Wednesday, August 14, 2019

Asymmetric Money Illusion

It is more than eighty years since John Maynard Keynes, writing in his seminal book "The General Theory of Employment, Interest and Money," popularised the term "Money Illusion" which had been coined by Irving Fisher.

It refers to the fallacy of treating the nominal value of a sum of money or level of income as equal to its' purchasing power.

The reality is that in a time of inflation, even relatively low inflation of about 2.8% such as Britain is experiencing at the moment, a fixed income will be depreciating in value.

It is bizarre that there seems to be limited understanding of this, as the childish and idiotic nature of most of the discussion on news programmes today about rail fare increases equal to the RPI demonstrate.

In fact what we have is asymmetric money illusion.

There is virtually no adult in the whole of Britain who is too stupid to realise that if you have inflation and prices are rising, then unless your income rises at least fast enough to keep pace with that inflation you will be worse off in real terms.

What baffles me is that although just about everyone understands this, it seems that even supposedly intelligent and certainly highly paid journalists, and almost everyone they went to for a quote about today's rail fare "increases," seem unable to understand that the same principle works the other way round.

If inflation as measured by the RPI (Retail Price Index) is 2.8% (which it is) and average wage increases are keeping pace with this (which they currently are: average weekly wages are up by 3.9% on a year earlier, although some people are doing better than this and others less well) then a price increase in cash terms equal to the 2.8% increase in the RPI will, for an average person, mean no change in real terms.

And therefore the 2.8% cash terms increase, in line with the RPI change, which has been announced this week represents a freeze in the real cost of rail travel to the average person. The discussion on the BBC and other media channels of this inflation indexing as if it were in any material sense an increase for the average user makes no sense at all.

This is so obvious that I am almost embarrassed to have to point it out.

It is sad that the quality of public debate in this country, even during the "silly season" should be so dumbed down.


Jim said...

I get that, Though for many people I would argue wages are not increasing with inflation, and they certainly dont go hand in hand with timing,

But lets just go with your example and we will say each April my wage increases exactly with RPI. Happy?

So In April its realised that I have lost 2.8% of my purchasing power, so I am given a 2.8 raise, smart. Thing is inflation does not stop, its a constant upwards slope, keep things simple and pretend its a constant rising slope.

So at the start of April, im good, or as good as I was last April. But at the start of May Inflation is up 0.23% but my wages have not changed, so Im down. By Sept i am down 1.4%. and in March Im 2.8% down again until I get the pay increase, that only just puts me back on track, but again only very briefly.

Jim said...

The one I have never gotten my head around is why is deflation bad? I really just don't get it, people have mentioned about different types of it before, including yourself Chris, but no one ever elaborates on what the different "types" are, and you never hear of different types of inflation, other than of course Hyper inflation but that was less than tremendous for places like Zimbabwe.

But why is deflation bad?? I have heard the argument that no one will spend anything as it will be cheaper later, but that is absolute and total tosh. It really is. I dont think I will buy any food this month as it will be cheaper next? I mean come on.

Look at Televisions, wow this brand new telly is £600, you know in 6 months time its going to be much cheaper but there is value in having it now, which is what you pay for. PlayStation games, new ones are often over £50, give it 7 months and they are going for £12, but people will pay the full price to have it now, many per order. Sure you can wait and get it cheaper as many do, but many people don't.

Computers same thing, Many people want the very best and the very latest and will pay a premium to have that.

Take mobile phones people certainly don't run into the car phone warehouse for the latest iPhone on its release day as they think its going to cost more if they leave that model for 6 months.

So my challenge to you Chris is this, can you explain, in really really simple language, so someone as thick as me can understand it, bearing in mind what I have written within this post, Why is deflation bad?

Chris Whiteside said...

Deflation used to have very negative connotations indeed because it tended to happen only during a recession or a full-blown depression.

The majority view among economists is that the people who manage the macroeconomics for an economy should aim at a very low level of positive inflation (e.g. around 2%) on the basis that a slight surplus of demand is likely to keep the economy working at close to full capacity.

We actually did have a couple of years of very slight deflation in this decade and it didn't appear to do any harm at all, so I am open to the view that the inflation target should be zero, though this is very much a minority opinion among economists.

The main reason why almost all economists - this time including me - dislike both substantial inflation and substantial deflation is that both kinds of price instability are extremely disruptive - both distort markets, make it harder for businesses to plan and invest, and can have unpredictable or harmful impacts on the pattern of real incomes.

Jim said...

In that last sentence you talk about "substantial" inflation or deflation, or as i had termed Hyper inflation, deflation. You see there is still no reason you have presented as to why deflation is bad. Yet the BBC throw dickyfits at the "nightmare" of it.

Jim said...

And why should not the goal be 2% deflation?

Chris Whiteside said...

I thought I had explained why all changes in the general price level are disruptive - up or down.

Hyper-inflation destroys savings, crucifies people on fixed incomes makes it impossible for businesses and individuals to plan, and distorts the economy.

Rapid deflation is also highly equally destructive for many of the same reasons - it also makes it impossible for businesses and individuals to plan and distorts the economy. Rapid deflation - I'm not talking about the very slight decrease in price levels we saw a couple of years ago - is also associated with recessions, although you could argue until the cows come home about which way the causal link goes (or whether it runs both ways.)

I actually agree with you that the panic in some quarters about even the tiniest drop in the price level is greatly overdone. It didn't tip Britain into recession in the middle of this decade when we had a short period of slightly negative inflation.

The reason I would not support a negative inflation target is that I cannot see that it would have any particular advantages compared with price stability.

Jim said...

I agree, but I was not arguing that rapid infation or deflation is bad, totally agree. I just cant see why most economists want 2% inflation, rather than 0%. I mean slow inflation is not great, but its not too devastating, slow deflation is OK, it does not do any damage, and does not seem to hamper the economy.

My main point was more about the over reaction to the "NIGHTMARE" of 0.25% deflation that we often hear, which you have already agreed with.

Jim said...

I think a range between +2% and -2% is ok, but the target should be 0

Chris Whiteside said...

Yes, I think there is a strong case for that.