Tracking economists’ consensus on money illusion, as a proxy for Keynesianism

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I’m probably not the only person playing catch-up on economics in order to get a better sense of what the hell is going on. Just two economists clearly called the housing bubble and predicted the financial crisis, and only one of them has several books out on the topic — Robert Shiller, the other being Nouriel Roubini. With Nobel Prize winner George Akerlof, Shiller recently co-authored Animal Spirits, a popular audience book making the case that human psychology and behavioral biases need to be taken into account when explaining any aspect of the economy, especially when things get all fucked up. That argument would seem superflous, but economics is the butt of “assume a can-opener” jokes for a reason.

To be fair to the field, though, they point out that before roughly the 1970s, mainstream economists all believed that the foibles of human beings, as they really exist, should be incorporated into theory, rather than dismissing them as behaviors that only an irrational dupe would show. Remember that Adam Smith was a professor of moral philosophy and wrote extensively about human psychology. From what I can tell, the recent shift does not have to do with the introduction of math nerds into the field, since the man who laid most of the formal foundation — Paul Samuelson — was squarely in the “psychology counts” camp. It looks more like a subset of math nerds is responsible — call them contemptuous autists, as in “What kind of idiot would engineer the brain that way?!” (Again, these are very rough impressions, and I’m winging it in categorizing people.)

Of the many ideas relevant to understanding financial crises, a key one from the old school period is money illusion, or the idea that people think in terms of nominal rather than real prices. For example, if the nominal prices of things you buy go down by 20%, you won’t be any better or worse off in real terms if your nominal wages also go down by 20%. However, most people don’t think this way, and would see a 20% pay-cut in this context as a slap in the face, a breach of unspoken rules of fairness. This is an illusion because a dollar (or euro, or whatever) isn’t a fixed unit of stuff — what it measures changes with inflation or deflation.

It’s the same reason that women’s clothing designers use fuzzy units of measurement — “sizes” — rather than units that we agree to fix forever, such as inches or centimeters. By artificially deflating the spectrum of sizes, a woman who used to wear a size 10 now wears a size 6, and she feels much better about herself, even if she has stayed the same objective size or perhaps even gotten fatter. How could they be so stupid to fall for this, when everyone knows it’s a trick? Who knows, but they do. Similarly, everyone knows that inflation of prices exists, and yet the average person still falls victim to money illusion, and economic theory will just have to work that in, just as evolutionary theory must work in the presence of vestigial organs, sub-optimally designed parts, and other things that make engineers’ toes curl.

Animal Spirits provides an overview of the empirical research on this topic, and it looks like there’s convincing evidence that people really do think this way. To take just one line of evidence, wages appear to be very resistant to moving downward, even when all sorts of other prices are declining, and interviews and surveys of employers reveal that they are afraid that wage cuts will demoralize or otherwise antagonize their employees. This is obviously a huge obstacle during an economic crisis, since firms will find it tough to hemorrhage less wealth by lowering wages — even only by lowering them enough to match the now lower cost-of-living.

The way Akerlof and Shiller present the history of the idea, it was mainstream before Milton Friedman and like-minded economists tore it down starting around 1967 and culminating by the end of the 1970s, although they hint that the idea may be seeing a rebirth. As an outsider, my first question is — “is that true?” I searched JSTOR for “money illusion” and plotted over time the fraction of all articles in JSTOR that contain this term:

Although the term was coined earlier, the first appearance in JSTOR is a 1913 article by Irving Fisher, and the surge around 1928 – 1929 is due to commentary on his book titled Money Illusion. Academics were still talking about it somewhat through 1934, probably because the worst phase of the Great Depression spurred them to try to figure out what went wrong. The idea becomes more discussed during World War II, and especially afterwards when Keynesian thought swept throughout the academic and policy worlds within the developed countries. In the mid-’50s, the term decelerates and then declines in usage, although the policies of its believers are still in full swing. I interpret this as showing that from the end of WWII to the mid-’50s, their ideas were debated more and more, and after this point they considered the matter settled.

Starting in the mid-late-1960s, though, the term begins to surge in usage to even greater heights than before, peaking in 1975, and plummeting afterward. This of course parallels the questioning of many of the ideas taken for granted during the Golden Age of American Capitalism, and the transition to Friedman-inspired thinking in academia and Thatcher-inspired thinking in public policy. Party affiliation clearly does not matter, since the mid-’40s to mid-’60s phase showed bipartisan support for Keynesian thinking, and after the mid-’70s there was also a bipartisan consensus on theory and policy applications. I interpret this second rise and fall as a re-ignited debate that was then considered a resolved matter — only this time with the opposite conclusion as before, i.e. that “everyone knows” now that money illusion is irrational and therefore doesn’t exist.

