42 THE BiG DROP
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’s Essay 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 ex-
pectations.” 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.
Like much of modern economics, this view works better in
the classroom than in the real world. Experiments by behavior-
ists 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 aca-
demics 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