that fiat money today is not legally convertible into gold – a historic administrative process – is true: it is a fact. That does not negate the fact that fiat money has real value, the change of which is indicated daily by the change in the Daily Consumer Price Index.

The fact that fiat money has real value is totally mainstream:  seven billion people know it and confirm it daily – 365 days a year – by using fiat money to buy and sell everything in the world economy. The fact that fiat money has real value is confirmed daily when daily inflation indices are published indicating the change in the real value of fiat money. It is thus misleading to imply that because it is a fact that fiat money cannot administratively be converted at the central bank or any other bank into gold, that fiat money has no value. All the gold in the world is today bought and sold using fiat money as the medium of exchange.

It is an indisputable mainstream fact that fiat money has real value despite the fact that it is not legally convertible into gold on demand and that the bank paper bank notes and metals bank coins are made of have no intrinsic value whereas historically gold and silver coins had intrinsic values equal to the real value of the gold and silver they were made of.

The numerous publications of Daily CPI and monthly CPI values world–wide are the creditable references to the fact that fiat money has real value. Statistics authorities are generally creditable sources.

Nicolaas Smith

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

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.

Deflation

Deflation

Deflation is a sustained absolute annual decrease in the general price level of goods and services. Deflation only occurs when the annual inflation rate falls below zero per cent (a negative annual inflation rate), resulting in an increase in the real value of money and all other monetary items. Deflation allows one to buy more goods with the same amount of money. This should not be confused with disinflation, a slow–down in the annual inflation rate (i.e., when annual inflation decreases, but still remains positive). Disinflation is a decrease in the annual rate of increase in the general price level. Annual inflation erodes the real value of money and other monetary items over time; conversely, annual deflation increases the real value of money and other monetary items in a national or regional economy over time.

Inflation and deflation are both undesirable economic processes. As far as the understanding of inflation and deflation allows us at the moment, it can be stated that whatever level of deflation – however low – is to be avoided completely. A low level of inflation in an economy with financial capital maintenance in units of constant purchasing power (CIPPA) as the basic model of accounting implementing IFRS in terms of a Daily CPI or monetized daily indexed unit of account would be the best practice. A low level of inflation (best practice is currently considered to be two per cent annual inflation) to limit the erosion of real value in money and other monetary items. Inflation-adjusting the total money supply in terms of a daily index rate with complete co-ordination would remove the total cost of inflation (not actual inflation) from the economy.  IFRS, excluding the stable measuring unit assumption, for the correct daily valuation of variable items and, thirdly, financial capital maintenance in units of constant purchasing power (CIPPA) as authorized in IFRS in terms of a daily index or other daily rate for automatically maintaining the existing constant real value of owners´ equity constant for an indefinite period of time in all entities that at least break even in real value during inflation and deflation – ceteris paribus – whether they own any revaluable fixed assets or not and without the requirement of extra capital or extra retained profits simply to maintain the existing constant real value of existing constant items (e.g., equity) constant.

Net monetary losses and gains would be calculated and accounted in the income statement during inflation and deflation when CIPPA is implemented for all monetary items not inflation-adjusted on a daily basis. The cost of inflation would be accounted as a loss and deducted from profit before tax and the gain from inflation would be accounted as a gain and added to profit before tax. Reducing the holding of net monetary items (cash and other monetary items) over time would reduce the net monetary loss to a minimum during low inflation. Entities do their best to compensate for the net monetary loss from holding cash and other monetary items by trying to invest them at rates higher than the expected inflation rate. Obviously, it is not possible beforehand to know what the inflation rate will be during any future period. Capital inflation-indexed bonds overcome this problem (2012).

Nicolaas Smith

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

Net monetary gains and losses

Net monetary gains and losses

Entities with net monetary item assets (weighted average of monetary item assets greater than weighted average of monetary item liabilities) over a period of time will suffer a net monetary loss (less real monetary item value owned / more real monetary item value eroded) during inflation. Entities with net monetary item liabilities (weighted average of monetary item liabilities greater than the weighted average of monetary item assets) will experience a net monetary gain (less real monetary item value owed/more real monetary item liabilities eroded) during inflation. The opposite is true during deflation.

