Money Illusion
Behavioral New World
June 1, 2021
Grandpa’s Money Illusion
“I remember when gas was 25 cents a gallon.” You might well have heard a (very) elderly relative make such a statement. The statement is not false, but it is highly misleading. The person making the statement suffers from one form of money illusion—not considering inflation, the rise in prices over time. Spoiler alert: As prices rise over time, 25 cents buys less and less.
This money illusion bias arises when we confuse physical money with its actual “purchasing power,” its capacity to be exchanged for goods and services. Another way economists put it is that money illusion is the confusion of nominal value (the face value, or number of dollars stated on the physical piece of paper) with real value. And real value is just another way of saying how much “power” you have to purchase specific items. Money illusion is akin to mistaking the menu for the food itself.[1]
Let’s consider how not taking inflation into account leads to money illusion. Suppose that your salary this year is $50,000. Over the ensuing twelve months inflation is 5 percent. Roughly speaking, this means that the goods and services that you purchase have gone up in (nominal) price by 5 percent. Now suppose that at the end of the year you get a 3 percent raise, so you’re now making $51,500. It might look (and even feel) to you as if you’re better off at the end of the year. After all, you’re making $1,500 more than you did last year. But if you think this way, you are suffering from money illusion. Why? Because your purchasing power has actually decreased. Prices have risen faster than your salary: you’re behind the game, in a very real and painful way. Your new salary can buy fewer goods and services at the now-elevated prices than your year-ago salary could at the old prices.
So how do you overcome money illusion? First some bad news: there is evidence that the tendency to fall for money illusion is hardwired into our brains.[2] As psychologists put it, dealing with nominal values is “cognitively easier” (or, as the rest of us might put it, “easier”). So overcoming money illusion is not going to be easy. But it can be done, and it starts with awareness. Once you are aware of the issue, some straightforward thinking and calculations will serve you well.
The calculations can be a bit tedious. Luckily, there are websites that do this for you, such as http://www.westegg.com/inflation/infl.cgi, which is free. For its calculations, this website uses the government’s Consumer Price Index, or CPI—the most widely accepted measure of inflation. Suppose Grandpa was referring to 25 cent gas in 1935. Using the calculator, you will find that the inflation-adjusted equivalent as of 2020 is $4.70. Given that gas as of today is around $3.00, gas has actually gotten cheaper in real terms!
In my 2017 book, The Foolish Corner, I proposed what I called individual purchasing power (IPP), a personal consumer price index that reflects the cost of living to reflect the purchasing power of your income over time. IPP asks: Is that power going up, down, or staying about the same? It reflects your economic reality, not the economic reality based on a broad measure of inflation such as the CPI. Measuring your IPP can be a challenge, but this recent article provides some help (I was just slightly ahead of my time):
You may wonder why I devote a newsletter to inflation, given the low inflation rates of the last decade. My concern is that inflation is picking up and the uptick might not be “transitory,” as the head of the Federal Reserve claims. I’m not a grandfather, but I do remember inflation rates in the double digits (nearly 15% in 1980).
The rule of 72 is useful for quick calculations: Divide the interest rate into 72 and you get (approximately) the number of years it takes to cut purchasing power in half. At the recently reported 4% inflation rate, the purchasing power of the dollar will be halved in 18 years. If you are saving for your kid’s college tuition or for your retirement, 18 years is a relevant horizon.
No doubt Grandpa has lots of wisdom to pass along, but perhaps not his understanding of inflation and purchasing power. He’s not a magician, so don’t fall for the illusion.
[1] A paraphrase from Alan Watts’s Does It Matter?: Essays on Man’s Relation to Materiality (New York: Vintage Books, 1971).
[2] Bernd Weber, Antonio Rangel, Matthias Wibral, and Armin Falk, “The Medial Prefrontal Cortex Exhibits Money Illusion,” Proceedings of the National Academy of Science 106, no. 13 (2009): 5025–28.