Sunday, November 28, 2010

Animal Spirits Pt. 2: Money Illusion

I am unfamiliar with the term "money illusion", but from what I'm gathering from this chapter as I read it, this refers to the failure by many people to account for changes in the purchasing power of money in their financial planning. In short, the term "money illusion" is kind of like the inverse of another term I am familiar with, "Neutrality of money". Most economists operation under the assumption that money is a neutral medium of exchange. Akerlof and Shiller, in advocating a return to the idea of "money illusion", appear to be saying something similar to what is said in Misesian circles: that money is not neutral.

As evidence of this money illusion, the authors point out that the vast majority of labor contracts fail to include wage increases to account for cost-of-living increases. In other words, in the vast majority of cases, workers bargain in monetary terms, not in "real" terms. But, there is another explanation other than "money illusion". It could be that both sides are simply less concerned with future prices than they were with current prices. The workers want to get as much as they can right now, gambling that future negotiations will enable them to keep up with the costs of living. The employers want to avoid built-in cost increases, and gamble that future negotiations will enable them to avoid excessive wage increases. Since nobody can truly predict the future, neither side can effectively negotiate in terms of future wages.

Then again, that whole argument could be the same thing as "money illusion". I'm still not sure what it means, exactly.

Still, if it is true that, as Akerlof and Shiller assert, conventional economists (I suspect they are referring to monetarists here) actually make the assumption that people see through the veil of inflation naturally... I weep for the profession. I suspect, however, that there is more to it than this.

In the sort term, of course many people are going to fail to account for inflation. People differ in their degree of financial savvy. Furthermore, people who maintain minimal savings have little to lose from inflation (aside from wage erosion, but those are not entirely under their control in the first place), and thus have little incentive or opportunity to think in terms of inflation. So if monetarists, when they say people behave "rationally" and "see past" inflation (in the authors' words), actually mean people are smart and know about inflation... obviously they fail. Hard.

However, though wages for unskilled labor will always tend to lag behind inflation, they will also tend to track inflation, quite in spite of the worker's lack of knowledge about inflation. For workers are not aiming at a specific level of "real wages". They are simply trying to get as much value out of their jobs as possible (including money, but also including such intangibles as job satisfaction, job security, risk aversion both physical and psychological, etc.). Likewise, their employers are not trying to maintain some specific "real value" in their wage rates, but are rather, day to day, simply trying to get as much value out of as little money as they can. Inflation is entirely irrelevant in this calculation, so long as both parties are dependent on that third, unassailable economic force: the consumer, who is simply trying to get as much value for as little money as possible, also. (Most labor contracts I am familiar with that include COLAs are those of government workers, such as teachers, who are not dependent on the consumer, but rather the taxpayer and the voter; entirely different incentives apply.)

So as workers move from job to job, they will tend to go with the highest bidder, regardless of who that is. Someone who fails to get a raise he thinks he deserves may attempt to move to a different company. A company that finds its wages too high and finds themselves unable to lower those wages will tend to look for excuses to fire overpaid workers outright, replacing them with new workers with whom they can negotiate lower wages. Whether either party will be successful is ultimately not up to either the employers and the workers, regardless of whether or not they "understand" inflation, but to market conditions as dictated by the consumers.

However, "money illusion" will still tend to skew the economy. Downward wage rigidity is part of this. Consumer resistance to price rises is another. The "wealth effect", in which people tend to spend more when the monetary value of their assets rises despite the unchanged form of those assets, is another. All these forms of resistance will ultimately crumble in the long term, as market realities force reassessments; however, these "money illusion" phenomena do tend to transform what should be gradual changes over time into sudden and traumatic lurches, which skew perceptions and beliefs even more.

At this point in the book, the authors have failed to point out the source of money illusion. Some changes in prices simply reflect changes in consumer disposition: a price for one thing drops because consumers value it less today than they did yesterday, or because costs in producing this good have dropped; a price for another thing rises, because consumers value it more today than they did yesterday, or because production costs have risen. However, when ALL prices rise, it can only be because consumers value the money, itself, less today than they did yesterday, OR because the supply of money itself has risen. And there is only one entity with the power to increase the money supply to the degree it has over the twentieth century: the State. This "illusion" is not a natural phenomenon: it is man made. I hope to see Akerlof and Shiller point out this fact later in the book.

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