The Money Illusion

01 September 2021
Market Insights

THE MONEY ILLUSION: NOW YOU SEE IT, NOW YOU DON'T...

The inflation discussion seems to dominate the financial news cycle these days. What does it all mean, and more importantly how is it likely to impact our daily lives? Historically, the real impact of inflationary pressures is often difficult to understand and almost impossible to predict. In his book titled, “An Analysis and History of Inflation,” Don Paarlberg explains, “the inability to recognize the effect of inflation results from the money illusion, the widespread but mistaken belief that money is, over time, a stable measure of value.”

The chart above shows how the dollar has lost more than 96% of its purchasing power since the Federal Reserve was created in 1913. Most consumers understand that prices for goods and services generally increase over time and can point to several clear examples over the last 18 months such as buying a car or items in the grocery store aisles. With that said, the money illusion is so strong that even professional economists and statisticians often fail to understand the full impact in real time.

Here is a simple example to make the point:

Baseline

Income = $100,000
Price for a loaf of bread = $5
Maximum number of loaves that can be purchased = 20,000

Option A

Income = $110,000 (10% increase)
Bread = $6 (20% increase)
Maximum number = 18,333

Option B

Income = $90,000 (10% decrease)
Bread = $4 (20% decrease)
Maximum number = 22,500

Which option would you choose? In this simple example, option B is the far better choice allowing the consumer to purchase 13% more bread even though income has fallen by 10%. Unfortunately, the real world is never so black and white. The main point is that wealth is not measured by the amount of money that one has, but rather by the total amount of goods, services, and property that one can acquire. We believe that we may currently be in the early stages of an option A type scenario. Incomes are generally up with increased wages, unemployment benefits and stimulus checks, but will it be enough to keep up with the rising cost of living? From an economic perspective, we know that the amount of money in the system does not do anything to improve standards of living unless improved productivity increases the total amount of goods and services that are available. There is a very real risk that the current dislocation in the economy and the increased money supply could result in prices rising faster than wages, which is a scenario that has occurred many times throughout history.

Should we be concerned? Not according to the Chairman of the Federal Reserve, Jerome Powell. Chairman Powell and other members of the Federal Reserve Board of Governors have told us repeatedly that the inflation that we are experiencing is transitory. In fact, we have heard the word transitory so many times in the last few months that is has become almost as nauseating as the word unprecedented was last summer. We believe there are a couple of important points to understand about the mainstream inflation discussion. First, under the best-case scenario, transitory simply means that the increased rate at which prices are going up will eventually fall back to a more manageable 2 – 3% per annum increase. It does not mean that prices for goods and services will go back to the levels of 2019. Rather, the price increases on many items are likely to be permanent, even if we get to a point where they stop rising as fast.

The second, and more insidious element of the inflation discussion, is the notion that it is somehow unintentional. Ever since the days of Ancient Rome, governments have used their monopoly on the money creation process to intentionally devalue their currency in an effort to bid away a greater portion of property, goods and services from the people. These efforts are often magnified in times of war or severe economic downturns such as the global pandemic that began last March. According to Professor Paarlberg, “inflation is chosen by government in preference to taxation, which is onerous and clearly perceived.” Therefore, inflation is much more palatable from a political standpoint relative to the other two options of cutting government spending or raising taxes. While we may not know how high the inflation rate will go, or how long it will last, we should understand that inflation, at its core, is a tax that is intentionally administered by the very same experts who tells us that it is likely to be ephemeral and that they are working on our behalf to fight against it.

We do not intend to be alarmist. We are not suggesting that it is time to sell the car and use the proceeds to buy livestock and excess supplies. Rather, we are simply trying to develop a clearer perception of what is happening and why. The Federal Reserve has increased the M2 money supply by approximately 34% since January of 2020. While that is that fastest rate of increase since the 1940s, it is still a long way away from the rate experienced in the Weimar Republic, post WWI, where the cost of a postage stamp eventually rose to 100 billion marks. It is unlikely that the policies that have been implemented thus far will take us to such disastrous levels. The question is what happens next time the economy falters. The real risk is not what has been done, but rather the complete abandonment of any trace of what we would have recognized as responsible fiscal and monetary policy just a few years back. We will not be fooled by the diversions of rising asset prices and government hand-outs. Nothing we are witnessing today is new. The money illusion is powerful, but the magician’s tricks have been revealed many times throughout history. We have seen this show before, and we will proceed with eyes wide open.

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