Net monetary gains and losses are accounted during hyperinflation as required by IAS 29 Financial Reporting in Hyperinflationary Economies. The accounting of net monetary gains and losses was also authorized in IFRS during low and high inflation and deflation, i.e., under the Constant Item Purchasing Power Accounting model with the approval of measurement of financial capital maintenance in units of constant purchasing power in the original Framework (1989), Par. 104 (a). This is due to the fact that the stable measuring unit assumption is not implemented under financial capital maintenance in units of constant purchasing power (CIPPA).  Net monetary gains and losses are not required to be computed under the traditional Historical Cost Accounting model although it can be done according to Kapnick.

‘Computing the gains or losses from holding monetary items can be done and the information disclosed when the books are maintained on a historical–cost basis.’

(Kapnick, 1976: p 6)

Net monetary gains and losses are constant items once they are accounted in the income statement under CIPPA. All income statement items are constant items under CIPPA.

This omission under the Historical Cost paradigm to compute the gains and losses from holding monetary items is one of the consequences of the stable measuring unit assumption as implemented as part of the traditional Historical Cost Accounting model. Net monetary item gains and losses are not required to be accounted because the stable measuring unit assumption is implemented under HCA.

‘The Measuring Unit principle: The unit of measure in accounting shall be the base money unit of the most relevant currency. This principle also assumes the unit of measure is stable; that is, changes in its general purchasing power are not considered sufficiently important to require adjustments to the basic financial statements.’

(Walgenbach, Dittrich and Hanson, 1973: p 429)

An increase in the general price level (inflation) erodes the real value of unstable money and other unstable monetary items with an underlying monetary nature, e.g., the capital values of nominal bonds and loans. However, inflation has no effect on the real value of non-monetary items.

Constant items never measured in units of constant purchasing power (e.g., trade debtors and trade creditors) are effectively treated as monetary items when the stable measuring unit assumption is implemented as part of the HCA model during inflation. Implementing the HCA model unknowingly, unintentionally and unnecessarily erodes their real values at a rate equal to the annual rate of inflation because they are measured in nominal monetary units during inflation. Inflation only erodes the real value of money which is the nominal monetary unit of account in the economy and other monetary items. The erosion of the real value of constant items never maintained constant by the stable measuring unit assumption under HCA would stop when financial capital maintenance is measured in units of constant purchasing power during inflation, i.e., implementing the CIPPA model. There is no stable measuring unit assumption under financial capital maintenance in units of constant purchasing power (CIPPA). It is thus the implementation of the stable measuring unit assumption and not inflation that is doing the eroding.

The generally accepted measure of inflation is the annual inflation rate calculated from the annualized percentage change in a general price index – normally the Consumer Price Index – published on a monthly basis.  

Financial capital maintenance in units of constant purchasing power (CIPPA) requires daily measurement in terms of a Daily CPI or a monetized daily indexed unit of account during non-hyperinflationary periods.

The correct measure of hyperinflation is either (a) the change in a relatively stable foreign currency daily parallel rate, normally the US Dollar daily parallel rate or (b) the change in a Brazilian–style Unidade Real de Valor daily index almost entirely based on the daily USD rate. The CPI published a month and a half to two months after the hyperinflationary changes in the real value of the monetary unit actually occurred (as happened in Zimbabwe), is completely impractical and totally ineffective when the aim is to stabilize the real economy during hyperinflation as Brazil so effectively did with daily indexation during 30 years of high and hyperinflation.

Nicolaas Smith

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

Inflation

Inflation

‘Inflation is always and everywhere a monetary phenomenon.’

Milton Friedman

Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time. Inflation is generally accepted to refer to annual inflation. All prices are normally quoted in terms of unstable money. During inflation each unit of the unstable monetary unit buys fewer goods and services. Inflation has no effect on the real value of non–monetary items.

Inflation erodes real value evenly in money and other monetary items. Under the Historical Cost paradigm there are, consequently, real hidden monetary costs to some and real hidden monetary benefits to others from this erosion in purchasing power in unstable monetary items that are assets to some while – a the same time – liabilities to others, e.g., the capital amount of  a monetary loan. Under the HC paradigm the debtor generally gains during inflation since he, she or it (a company) has to pay back the nominal value of the loan, the real value of which is being eroded by inflation. The debtor pays back less real value during inflation. The creditor loses out because he, she or it receives the nominal value of the loan back, but, the real value paid back is lower as a result of inflation. Efficient lenders attempt to recover this loss in real value by charging interest at a rate they hope will be higher than the inflation rate during the period of the loan.

Capital inflation-indexed government and commercial bonds overcome this problem for lenders.

Nicolaas Smith

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