Thursday, November 24, 2011

The lies economists tell us about money

Nov 24, 2011

Understand the 'money illusion' and how it confuses your brain

By Andy Mukherjee

ONE of the biggest frauds perpetrated by the economics profession on hapless mortals over the last 70 years is its insistence that there is no such thing as 'money illusion'.

New evidence suggests that money does create illusions: it not only muddles the thinking of individuals; en masse, it precipitates property and stock market bubbles. When these bubbles burst, as in many parts of the world in 2007-08, societies come under severe stress.

But what exactly is money illusion?

British thinker John Maynard Keynes was the first to use the term, and, in 1928, the great American economist Irving Fisher devoted an entire book to it.

Simply put, money illusion is the inability of the human mind to separate 'nominal' variables, such as wages, rents, mortgage payments and dividends, from 'real' variables, which factors in how inflation affects incomes and expenses. The purchasing power of money keeps getting altered without our fully realising it.

No other unit of measurement is like money. What we mean by a kilogramme of sugar, a metre of cloth or a kilowatt hour of electricity, remains constant. But what we mean by US$1 or €1, and the happiness we derive from owning it (or the unhappiness we suffer from losing it) keeps changing.

Take two girls - Ann and Barbara - who graduate one year apart and have the same starting pay. At the end of the first year, Ann gets a 2 per cent raise. At the end of Barbara's first year at work, during which the inflation rate is 4 per cent, her pay goes up by 5 per cent.

In economic terms, Ann is better off at the start of her second year at work. Her inflation-adjusted, or real pay increase is (2-0) = 2 per cent, while Barbara's real increment is (5-4) = 1 per cent.

But who, between the two, will be a happier employee? Who will be more likely to switch jobs in the second year?

Thanks to a sharp turn the economics profession took 67 years ago, it became illegitimate to even ask such questions.

This is how it happened: In 1944, John von Neumann, one of the greatest mathematicians of all time, teamed up with German-born economist Oskar Morgenstern, a colleague at Princeton University's Institute of Advanced Studies, where they were both contemporaries of Albert Einstein's, and decided to bring some mathematical rigour to economics.

von Neumann and Morgenstern developed a calculus of 'subjective expected utility', the personal happiness that we seek to maximise. The theory relied on four axioms. Any human behaviour that violated any of the axioms was deemed irrational, unlikely to persist and unworthy of further comment; if all four held, then it was stable and predictable. Economists declared that this latter type of rational, self-seeking, utility-maximising behaviour is what makes the world go around.

How wrong they were.

Cognitive psychologists Eldar Shafir and Amos Tversky, together with economist Peter Diamond, decided to test people's opinion about Ann and Barbara. While 71 per cent of those they surveyed agreed that the pay increase had left Ann better off than Barbara 'in economic terms', fully 64 per cent of the respondents believed that Barbara would be happier than Ann at the start of her second year at work and less likely to quit.

Published in 1997, the Shafir-Diamond-Tversky study showed that the von Neumann-Morgenstern model of rationality, the foundation stone of modern macroeconomics, was shaky. And that the hunch of Keynes and Fisher is right - that we suffer from money illusion and don't factor in how inflation changes the value of a dollar.

A decade later, researchers at the University of Bonn and California Institute of Technology did a more direct test. They ran MRI scans and found that a part of the brain's pre-frontal cortex, which decides our response to rewards and punishments, reacts more to nominal than real variables. (The same part of the brain derives greater satisfaction when we're drinking Pepsi that's labelled as Coke.)

But all that came later. Meanwhile, the theory of Rational Economic Man (and Woman) became so entrenched that there was total disdain for the notion that money confuses the mind. James Tobin, who would win a Nobel prize in economics in 1981, said: 'An economic theorist can, of course, commit no greater crime than to assume money illusion.'

The banishing of money illusion was a crucial victory for the finance profession because if there was widespread money illusion, there could never be such a thing as efficient markets.

And efficient markets was the lie that the financial industry wanted you, me and politicians everywhere to believe so that no one gets terribly nervous when asset prices reach the stratosphere.

Ask yourself, why is it that housing markets in the United States, United Kingdom, Canada, Australia and many other advanced economies saw spectacular run-ups, followed by dramatic crashes, starting in the 1980s, a theme that played repeatedly until the huge subprime mortgage collapse in 2007-08? One part of the answer is money illusion, say Princeton University economist Markus Brunnermeier and London School of Economics professor Christian Julliard.

After creating havoc in the 1970s, the inflation genie went back into the bottle in the early 1980s. Nominal interest rates declined, making mortgages appear attractive to home buyers. What they didn't understand was that inflation had collapsed more than interest rates. So the real interest rate had actually risen; mortgages had become more expensive, not less.

Banks that financed the gush of mortgages profited, while governments and central banks stood by and watched. They were powerless to act because mainstream economists had no advice on how to deal with irrational exuberance caused by money illusion. After all, no such mirage was supposed to exist.

With the world economy still reeling from the 2008 crash, let's hope something has been learnt. One lesson is that as long as we use a thing of no fixed value as money, we will continue to be confounded by it. Thus, asset bubbles are inevitable. But as prices start getting out of whack, policymakers have to step in and ask people to sober up. Parties that break up early are less painful the morning after. A second lesson is that when modern macroeconomists claim to describe or predict behaviour, ask them if they are assuming people to be rational. If they are, chances are they're wasting your time.

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