Beware the Money Illusion Coming to Destroy Your Wealth

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A money illusion sounds like something a prestidigitator performs by pulling $100 bills from a hat shown to be empty moments before. In fact, money illusion is a longstanding concept in economics that has enormous significance for you if you�re a saver, investor or entrepreneur.

Money illusion is a trick, but it is not one performed on stage. It is a ruse performed by central banks that can distort the economy and destroy your wealth.

�that people prefer a raise over a pay cut while ignoring inflation is the essence of money illusion.

The money illusion is a tendency of individuals to confuse real and nominal prices. It boils down to the fact that people ignore inflation when deciding if they are better off. Examples are everywhere.

Assume you are a building engineer working for a property management company making $100,000 per year. You get a 2% raise, so now you are making $102,000 per year. Most people would say they are better off after the raise. But if inflation is 3%, the $102,000 salary is worth only $98,940 in purchasing power relative to where you started.

You got a $2,000 raise in nominal terms but you suffered a $1,060 pay cut in real terms. Most people would say you�re better off because of the raise, but you�re actually worse off because you�ve lost purchasing power. The difference between your perception and reality is money illusion.

The impact of money illusion is not limited to wages and prices. It can apply to any cash flow including dividends and interest. It can apply to the asset prices of stocks and bonds. Any nominal increase has to be adjusted for inflation in order to see past the money illusion.

The concept of money illusion as a subject of economic study and policy is not new. Irving Fisher, one of the most famous economists of the 20th century, wrote a book called The Money Illusion in 1928. The idea of money illusion can be traced back to Richard Cantillon�sEssay on Economic Theory of 1730, although Cantillon did not use that exact phrase.

Economists argue that money illusion does not exist. Instead, they say, you make decisions based upon �rational expectations.� That means once you perceive inflation or expect it in future, you will discount the value of your money and invest or spend it according to its expected intrinsic value.

In effect, inflation is a hidden tax used to transfer wealth from savers to debtors�

Like much of modern economics, this view works better in the classroom than in the real world. Experiments by behaviorists show that people think a 2% cut in wages with no change in the price level is �unfair.� Meanwhile, they think a 2% raise with 4% inflation is �fair.�

In fact, the two outcomes are economically identical in terms of purchasing power. The fact, however, that people prefer a raise over a pay cut while ignoring inflation is the essence of money illusion.

The importance of money illusion goes far beyond academics and social science experiments. Central bankers use money illusion to transfer wealth from you � a saver and investor � to debtors. They do this when the economy isn�t growing because there�s too much debt. Central bankers try to use inflation to reduce the real value of the debt to give debtors some relief in the hope that they might spend more and help the economy get moving again.

Of course, this form of relief comes at the expense of savers and investors like you who see the value of your assets decline. Again a simple example makes the point.

Assume a debtor bought a $250,000 home in 2007 with a $50,000 down payment and a $200,000 mortgage with a low teaser rate. Today, the home is worth $190,000, a 24% decline in value, but the mortgage is still $200,000 because the teaser rate did not provide for amortization.

This homeowner is �underwater� � the value of his home is worth less than the mortgage he�s paying � and he�s slashed his spending in response. In this scenario, assume there is another individual, a saver, with no mortgage and $100,000 in the bank who receives no interest under the Fed�s zero interest rate policy.

Suppose a politician came along who proposed that the government confiscate $15,000 from the saver to be handed to the debtor to pay down his mortgage. Now the saver has only $85,000 in the bank, but the debtor has a $190,000 house with a $185,000 mortgage, bringing the debtor�s home above water and a giving him a brighter outlook.

The saver is worse off and the debtor is better off, each because of the $15,000 transfer payment. Americans would consider this kind of confiscation to be grossly unfair, and the politician would be run out of town on a rail.

Now assume the same scenario, except this time, the Federal Reserve engineers 3% inflation for five years, for a total of 15% inflation. The saver still has $100,000 in the bank, but it is worth only $85,000 in purchasing power due to inflation.

- Source, Jim Rickards via Daily Reckoning

Greenspan Has Traditional Been Gold Positive

If you look at Greenspan�s record, before he became Chairman of the Federal Reserve he said many positive things about gold. Since leaving the chairmanship, he�s said positive things about gold on numerous occasions � for instance at the Council on Foreign Relations this week. He has a history of looking on gold favorably but during the entire 20 years that he was Chairman of the Federal Reserve, he never had a good thing to say about gold. I think it says more about the constraints on central bankers; in other words, central bankers can�t tell the truth or what they really think because the market impact would be too great. I think that Greenspan is reverting to saying things today that he was saying 40 years ago but could not say when he was Chairman of the Fed.

