Saturday, February 12, 2011

The Money Illusion

I found the exchange between Federal Reserve Chairman Ben Bernanke and House Budget Chairman Paul Ryan last week to be interesting.  Ryan has been a vocal opponent of the Fed's current policy of trying to stimulate the economy through quantitative easing (QE2).  This policy is pumping $600 billion into the economy through purchases of long term treasuries.  What this really means is that the Fed is printing money out of thin air and financing the federal deficit.

Ryan is concerned that this policy could lead to inflation as this excess cash starts to circulate around the economy.  This could also pose a threat to the value of the dollar if investors lose more confidence in the greenback.

Bernanke seemed to be clear that he would not allow inflation to take hold. He stated that the Fed plans to reverse course before that happens.  This may be his honest intention but there is a lot of room for error.  This will also bring its own form of pain.  It is easy to throw money from helicopters like the Fed is doing today.  It is harder to go out and take that money away when it is in someone's pocket.

The problem I see it is that inflating the debt load away is the easiest policy choice.  It has been my experience that most people (and even more so for politicians and policy makers) will take the easy way out.  This view is shared by Mohamed El-Erian, CEO and Co-Chief Investment Officer of bond giant, PIMCO, as reported in
“There are several ways that a country can deal with its debt issues. I suspect the U.S. will end up with a mix of some fiscal adjustment and inflating its way out,” El-Erian said.

That’s because U.S. policymakers have an innate fear of recession thanks to U.S. history, more than of inflation, which is more relevant to the financial history of Europe, El-Erian told Der Spiegel, the German newsweekly.

This country has a huge aversion to recession, huge. And if you ask a policymaker if you're going to make a mistake, which mistake would you rather make, they would say I'd rather make an inflation mistake than make a growth mistake,” he said.
El-Erian describes the QE2 this way.
The U.S. economy cannot productively absorb all this liquidity. So when all the liquidity is injected into the system, it also goes elsewhere,” El-Erian said. “It’s like pouring water on a hard surface, it splashes everywhere. That explains the large skepticism about QE2 outside the U.S.”
I have a more profound concern that is based on behavioral economics.  Many studies have shown that you can use inflation to steal money from people and they don't even recognize the theft.

Consider this study by Daniel Kahneman, Richard Thaler and Jack Knetsch as reported in the book "Priceless" by William Poundstone.  By the way, I highly recommend this book which is essentially a book on the psychology of pricing. Or as he puts it in the subheading of the book, "The Myth of Fair Value (And How to Take Advantage of It).  There are some great lessons in negotiating in the book.

One survey question in the KTK study presented these facts:
A company is making a small profit.  It is located in a community experiencing a recession with substantial unemployment but no inflation.  There are many worker anxious to work for the company.  The company decides to decrease wages and salaries 7% this year.
62% of respondents deemed this unfair.
Another version of the question had the exact facts but inflation was stated to be 12% and the company was going to limit salary increases to 5%.  
78% of respondents thought this was fair even though in each case the workers have lost 7% of their buying power.

Poundstone also references the work of Irving Fisher and his 1928 book, "The Money Illusion" which explores inflation psychology.  Fisher argued that it is far easier to think in terms of the price you are paying for something rather than the purchasing power that the price represents.  Therefore, if you buy a house for $100,000 and inflation increases two-fold over 10 years you are likely to say you doubled your money.  All you have really done is stay even in buying power terms.  However, the math seems to be too hard for most people to easily wrap their mind around it.

The lesson here is to be very careful.  Inflation is the easiest policy option for government to solve its debt problems.  It is also the easiest way to hoodwink the public.  It just does not feel like you are losing.  Receiving a 2% social security increase when prices are rising 10% just doesn't seem to feel as bad as having your social security payment cut by 5% when inflation is 2%.   You are actually better off with the 5% cut from a buying power perspective.  Beware the "Money Illusion" and policy makers who think they are magicians.

Postscript: For more information on the "Money Illusion" from an investment perspective you might want to look at this blog post by Joshua Kenton that I found in research for my post above.

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