The data end in 2003, since there’s typically a five-year lag between the publication date of an article and its appearance in JSTOR. So, unfortunately I can’t use this method to confirm or disconfirm Akerlof and Shiller’s hints that the idea might be on its way to becoming mainstream in the near future. Whatever the empirical status of money illusion turns out to be — and it does look like it’s real — the bigger question is whether or not economists will return to a serious, empirical consideration of psychology — both the universal features (however seemingly irrational), as well as the individual differences that allow Milton Friedman to easily work through a 10-step-long chain of backwards induction, but not a typical working class person, who isn’t smart enough to get into college (and these days, that’s saying a lot). If all the positive press, not to mention book deals, that Shiller is getting are any sign, the forecast looks optimistic.

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  1. only this time with the opposite conclusion as before, i.e. that “everyone knows” now that money illusion is irrational and therefore doesn’t exist 
    There is another possibility: since the more or less the last vestiges of non-fiat money were swept away in 1971, it’s reasonable to suppose that major episodes of deflation are mostly of historical interest – which would make wage stickiness relevant only in a few microeconomic contexts. Of course there was some deflation in Japan recently, but really compared to the kind of collapsing star that was the US money supply 1929-1931, this was a very mild episode. It’s not like Japanese unemployment skyrocketed.  
    Note, I’m not saying you can’t theoretically have massive deflation in a fiat money system (see Steve Keen for a nice writeup of debt, money, and deflationary collapse), just that the central banks have the means and the motives to fight it.

  2. Scott Sumner titled his blog The Money Illusion and has a post touching on the subject here
    I find Bryan Caplan’s heavy reliance on his own intuition and experience on monetary matters annoying. It’s possible most people really do behave like him, but he doesn’t seem interested in gathering any non-anecdotal evidence to find out.

  3. Given the complexity and difficult to predict nature of the economy, It’s not always a good idea to find the guy who ‘called’ events and proclaim him a prophet. If a weatherman predicts rain for a week and hits it, he’s not necessarily right for the right reasons. Krugman and Roubini have both been bears for a long time, predicting recession for any number of reasons (many of which are unrelated to the current problems).  
    These guys are definitely worth listening to (especially Shiller); you just need to take them with a grain of salt.

  4. I’ve started the Akerlof-Schiller book and I’m quite hopeful. At the same time I suspect that they will keep the individualist model it shares with psychology. “Animal Spirits” is group psychology or sociology, channeled by institutions and customs. Individual psychology is part of the story, but group psychology is enormously far from being the additive or multiplicative summation of x number of individual psychologies. 
    Gradually over the decades Econ came to define itself as an autonomous science more fundamental than, and mostly independent of, culture, politics, social organization, and psychological differences. That worked for awhile, but no longer.  
    Now everybody’s back in the room trying to figure out “WTF?”. And because it’s dropped the ball, econ has lost its ability to clear the room with the snap of a methodological finger.

  5. I, a Chemistry Ph.D., offer: 
    Real asset price histories (USA) are overwhelmingly compelling, see first chart here: 
    And the histories are evidently serial herd behavior: 
    The profession’s defensible behavior has these histories overwhelmingly apparent. 
    The opposite apparence is the case, by the profession’s indefensible behavior.

  6. Peter Schiff seems to me to have made a better call on the housing bubble than Shiller, predicting a “precipitous” drop in prices vs. Shiller’s prediction that they would “fall 40 percent in inflation-adjusted terms over the next generation.” Schiff’s description of what was going wrong in the housing market appears in hindsight to have been dead on. Given that, one would think the Austrian school would have gained a bit of respect, yet on Google Trends the term “malinvestment” can’t even generate a graph.

  7. Great post… I didn’t know that tidbit about Adam Smith.

  8. In real life, people are never asked, “would you rather have a cut in salary or a cut in prices”. They are just asked to cut their salary, which they never like under any circumstances. On the other hand, in the 70s, when there was high inflation, ordinary people came to expect it and built it into their contracts. The real illusion is not about money, it’s that what’s happening today predicts what will happen tomorrow. (And even this isn’t an illusion – most of the time.)

  9. Inflation-adjustment, or adjustment for cost-of-living, is hardly ever built into wage contracts.

  10. Inflation-adjustment, or adjustment for cost-of-living, is hardly ever built into wage contracts. 
    No, but automatic increases (assuming inflation) were common.

