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Wednesday, 4 August 2010

Money Illusion

Sleep Soundly

Money illusion is just about the most venerable of all of the behavioural biases that afflict people’s financial good sense. It was recognised back in the early part of the twentieth century, was an integral part of financial theories from thereon and spawned a range of measures that are more or usually less useful to us in everyday life.

Then economists decided that money illusion was ... illusory. Which led to various predictable, albeit unpleasant, consequences such as believing “you can’t go wrong with property” or that storing cash in your mattress equates to sensible financial planning. Being poor is one thing, but not being able to get a good night’s sleep is entirely another …

Vanishing Trick

Money illusion is the trait that causes people to focus on the amount of money they possess rather than it’s worth to them. A hundred dollars a hundred years ago is obviously worth much more than a hundred dollars now: prices have inflated and the value of the hundred dollars is far less than it used to be. Measuring this exactly isn’t possible: what price would a businessman have paid for instant communication across the world a century ago compared to the peanuts we pay for the internet today?

In deciding to ignore the idea of money illusion economics was, for once, joining the mainstream, where most people happily ignore the fact that the value of the dollar in their pocket isn’t what it once was. This leads neatly to a world where there are more unemployed people than there should be, where central banks run around like puppy dogs chasing their tails trying to avoid the dreaded d-word and lots of people end up much, much poorer than they ought to be. As ever in monetary matters the world is stranger than we can possibly want to imagine.

Fisher’s Indexes

Despite the practical impossibility of real comparisons we know perfectly well that the value of a dollar or a pound, shekel, rouble or euro isn’t what it used to be. In fact, in the case of the euro it almost certainly isn’t what it was when you started reading this. This fact, however, doesn’t stop us from almost exclusively focussing on how much money we have today rather than what it can purchase for us: we think about money in nominal terms rather than real ones.

The economist Irving Fisher – he who noted that shares had attained a “permanently high plateau” just moments before the Wall Street Crash started – was particularly taxed by this issue. He spent lots of time and trouble trying to invent measures to help people understand the impact of inflation on their cash and that’s at least partly why we have various price indexes today to help us understand this. Understanding is one thing, however, doing something about it is another.

Inflationary Effects

So people still hoard cash in low interest savings accounts or get excited about huge multiples of value increases in their house prices without really thinking through what this means in real terms. The brutal reality is that most asset classes lose you money when inflation is taken into account. Money illusion really matters and striving to ensure that we’re not victims of it is a fight well worth picking.

It’s not just savings and investments where money illusion causes a problem. Just as we don’t easily take into account the effect of inflation neither do we readily come to terms with its opposite, the dreaded deflation. Now if we think about this a bit it’s not entirely obvious why everyone gets quite so anxious about deflation, because it would generally seem to a good thing to be able to buy a new car tomorrow for less than you can today. Partly this can be explained by people putting off purchases while prices are falling, hoping for a bigger bargain tomorrow, but not entirely.

What gets politicians and bankers all nervous and edgy is the experience of deflation in the Great Depression when the only seemingly high plateau that was achieved was in mass unemployment. This left a generation of workers deeply scarred and central bankers worried about the social problems that arise from such situations. If it was a golden age of anything it was labor disputes. Yet according to economics this problem is impossible – as employment falls then people should adjust their sights downwards to a wage that employers are willing to pay.

Cutting Wages, Firing Hires

Sadly, money illusion has its part to pay in this going wrong. If prices are falling then profit margins are also decreasing so, assuming that wages are a significant part of a company’s expenditure, it makes sense to reduce their wage bill. Rationally they should achieve this by cutting wages – after all, if prices are deflating, then a wage cut doesn’t mean you’re any worse off because you can still buy just as much as you used to be able to. Unfortunately, driven by money illusion most people react violently against such proposals, employers feel unable to make such requests and to cut their wage bills they adopt the more "socially acceptable" method of firing workers.

