Saturday, 23 April 2011

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 value day by day and even hour by hour. In low inflationary countries people are vaguely aware that money loses 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. “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 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 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 the Pound’s value changes month after month within the UK economy as indicated by the monthly change in the CPI.

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. 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 the stable measuring unit assumption – the assumption that money is stable in real value over time – as related to the British Pound over the years in question.

Nicolaas Smith

Copyright (c) 2005-2011 Nicolaas J Smith. All rights reserved. No reproduction without permission.

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