  11. In any case, I’m one of those who doesn’t think that the quirks of human psychology play a big direct role. What’s important are feedback effects, and it is in this context that you have to look at the importance of psychological quirks. If you car tends to list to the right, your automatic feedback mechanism naturally corrects by turning the steering wheel to the left. But what happens when one wheel goes off the side of the road, and you try to correct by turning sharply to the left? Then you go out of control. 
    Under normal circumstances the feedback mechanisms seem to work pretty well, that’s why we have long stretches of stability. But not circumstances are normal…

  12. I presume the title ‘Animal Spirits’ is a nod to Keynes, who used the term himself to describe the irrational element in confidence. Maybe this is well known, but I thought I’d mention it.

  13. The Keynesians fell from favor because what they claimed could never happen did happen in the seventies, and big time: high inflation, high unemployment, stagnant growth. Then what the monetarists claimed could happen did – stable growth, low inflation, low unemployment from ’83 to ’01, with a slight blip in 1991. So they’ve come to dominate. 
    What none of them understood is how individuals would respond to the underlying incentives these policies created – in particular, the ability of savvy, influential players to tweak rules to their advantage (the most notorious being the leverage rule relaxation of a few years ago). 
    I don’t think micro-behavioral theories like money illusion are needed when the simple incentive concept suffices.

  14. Inflation-adjustment, or adjustment for cost-of-living, is hardly ever built into wage contracts. 
    Thats partially true. Though you are correct to the extent that these days with with low inflation and at will employment (so no contract), the compensation for most employees is obviously not related to inflation/cost of living.  
    However, in union contracts, or any employment where there is an actual contract especially in inflationary times, this is not an uncommon clause. Now the standard clause is usually not a direct multiplier but in the form of intervals where you re-negotiate the wage or some variant of that. 
    Even today, a lot of the collective bargaining agreements and public employee contracts contain some variation of wage adjustment clauses. 
    I think once Obama’s trillions inventually (hopefully soon) lead to inflationary pressure on the economy, these adjustment clauses will be back in vogue again.

  15. There’s a whole economics school called the Austrian school that predicted the housing bubble before there even was a housing bubble. 
    I recall reading one article, perhaps by an Austrian, that made the case that the reason the dollar held its value when it was only a piece of paper, was because the idea of a gold-backed dollar was passed along culturally.  
    There’s actually a lot of economics out there that is human centric and doesn’t create faulty mathematical models. The problem is that government wants mathematical models that treat the citizens as clay, it doesn’t want to be told that mostly everything it does will end in disaster and failure.

  16. Venn diagram for economics 
    A = set of people who can do math and are, perhaps, sympathetic to the idea of optimizing rational agents. 
    B = set of people with psychological insight into human decision making and group behavior. 
    (A and B) = the intersection of A and B = the people who can understand markets. 
    A – (A and B) = autistic people who like math ; they make crazy assumptions about efficient markets. 
    B – (A and B) = average (non-economist) social scientist who is intimidated by math but can see economists are making crazy assumptions. 
    Most physicists start in A – (A and B) but have been trained to recognize when models fail to reflect reality, so they eventually migrate into (A and B). Most successful traders and hedge fund managers are in (A and B). Alan Greenspan only recently migrated there after 40 years ;-)

  17. Google “Lucas critique”. And “Microfoundations.”

  18. I think human psychology plays some role. Simply wanting to make a better return and willing to take risk is psychological. Then there are the degrees of risk.  
    However, another important ingredient is demographics. The average age of people world wide is increasing. The trend is a deceleration of the growth of world population and the decrease in the absolute number of people under 18 has already occurred. What models of economic growth fit this pattern? Well, I think, none. We will have to invent a new way of looking at economic development.  
    These musings aren’t answers, rather just problem posing, and framing of questions. 
    Are we psychologically able to cope without the economic growth that comes from putting money into an investment and letting a company that has a growing customer base and growing profits just let us tag along. I mean when there are more old than young, does this paradigm really fit? It has always seemed to me that the economic growth paradigm only fits demographics shaped like a pyramid. Is our future still a demographic pyramid? In Japan and several countries in Europe, population is already shrinking and a growing percentage are not working. How do you get economic growth in terms of a growing customer base and growing profits (not just inflated) if the whole world plays that game? (and it looks like we are). We need a new way of measuring economic health besides just ecomomic growth. I think that new metric could help us on the psychology side.

  19. My main beef with the Austrian people is their antipathy to logical positivism. They don’t produce mathematical models, but that’s what we need to see if their ideas are right. 
    It wouldn’t be hard to take their verbal reasoning and turn it into a set of differential equations, and maybe someone already has. Then we take competing models and see how well they all account for historical data, and how many parameters each requires. It’s just model comparison using information criteria. 
    As an outsider, economics seems too ideological — just formalize your ideas, and whichever one provides the best fit to the data while positing the fewest parameters wins. Who cares if it ends up offending the sensibilities of your mentors, heroes, and friends?