Rationally this is crazy – why would people would rather lose their jobs and earn nothing than take a pay cut? It’s almost possible to see why economists find it difficult to believe. However, the evidence speaks for itself; money illusion blinds people, wages exhibit downward stickiness but not upward. Ernst Fehr and Jean-Robert Tyan found exactly this relationship:
“The major cause for nominal inertia after the negative shock is that subjects’ expectations are very sticky. In our view this stickiness of price expectations is related to the nature of money illusion in our experiment, i.e. to the belief that there are subjects who take nominal payoffs as a proxy for real payoffs.”
It also explains why many companies can actually increase their profits when inflation is on the rise. When inflation is low people still want pay rises and corporations find it difficult to resist this, ultimately having to raise wages in real terms – i.e. over and above the rate of inflation. When inflation is high people are often satisfied with wages that increase only with the rate of inflation – they still get a nice big pay rise, and happily ignore the fact that they’re no better off than they used to be.

Investing Lessons

Of course this matters for investors, too. Money illusion seems to be indicted in house price booms (see Brunnermeier and Julliard) and in the stock market. So Cohen, Polk and Vuolteenaho looked at the Modigliani-Cohen hypothesis which argues that:
“Stock market investors suffer from a particular form of money illusion, incorrectly discounting real cash flows with nominal discount rates. An implication of such an error is that time variation in the level of inflation causes the market’s systematic expectation of the future equity premium to deviate systematically from the rational expectation”.
Or: if inflation’s high then people think that increases in stock prices include the excess returns that stocks offer over other securities, and systematically undervalue them. It’s money illusion, again. The researchers’ results confirm this hypothesis and, in particular, indicate that it affects investors’ expectations of returns regardless of risk.

Hoping for Inflation?

It very much looks as though higher periods of inflation are great times for long term investors, as stocks are on offer at a discount due to the effects of money illusion. Lower inflation seems to be more indicative of over-pricing in the markets. Basically everything’s governed by money illusion – revenues, earnings, stock prices and, of course, valuation ratios.

This is yet another reason why it’s hard to compare the value of stocks between the decades – a price-earnings ratio in a decade of low or reducing inflation will be more real than one in a time where inflation is rampant. Repeat it one more time: price is what you pay, value’s what you get.


Related articles: To Predict the Next Bust Ask An Austrian, Index Tracking at the Omega Point, Memes, Money, Madness

6 comments:

Rob Bennett said...

The biggest money illusion of them all is the idea that the nominal price of the market is its real value. In the past three decades we have seen stocks go from being valued at one-half of fair value to being valued at three times fair value. That means that those who owned $60,000 worth of stock in 2000 owned the equivalent of what those who owned $10,000 worth of stock in 1982 owned!

Rob

gatorbrit said...

Great post and great blog. Regarding stock prices: money illusion affects stock prices because investors use a higher nominal discount rate to value stocks, but fail to project cash flow growth at the correspondingly higher nominal growth rate.

Here's a post I wrote on the topic a while back.
http://financeclippings.blogspot.com/2009/10/inflation-and-stock-prices.html

I've added your blog to my blog roll on my blog http://financeclippings.blogspot.com.

Keep up the good work!

Parker Bohn said...

Inflation isn't real wealth, but inflation caused capital 'gains' are still taxable.

Maybe this is one reason governments hate and fear deflation so much.

Due to the 'money illusion', governments can tax inflation caused capital gains, and people don't realize that their tax rates are actually higher than they appear.

eZonomics said...

Think about money illusion next time you are negotiating wages.

The What is ... money illusion? article on eZonomics says experiments have shown that, in general, people think a cut of 2% to their wages is unfair.

Perhaps the finding is not surprising. But the same research showed that people tend to see a 2% rise in nominal income as fair even when if inflation is running at 4%.

See more at http://www.ing.com/ezonomics/showdoc.jsp?left=false&docid=427519

Barb Friedberg said...

As one with graduate degrees in both counseling and business (finance), I find your blog intriguiging. I especially liked the last line of this post relating price and value. Thanks for an interesting subject. Best regards, Barb Friedberg

Monevator said...

Very true about comparing asset class returns across the decades while ignoring inflation.

We really have to look at everything through the lens of real prices, although as you imply about half way down, one man's deflation is another man's cheap trainers that don't make up for the rising cost of health care.