Saturday, October 25, 2014
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Let’s Get Real About Money

Throughout the world, people suffer from a serious perception error that has inhibited them from taking concrete steps to protect themselves from inflation or deflation. The error is called the “money illusion ” – the belief that a nominal unit of currency is the best measure of value, even though its real value is unstable.

Historically, failure to protect against inflation or deflation has helped spur calamitous outcomes. When spectacular inflation hit Germany in 1923, it wiped out the real value of the (unhedged and unindexed) life savings and social-security benefits of millions of people, whose anger contributed to the rise of Nazism.

Similarly, spectacular deflation in many countries around the world in the early 1930’s magnified the real value of (unhedged and unindexed) debts, leading to millions of defaults and widespread bank failures. Deflation also magnified the real value of wages and salaries, thereby fueling layoffs and unemployment. Failure to hedge or index brought us the Great Depression. Much of Japan’s economic malaise in recent years also reflects (unhedged and unindexed) debts magnified by deflation since 1999.

In 2003, an IMF study raised the specter of Japan-like problems around the world, and listed thirteen countries, including, China, Germany, Singapore, and Poland, with a moderate to high risk of deflation. Yet, in the face of overwhelming evidence of the importance of inflation or deflation risk, most people – even in countries that have been warned – generally still have not taken steps to protect themselves.

Given widespread apathy about changes in consumer prices, the modest success of a new market to hedge inflation risk, the European inflation futures market at the Chicago Mercantile Exchange (CME), is noteworthy. Since September, this new market has traded the Eurozone’s Harmonized Index of Consumer Prices, or HICP – a contract that traders call the “hiccup.” By purchasing or selling it, companies and individuals can protect themselves against losses stemming from changes in the value of their currency.

The open interest recently was 355 contracts, with a notional value of €355 million. This is a real beginning, and we should encourage such contracts to grow in order to help billions of people hedge their inflation and deflation risks. But this promising start follows a long trail of failures to create inflation futures, owing to the public’s lack of interest.

This failure can be explained only by the money illusion, which ultimately is connected with what psychologists call “framing.” How a concept is framed, the context and associations with which it is presented, affect human judgments enormously. A tax called a “death tax” is regarded very differently from a tax called an “inheritance tax,” even though the two are really identical. The money illusion occurs because we are accustomed to economic values almost always being framed in terms of money.

For years, I have been arguing that national governments should take some simple steps to reframe economic quantities and help the public overcome the money illusion. They could merely create an indexed unit of account to replace currency for measuring economic quantities and defining prices. The unit would be nothing more than a consumer price index, given a simple name, and published daily, so that people could use this unit and its name to quote prices in real terms. This would help reframe public thinking, which is all a government really needs to do. It would be easy and virtually costless.

Indexed units of account are not a new idea; Chile’s government led the way in 1967 by creating the Unidad de Fomento (UF), and other Latin American countries have followed suit. Despite the unit’s technical-sounding name, people in Chile seem to have learned to think in terms of the UF instead of the peso for important contracts.

Following Chile’s example, governments also could redefine the tax system in terms of the units of account rather than currency. That way, people who fill out tax forms would have to learn the units of account. As a side benefit, the tax system would be automatically, fully, and transparently indexed to inflation.

In my 2003 book The New Financial Order, I proposed that such units be called “baskets,” since a consumer price index is the price of a representative market basket of goods and services. That name is very simple, and it conveys a new conceptual framing: by promising to pay someone so many baskets at a future date, one is promising to pay in market baskets of goods and services. Of course, the actual payment will be made in ordinary currency at the contemporaneous exchange rate, based on the consumer price index, between baskets and the currency.

What if people really got used to expressing quantities in baskets? Wouldn’t futures contracts sound completely different if they were reframed as contracts for ”baskets” instead of “hiccups?” A futures market for the complete market basket that consumers buy certainly rings with importance.

Ultimately, the advance of information technology will be the salvation of ideas like the CME’s inflation futures market and indexed units of account. Inflation futures appear to be gaining hold in part because the new contract is traded on an efficient electronic market (the Globex system) that allows futures contracts to get going without the initial splash that is required by open-outcry pit-based futures markets.

Indeed, this is also why an American exchange can make a market for European inflation; with new information technology, it no longer matters where people live. This should help popularize indexed units of account, too, since computer technology can now handle all the calculations involved in translating them into currency. The sooner this happens, the sooner one more scourge of financial instability will be behind us.

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