When things are not what they seem
If you bought a car for £1,000 yesterday, and you sold it today for £1,200, did you make a profit? Most likely you’ll say yes. £1,200 is more than £1,000, so you are £200 better off, of course. But what if it is a car you bought not yesterday but ten years ago? The difference is still £200, but is that still your gain?
The potential problem here is monetary inflation: the process by which money becomes “worth less” over time. Money, the economics textbooks say, is “a medium of exchange, a store of value, and a unit of account”. Inflation makes using it as a unit of account a little precarious. Imagine measures of distance shrunk with time like money does. Your grandchildren would come to visit you and moan about the six mile walk from bus stop to your door, and you tell them that, when their mum was a little girl, that distance was barely half a mile.
The incredible shrinking currency
We are familiar with the fact that physical measures do retain their value, and that money doesn’t. Or are we? In 1928, the economist Irving Fisher wrote a little book entitled The Money Illusion, noting that in those post-war days, few people were aware of the fact that their contemporary dollar was only worth 70 cents of its pre-war equivalent. People thought of money in nominal terms, the number written on the note or coin, and failed to “perceive that the dollar, or any other unit of money, expands or shrinks in value.”
Two behavioural financial economists, the later Nobel prize winner Robert Shiller and George Akerlof, devote an entire chapter to the money illusion in their book on the important role of human psychology on the economy, Animal Spirits. Of course, we know better now than to believe that money, like a chair or a table, keeps its value over time. But, the authors say, that realization only seems to work up to a point. In many countries, for example, labour contracts do not contain automatic adjustments to wages based on inflation. The same applies to debt — the principal of a mortgage is always expressed in units of the past, not of the present.
Two more future economics Nobel prize laureates, Daniel Kahneman and Richard Thaler, together with Jack Knetsch, made a similar observation in a paper from 1986. Through a household survey they explored what people consider as fair or unfair behaviour. In one of the questions they asked whether a firm deciding to decrease wages by 7% in a no-inflation situation was acting in an acceptable manner. 68% of the respondents found this unfair. Other participants received a variant of this question: inflation ran to 12% (this was not implausible in the 1980s!), and the company decided to increase workers’ pay by 5%. 78% of the respondents found this acceptable, and only 22% thought it was unfair. Yet in real terms, the effect to the employees was approximately the same in both cases. But that is not how we see it, and workers are likely to feel more pleased with a 9% raise with an inflation of 9%, than with a pay increase of 0% when inflation is 0%.
So we may have some appreciation of inflation, but money illusion has not vanished. A typical savings account interest rate of 1.5% will see a deposit of £10,000 grow to £10,150 over a year. That doesn’t look too bad: a gain of £150 is not a trivial amount of money. But with a modest inflation rate of just 2% per year, the real value of what’s in the account will be just £9,950. You’d have lost £50 rather than gained £150.
It is not only time, but also space that can confuse us. We’re all used to our home currency, so when we travel abroad we see familiar goods and services priced differently. When I first came to London on a school trip in the days before the euro, even a relatively expensive record costing £4 would appear cheaper than one at home costing 300 francs, yet at the prevailing exchange rate it was nearly 10% more expensive. Conversely, I remember paying over 150,000 Italian lira for a far from extravagant Rome hotel room in the 1990s (about £80 at the time). Exchange rate or not, it’s hard not to see 4 as less than 300, or 150,000 as more than 80.
The introduction of the euro in 2002 presented this kind of shock to more than 300 million people overnight. Two researchers, Benjamin Bittschi and Saskia Duppel, looked in the German tax records for an unusual real change in charitable donations following the currency changeover. And they found it. Even controlling for a range of potentially confounding factors (like regional GDP and age, and the presence of potentially distorting specific disaster appeals), they found the money illusion effect to be between 2.4% and 7.6%. 1 euro is approximately 2 marks, and that made the Germans donate between €89 and €281 million more than they would normally have done.
Not just money
The money illusion is not limited to money and more generally known as the nominal illusion. we know that the we are misinterpreting the figures we see, but we are still influenced by them as they are. When I drive on the European continent, I cannot help feeling pleasantly surprised that it’s a lot faster to travel 200km than 200 miles. But in the months after I moved to the UK, I often underestimated the reality of a 50 mile distance (which is 60% more than 50km).
And there is more. Economist Justin Wolfers recently asked on Twitter for examples of nominal illusion, and among the responses were some real gems. One that I could leave unmentioned is that of behavioural economist Richard Thaler’s tough exam (related in his book Misbehaving). He had composed it such that the average score would be 72 points out of a possible 100, but the students found this unacceptably low. How to deal with that discontent? Thaler had a flash of inspiration: he would increase the total number of points available to 137. 70% of the points would thus be “a cheery 96 points” in nominal terms — to the delight of the students. Along the same lines, someone reports that Austan Goolsbee (perhaps not surprisingly, also an economist) once accidentally wrote an exam that added up to only 90 points. When the students pointed this out, he announced that the whole class would get a 10-point bonus — to widespread cheering.
Pinball machines have also been subject to a quasi-Zimbabwean points inflation. Chicago Coin’s Moonshot machine from 1969 accumulated players’ points in just 4 digits. In 2016, a pinball wizard by the name of DirtyDeeds reached a high score of 43 billion points on the Ghostbusters machine. A maximum score of 9,999 would not get you very far today.
If you’re not into arcade games, consider the use of loyalty points. These often have less value than even the smallest coin in circulation. The British supermarket chain Sainsbury’s uses the Nectar scheme: for each pound spent, cardholders receive 1 point, worth 0.5p (making it equivalent to a 0.5% discount). Often you receive extra points for certain purchases, so typically you’d earn about 200 points at the till. This, of course, sounds more impressive than £1 in cash. Furthermore, with points worth so little, it’s not very expensive to occasionally run an attention-grabbing “10 x points!” promotion.
The nominal illusion is an intriguing effect, which has the power of influencing us even if we know very well how it distorts our thinking. The best we can do is try to be even more conscious of its existence, and make our decisions as conscious as we can.
We can use it to our advantage too. For example, some people put their watch forward by 5 minutes or so. Even though they know that the real time is earlier, the nominal time makes them consider leaving for the train, or preparing to conclude a meeting in good time. (I can confirm that it works.)
But possibly the best way to remember the nominal illusion and what it does is this little clip from the mockumentary This is Spinal Tap, with a guitar amplifier with knobs that go not to 10, but all the way to 11:
Originally published at koenfucius.wordpress.com on June 7, 2018.
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