How central banks exploit money illusion
Money illusion is a longstanding concept in economics that has enormous significance for you if you’re a saver, investor or entrepreneur.
Money illusion is a trick, but it is not one performed on stage. It is a ruse performed by central banks that can distort the economy and destroy your wealth.
The money illusion is a tendency of individuals to confuse real and nominal prices. It boils down to the fact that people ignore inflation when deciding if they are better off. Examples are everywhere.
Assume you are a building engineer working for a property management company making £100,000 per year. You get a 2% raise, so now you are making £102,000 per year. Most people would say they are better off after the raise. But if inflation is 3%, the £102,000 salary is worth only £98,940 in purchasing power relative to where you started.
You got a £2,000 raise in nominal terms but you suffered a £1,060 pay cut in real terms. Most people would say you’re better off because of the raise, but you’re actually worse off because you’ve lost purchasing power. The difference between your perception and reality is money illusion.
The impact of money illusion is not limited to wages and prices. It can apply to any cash flow including dividends and interest. It can apply to the asset prices of stocks and bonds. Any nominal increase has to be adjusted for inflation in order to see past the money illusion.
The concept of money illusion as a subject of economic study and policy is not new. Irving Fisher, one of the most famous economists of the 20th century, wrote a book called The Money Illusion in 1928. The idea of money illusion can be traced back to Richard Cantillon’s Essay on Economic Theory of 1730, although Cantillon did not use that exact phrase.
An academic fallacy
Economists argue that money illusion does not exist. Instead, they say, you make decisions based upon “rational expectations.” That means once you perceive inflation or expect it in future, you will discount the value of your money and invest or spend it according to its expected intrinsic value.
Like much of modern economics, this view works better in the classroom than in the real world. Experiments by behaviourists show that people think a 2% cut in wages with no change in the price level is “unfair.” Meanwhile, they think a 2% raise with 4% inflation is “fair.”
In fact, the two outcomes are economically identical in terms of purchasing power. The fact, however, that people prefer a raise over a pay cut while ignoring inflation is the essence of money illusion. The importance of money illusion goes far beyond academics and social science experiments. Central bankers use money illusion to transfer wealth from you — a saver and investor — to debtors. They do this when the economy isn’t growing because there’s too much debt.
Central bankers try to use inflation to reduce the real value of the debt to give debtors some relief in the hope that they might spend more and help the economy get moving again.
Of course, this form of relief comes at the expense of savers and investors like you who see the value of your assets decline. Again a simple example makes the point.
Assume a debtor bought a £250,000 home in 2007 with a £50,000 deposit and a £200,000 mortgage with a low teaser rate. Assume that today, the home is worth £190,000, a 24% decline in value, but the mortgage is still £200,000 because the teaser rate did not provide for amortization.
This homeowner is “underwater” — the value of his home is worth less than the mortgage he’s paying — and he’s slashed his spending in response. In this scenario, assume there is another individual, a saver, with no mortgage and £100,000 in the bank who receives no interest under the Fed’s zero interest rate policy.
Confiscation by stealth
Suppose a politician came along who proposed that the government confiscate £15,000 from the saver to be handed to the debtor to pay down his mortgage. Now the saver has only £85,000 in the bank, but the debtor has a £190,000 house with a £185,000 mortgage, bringing the debtor’s home above water and a giving him a brighter outlook.
The saver is worse off and the debtor is better off, each because of the £15,000 transfer payment. Most people would consider this kind of confiscation to be grossly unfair, and the politician would be run out of town on a rail.
Now assume the same scenario, except this time, the Bank of England engineers 3% inflation for five years, for a total of 15% inflation. The saver still has £100,000 in the bank, but it is worth only £85,000 in purchasing power due to inflation.
The borrower would still owe £200,000 on the mortgage, but the debt burden would be only £170,000 in real terms after inflation. Better yet, the house value might rise by £28,000 if it keeps pace with inflation, making the house worth £218,000 and giving the debtor positive home equity again.
The two cases are economically the same. In the first case, the wealth transfer is achieved by confiscation, and in the second case, the wealth transfer is achieved by inflation. The saver is worse off and the debtor is better off in both cases.