- Source, Jim Rickards via Proactive Investor

Jim Rickards - The Fed Will Start QE4 In 2015

The Fed Basically Still Uses LTCM�s Financial Models

The models that LTCM was using the 1990�s were the same models that Wall Street was still using in the early 2000�s and, for that matter, the same models being used today. They are called �dynamic stochastic general equilibrium models� and also risk management models like �value at risk� or VaR models. They were the ones that we used in the 90�s and have continued to use for the last 16 years. They�re still being used now. They do not correspond with how markets actually work or to actual human behavior. They have failed in the past and they will fail again. If you have the wrong model, you will get the wrong policy and you will be negatively surprised by results every single time.

According to Greenspan, the Fed expanded its balance sheet not to boost the economy or to keep inflation moving higher. It was because the Federal government had such large expenditures that it would have �crowded out� private borrowers if the Fed had not increased the size of its balance sheet. Do you think that�s true? Is the Fed directing the economy? Or just reacting to the capital demands of the US government?

I think both things are true. I think Greenspan is right that we are seeing monetization of debt. This is what Frederick Mishkin, the former member of the Federal Reserve board of governors refers to as �fiscal dominance.� Yes, I think Greenspan is right about that but it�s also true that they�re trying to fulfill the dual mandate of price stability and creating jobs. As between the two, the Fed is willing to tolerate higher inflation if they can create more jobs. They don�t talk about �fiscal dominance� and they don�t explicitly say they�re monetizing the debt. In fact they deny that they�re monetizing the debts.

Greenspan�s right. When the credit demands of the Federal government are that great, you either have to accommodate the demands or somebody is going to be crowded out. I think that the result would be deflationary. Governments cannot tolerate deflation. So rather than choose between stimulus from monetary ease and monetization of debt, I think that they are doing both.

- Source Jim Rickards, via Proactive Investor

Financial War and Currency Wars Are Very Different

I have discussed financial war, which is different from currency war. Currency war is an economic policy countries use to fight deflation and encourage inflation by cheapening the currency and creating inflation in the form of higher import prices. It�s a way of creating monetary easing. It�s an age-old economic policy, used most famously in the late 1920�s and 1930�s in what became known as �beggar they neighbor.� Countries were stealing growth from each other by debasing their currencies, trying to import inflation and improve their trade balances by causing cheaper exports to foreign buyers and more expensive imports for domestic buyers. That combination was seen to bolster growth.

Financial war is different. Financial war involves countries that are traditional rivals or even enemies, for instance the US, Russia, and China, with competing interests everywhere from Eastern Europe to the South China Sea. Countries have fought wars in the past using traditional kinetic methods � armies, navies, air forces, missiles, submarines and so forth. We now live in an age where, thinking about warfare, you have to look at asymmetric forms of warfare � not just traditional forms � like chemical, biological, radiological weapons, guerilla warfare, terrorism, and financial warfare. So the scenario I was discussing that involves China buying gold and selling the dollar was not a currency war; it was a financial war. There you are trying to destroy the economy of your opponent, which is a very different situation.

- Source, Jim Rickards via Proactive Investor

The Goal of Currency Wars is Inflation

I expect a collapse in the value of currencies relative to real goods, real assets and real services. This will happen to all currencies, not just the dollar. I don�t expect a word where people lose confidence in the dollar and the euro does really well. On a relative basis, I�ve been bullish on the euro for some time. In the endgame, however, if people lose confidence in the dollar this will be inflationary in all countries around the word and I don�t think that any currency will be able to withstand it. When I say �the death of money� what I really mean is the loss of confidence in the purchasing power of money. That�s very likely to be a global phenomenon not confined to any particular country.

Currency wars are part of the picture because the way you fight a currency war is by cheapening the currency, cutting rates and quantitative easing. We saw that recently with the announcement of more quantitative easing from Japan, which took the markets by surprise and caused the Japanese Yen to fall by over 2 percent in a single morning. That is a huge move in the currency markets.

Another big factor in currency wars is the question of paying sovereign debts. It�s the sovereign deficits that are really the problem and the question is how to deal with them. One way to deal with them is through inflation, which, of course, is the goal in a currency war. The problem is that not everybody can devalue against everybody else all at once. You have to take turns. So it goes back and forth and back and forth. That�s what happened in the 1920�s and 1930�s and it�s happening again today.

- Source, Jim Rickards via Proactive Investors

Catastrophic Outcomes May Come Faster Than Expected