Inflation is a Drug, But Which Kind of Drug?

Posted by Wealth Wire - Monday, October 1st, 2012

The New York Herald of 1933 suggests it’s the bad kind, a sort of monetary heroin:

As the effects of the first jab in the arm wear off, the country is plainly more than a little worried over the cure-all drug called inflation.  The first dose was just a promise – and what beautiful dreams it produced!  Exchange was about to be stabilized, stocks and commodities were to go kiting, everyone was to be prosperous – long live the 50-cent dollar!

Now the headache of the morning after is already unmistakable in many quarters.  Such is the familiar inevitable history of the inflation treatment, and it is interesting to see even the first preliminary stage following the classic formula.  Nothing is more certain to produce a temporary thrill, a delusion of wellbeing; nothing is more certain that, as the effects wear off, the patient feels worse than ever.  That is the chief viciousness of inflation.  It is in literal truth a habit-forming drug requiring ever larger and larger doses to keep the patient satisfied. (New York Herald, 4/27/33)

But Saturos sent me some recent research suggesting that it’s more like a drug to treat neurosis, helpful in allowing the economy to cope with irrational fears of lower nominal wages:

ScienceDaily (Mar. 27, 2009) — What would you prefer: a three per cent wage rise at five per cent inflation? Or a two per cent wage-cut with stable prices? Many people, faced with this choice, would take the first option, although the true purchasing power of their income sinks in both cases by exactly the same amount, namely two per cent.

Researchers at Bonn University and the California Institute of Technology have now discovered the cerebro-physiological cause underlying this so-called “money illusion”. This effect is of great practical relevance in that it explains, for instance, why financial policy and inflation can have a beneficial effect on employment and economic growth.

.  .  .

“We had now confronted our test subjects with two different situations”, Falk explains. “In the first, they could only earn a relatively small amount of money, but the items in the catalogue were also comparatively cheap. In the second scenario, the wage was 50 per cent higher, but now all the items were 50 per cent more expensive. Thus, in both scenarios the participants could afford exactly the same goods with the money they had earned – the true purchasing power had remained exactly the same.” The test subjects were perfectly aware of this, too – not only did they know both catalogues, but they had been explicitly informed at the start that the true value of the money they earned would always remain the same.

Despite this, an astonishing manifestation emerged: “In the low-wage scenario there was one particular area of the brain which was always significantly less active than in the high-wage scenario”, declares Bernd Weber, focusing on the main result. “In this case, it was the so-called ventro-medial prefrontal cortex – the area which produces the sense of quasi elation associated with pleasurable experiences”. Hence, on the one hand, the study confirmed that this money illusion really exists, and on the other, it revealed the cerebro-physiological processes involved.

An Explanation for the unpopular “Teuro”?

The results achieved by these scientists in Bonn demonstrate that as far as the brain is concerned money is represented as being “nominal”, and not only “real”. In other words: people like to be seduced by large numbers. This is of great practical relevance as the money illusion explains, for example, why the economy allows itself to be reflated by expansive financial policy. It also offers an explanation for why nominal wages rarely sink, whereas true wages, in contrast, fall in value in periods of inflation. Many economists also see the money illusion as an explanation for speculative bubbles, such as those in the property or shares markets. Armin Falk declares: “Even minor departures from rational behaviour, i.e. a “little money illusion” can have major economic consequences”.

I’m often taunted by RBC-types: “Where’s your model.”  ”That’s not scientific.”  We now have hard science showing money illusion exists.  In contrast, the RBC belief in the non-existence of money illusion is akin to religious faith.  ”Our models say it shouldn’t exist, so it can’t.”

Unfortunately, it does exist.

*Post courtesy of Scott Sumner at The Money Illusion. Sumner has taught economics at Bentley University for the past 27 years. His research has been in the field of monetary economics, particularly the role of the gold standard in the Great Depression.

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