The monetary illusion: a magic trick that will not enchant your finances!
We cannot ignore the many comments about the resurgence of inflation. Yet we don’t seem to be concerned about that when it comes to financial decisions. How do we explain this danger to our personal finances?
While the topic of purchasing power is at the center of public debate in many countries, the name of Gérard Majax, a famous magician of French television, was quoted during the in-between rounds of the French presidential election! A reference far from being incongruous… Indeed, we will see in this article that, in terms of purchasing power, illusion has a real place.
Reasoning out inflation: no magic wand!
Spring is here, with its many garage sales and fairs, which give us opportunities to bring out objects from past decades to try to get a couple of bucks from collectors. Therefore, some hope to realize great capital gains by reselling, for example, 300 euros, objects initially bought half price in the 1980s (1000 French francs or the equivalent of 150 euros)! Apparently enough to make a fortune… but in the meantime inflation has gone through there and this 1,000 francs are now equivalent to nearly 450 euros today according to the Insee (Institut national de la statistique et des études économiques – National institute of statistics and economical studies)(1)… Wealth will not be there…
The “monetary illusion” is precisely defined as the preference for indicators excluding inflation (in nominal terms), rather than after taking it into account (in real terms). How to explain that? Firstly, it is easier to understand aggregates – in other words, financial elements - excluding inflation; secondly, because of our easier attention to nominal terms. This unfortunate preference was highlighted in a famous 1979(2) study in which the participants had to classify the financial choices of three fictitious characters, Adam, Carl and Ben, in order to distinguish who had made the best deal. The case was as follows: after receiving a home for $200,000, Adam sold it for $154,000, 23% less, but with 25% deflation (price drop) over the period; Ben sold it for $198,000, down 1%, while prices remained stable over the period; Carl sells it for $246,000, an increase of 23%, with inflation of 25% over the period.
The majority of participants considered that Adam (+2% in real terms) performed the worst operation and that conversely Carl (-2% in real terms) recorded the best operation! By focusing on the emotional aspect, the participants reasoned in nominal terms!
The monetary illusion is of particular importance today: by not integrating monetary erosion linked to inflation, certain asset allocations can be unfortunate. Similarly, it is necessary to change our perception of what constitutes an attractive level of profitability (in terms of risk-taking) in this inflationary context.
The smoke and mirrors of emotions
A more recent experience(3) confirms our difficulty in understanding financial equations when our emotions take over. Thus, taking again a fictitious case, participants to the study were asked to judge a real estate transaction mixing borrowing and resale of a house previously bought. This experience has shown that when the question asks to focus on the economic terms of the transaction (the “best transaction”), the answer given is well considered: regardless of the amount of residual debt at the time of resale, the transaction is perceived as equivalent. On the other hand, in the event of a loss of value resulting in a negative flow to repay the remaining debt, taking into account the pain related to the negative flow blurs the perception, even with an identical amount of loss of value between the owners. Finally, this study highlights that the concentration of respondents on feelings (“happiness”) influences the response: the possible negative flow and the associated liquidity constraint is all the more badly felt.
Thus, to integrate the changing economic environment and rising prices, it is key not to be blinded by emotions but to stay on economic aspects, sometimes very calculating.
You will have noted the length of the article… also a victim of inflation… or how to let yourself be overwhelmed by emotion when writing!
(2) « Money Illusion », E. Shafir, P. Diamond et A. Tversky (1997)
(3) "Is There a Link Between Money Illusion and Homeowners’ Expectations of Housing Prices?", L. Ackert, B. Church et N. Jayaraman (2011)
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