But confiscation is politically unacceptable, while inflation of 3% per year is barely noticed. In effect, inflation is a hidden tax used to transfer wealth from savers to debtors without causing the political headaches of a real tax increase.
Why do central banks such as the Bank of England pursue money illusion policies? The answer involves another academic theory that doesn’t work in the real world. The Fed believes that underwater debtors are from a lower income tier than savers and investors. This means the debtors have what’s called higher marginal propensity to consume, or MPC.
The MPC measures how much you spend out of each dollar of wealth you gain. If you gained £1,000 and decided to spend £50, your MPC would be 5%. If you spent nothing after getting an additional £1,000, your MPC would be 0%.
Academic theory says that poorer debtors have a higher MPC than wealthier savers. This means that if inflation transfers wealth from savers to debtors, total spending will go up because the debtors will spend more of the money than the savers would have.
This is said to benefit debtors and savers, because debtors gain from the increased wealth, while savers gain from more overall spending in the form of jobs, business revenues and stock prices. This makes inflation a win-win.
This theory sounds neat and tidy, but it has serious flaws. By lumping all savers together, the theory fails to distinguish between truly wealthy savers and middle-class savers. It may be true that if you’re a very wealthy saver, you have a low MPC. If you are spending a certain amount on vacations and fine wine and the Bank of England steals some of your savings through inflation, you will probably spend just as much on vacations and fine wine.
Not everyone can afford to see their savings eroded
But if you’re part of the middle class who is struggling with an unemployed spouse, children’s tuition, elderly parents’ health care and higher property taxes, your savings and investments are a lifeline you cannot afford to lose. If your savings are eroded by inflation, the pain is real and your spending may be cut. There is no free lunch.
Richard Cantillon’s Essay on Economic Theory in the 1730s suggested an even more insidious flaw in the central bank’s reasoning. He said that inflation does not move uniformly through an economy. It moves with lags, something Milton Friedman also said in the 1970s. Inflation, according to Cantillon, moves in concentric circles from a small core of people to an ever widening group of affected individuals.
Think of the way ripples spread out when you drop a pebble in a pond. Cantillon said that the rich and powerful are in the inner circle and see the inflation first. This gives them time to prepare. The middle class are in the outer circles and see the inflation last. They are the victims of lost purchasing power.
This Cantillon Effect may explain why wealthy investors such as Warren Buffett are buying hard assets like railroads, oil and natural gas that will retain value when inflation hits. Official measures of inflation are low today but those in the inner circle already see it coming first, just as Cantillon suggested.
If you’re in the wider circles, however, you may stay in conventional stock and bond portfolios too long and will see the value of your assets diluted by inflation. You may not realize it until it’s too late, either. The money illusion deceives everyday investors.
The four stages of money illusion
Money illusion has four stages. In stage one, the groundwork for inflation is laid by central banks but is not yet apparent to most investors. This is the “feel good” stage where people are counting their nominal gains but don’t see through the illusion.
Stage two is when inflation becomes more obvious. Investors still value their nominal gains and assume inflation is temporary and the central banks “have it under control.”
Stage three is when inflation begins to run away and central banks lose control. Now the illusion wears off. Savings and other fixed-income cash flows such as insurance, annuities and retirement incomes rapidly lose value. If you own hard assets prior to stage three, you’ll be spared. But if you don’t, it will be too late because the prices of hard assets will gap up before the money illusion wears off.
Finally, stage four can take one of two paths. The first path is hyperinflation, such as Weimar Germany or Zimbabwe. In that case, all paper money and cash flows are destroyed and a new currency arises from the ashes of the old. The alternative is shock therapy of the kind Paul Volcker imposed in 1980. In that case, interest rates are hiked as high as 20% to kill inflation… but nearly kill the economy in the process.
Right now, we are in late stage one, getting closer to stage two. Inflation is here in small doses and people barely notice. Savings are being slowly confiscated by inflation, but investors are still comforted by asset bubbles in stocks and real estate. Be nimble and begin to buy some inflation insurance in the form of hard assets before the Stage Three super-spike puts the price of those assets out of reach.