Sunday, November 08, 2015

Money Illusion is alive and well ...

"Money Illusion" should not be a difficult concept to grasp.

It's failing to recognise that inflation destroys the value of what Harold Wilson described as "The Pound in your pocket."

Surely it should not require a  rocket scientist to recognise that if you are paid 5% more but inflation is running at 10% you are 5% worse off, while if your income is static but prices are falling by 1% a year you are effectively 1% better off.

Mark Twain understood it, although he recognised that not everyone did: there is a very funny passage in his comic novel "A Connecticut Yankee at King Arthur's Court" in which his hero, who has been sent back hundreds of years to the time of King Arthur and Camelot, is arguing against trade restrictions which mean that the artisans he is talking in a tavern have more cash but the prices they have to pay for things are so much higher that even with the extra money their income buys a lot less. He cannot get the idea over to his listeners.

But it seems that some highly paid BBC writers are unable to follow the concept any better than Mart Twain's imaginary dark age tavern audience.

UK inflation has again gone marginally negative as was reported by the BBC, with the website version of the article available here.

In this article a man called Kevin Peachey who is described as a "personal finance reporter" said that

"The figures will be a blow for the millions of people" on certain index linked pensions

What planet is this man on?

And why on earth do people like me have to pay through the BBC licence fee for the salary of someone who is so manifestly incompetent to do his job that any well-run organisation would fire him immediately?

People on index-linked pensions will do better out of falling prices than they would out of fixed or rising ones, because their pensions will not be reduced to compensate.

His argument appears to be that because the measure of inflation suggests that overall prices are not rising, people on various index linked benefits and pensions will not get the increase which they would have needed to compensate them for the loss of spending power if prices had been rising.

Give me strength!


If the measure used for inflation - the applicable Consumer Price Index (CPI) is accurate and representative of the actual living costs of these people, the price increase (or lack of it) and the pension or benefits increase (or lack of same) will cancel out.

If prices are going down - as the article reports that food, petrol, diesel and gas prices have been doing - then people will be better off unless their income actually goes down, and neither benefits or index-linked pensions are actually reduced. Indeed from April pensions will automatically increase even when prices don't under the so-called triple lock.

The only circumstance in which the fact that the CPI index is not going up should cause anyone a problem would be if it was failing to accurately capture what is really happening to prices - e.g. if the truth was that prices were actually going up but the measure of inflation was not.

There is not the slightest impression given in the article that either Mr Peachey or anyone else thinks that. It reports that the Bank of England does not expect inflation to reach 1% until Spring 2016.

Ben Brettell, senior economist at Hargreaves Lansdown, is quoted as saying that CPI inflation is likely to climb in the coming months, as the previous big drop in fuel prices falls out of the year-on-year calculation.

He added: "But core inflation, which strips out volatile components like food and energy, also remains weak at 1.0%. This offers little suggestion that underlying inflationary pressures are building in the UK economy, despite continuing strength in wage growth."

In other words, the price of fuel and food has dropped, the price of everything else is rising by about 1% a year and over the next six months inflation is likely to head back to that level, but at the moment overall average prices are staying pretty much exactly where they are or even dropping very slightly. And wages are rising while prices are not so people are getting back some of the spending power they lost during the recession which started under the last Labour government

For most of my lifetime people would have been delighted to have stable prices. The combination of wages going up and prices staying the same would have sounded far too good to be true.

So why on earth make out that this is a problem?

If prices were dropping fast, that could lead to a recession and cost jobs, but they are not and the number of people in work is rising. Inflation can have destructive effects on saving and can cause all manner of problems, but at the moment that is not happening either.

No government can ever permanently abolish boom and bust, as the last PM to make such a claim found out the hard way, so the present situation of stable prices, rising employment and rising wages will not last forever. But while it does, why not enjoy it?

6 comments:

Jim said...

Its not a difficult concept is it?

BBC reporters will often refer to "the nightmare of deflation" without ever stating why its a nightmare. in reality of course as i keep saying its not.

they will also refer to a benefit of Fiat currency being that they allow interest rates to go negative...... which again makes me have to ask "and that is a benefit because?............" i cant think of a world so stupid where I would lend someone some money, and then have to pay them as well for the privilege of doing it.

Jim said...

there are lots of things really that do confuse me.

lets take for example the banks bailout.

see the banks had ran out of money, so the government at the time bailed them out, but the government at the time did not have the money to give to the banks, so the government borrowed it, from the banks at interest, to give to the banks to bail them out.

Hmmmmmmmm

Jim said...

And then after doing it, HWSNBN stood up in the house of commons and told every one how the government had saved the world by doing it.

Jim said...

And yes, let me repeat that.

1. The banks had no money as they had lost it all and needed a bail out.
2. The government had no money to bail them out
3. The banks said "that's ok we will lend you it, at interest"
4. The government said "ok, we will take the loan as you need it so badly"
5. The government bailed out the banks with the money they had borrowed from the banks, passing the debt to the british taxpayer (Without asking)

Just work thought those steps and tell me where are the problems here?

Chris Whiteside said...

Ok, I could spend weeks responding to that but

1) negative inflation of 0.1 of one percent certainly is not a problem

2) the kind of deflation we had in the 1930's certainly is a problem, and people who use expressions like "the nightmare of deflation" are afraid that the one might turn into the other

3 I don't think it will, but that's the sort of risk we pay central bank governors to watch our for and try to ensure does not happen.

4) I don't recognise your description of the banking crisis. It might be more helpful to say that certain Banks had made some foolish investments and consequently had a poor asset structure, and that to deal with this situation the government effectively nationalised most of the banks.

5) You are of course right that GB claimed to have "saved the world" by doing this, apparently as a slip of the tongue, and that the taxpayer did not get good value for money.

Jim said...

I still cant see why major Deflation is bad, so long as we dont end up in a situation where by wages, and taxes remain constant. See if my wages today can buy me 100 mars bars a week, and following deflation I take am forced to take a pay cut, thus my taxes fall, and so have prices, then even with my lower wage I can buy 120 mars bars, I am no worse off.

Though for what its worth, I dont think we will ever see that type of deflation again, I think the currency is more likely to end in Hyper Inflation