  20. Here is a post at Future Pundit which seems to confirm what Irving Fisher, Robert Schiller, and Raj are noting 
    Wishful Bettors Draw Others Into Dubious Investment Choices 
    Overly optimistic people end up drawing more knowledgeable investors into unwise investment positions. 
    “AUSTIN, Texas?Wishful bettors, those who make overly optimistic investments, will ultimately harm themselves financially, but they can harm entire markets as well, new research shows. 
    In the paper, “Contagion of Wishful Thinking in Markets,” researchers from The University of Texas at Austin and Cornell University demonstrate how wishful betting can contaminate beliefs throughout markets, as other market participants infer wishful bettors possess more favorable information than they do. As a consequence, investors who initially held accurate beliefs become overly optimistic about stock values. The research will be published in a forthcoming issue of Management Science. 
    “The findings of our studies contradict what many people assume about markets, that wishful thinkers will be identified and disciplined by more sophisticated investors,” said Nicholas Seybert, an assistant professor of finance at the McCombs School of Business at The University of Texas at Austin. “Instead, investors fail to recognize the existence of wishful betting even though most of them do it. As a result, wishful thinking can be contagious in financial markets.”  
    Over the years I’ve gradually dialed down in my mind my assumptions about the levels of competence in others in higher status positions. One of the biggest mistakes to avoid: just because someone is very competent about topic A that does not mean when they make equally confident statements about topic B that they have a clue as to what they are talking about. So many experts do not realize how ignorant they are outside of their areas of real expertise. 
    People expect others must know better what they are doing. I think we are all looking for leaders to follow. 
    Investors started with a short position in half of the stocks and a long position in the other half. The researchers reasoned that investors in short positions would desire low stock values, while those in long positions would desire high stock values. Despite all investors’ initially holding unbiased beliefs about intrinsic stock values, those in short positions sold too many shares and those in long positions purchased too many shares. More surprisingly, investors did not anticipate this wishful betting behavior on the part of others. Even though they themselves purchased or sold too many shares of stock, they believed that other investors’ trades were based on fundamental information about intrinsic value. By the end of trade, market prices were too extreme and the average investor appeared to be a “wishful thinker” ? holding overly optimistic beliefs about intrinsic value. 
    Beware the confident.”

  21. SG: Rather than profit, or ROI, in financial terms, perhaps what we really ought to be charting is ecological efficiency. That is, how much energy/water/arable land/mineral wealth and so on that we’re using, how much we’re polluting our environment and thus affecting our future welfare, and most important, how EFFICIENTLY we’re using the resources that we do use.  
    An industrial process that uses fewer raw materials and less energy to produce a more useful, recyclable product should be rewarded. The market may or may not recognize this efficiency; if not, regulation should supplement the market. 
    Note that human social groups/organizations may be more or less efficient, that the nurture of human capital (health and education) is part of efficiency, and that imponderables such as generalized social trust can make a big difference in social functioning.

  22. Here is a great post by an insider (ie, a trader on Wall St.) on what went wrong at AIG: 
    Part math, part psychology.

  23. if not, regulation should supplement the market. 
    Note that human social groups/organizations may be more or less efficient, that the nurture of human capital (health and education) is part of efficiency, and that imponderables such as generalized social trust can make a big difference in social functioning. 
    I wonder how you quantify an imponderable, or is that just more mental masturbation?

  24. The first rule of economics is that you can not talk about economics without treating it as a form of religion. At least in “advanced” countries, you either think that the rich are deserving and redistribution of income a vile crime against nature, or you think the less rich are deserving and redistribution is all that keeps us hanging by our fingernails above an pit of savagery. This pollutes any attempt at rational discussion.  
    The locus classicus is a well-meaning professor trying to explain things to a student with a trust fund. They might as well be from different planets.

  25. Richard Sharpe wrote: I wonder how you quantify an imponderable, or is that just more mental masturbation? 
    Is it mental masturbation to say that there are processes that will affect environmental and human welfare that we don’t yet know how to measure? Frex, to pick an example doubtless dear to many hearts here, bureaucracy can be grossly inefficient. Even if it’s not corrupt.  
    Talking about efficiency only in terms of money (money as measured and recorded) is acting like the drunk who was asked why he was crawling on his hands and knees around the lamppost. Answer: he had dropped his keys somewhere in the last block. Question: Why, then, are you only looking near the lamppost? Answer: because that’s where the light is.  
    I agree that it would be good to have some sort of measure for the imponderables I mentioned. Perhaps it should be in kilowatts or calories rather than currency?

  26. Agnostic: 
    Regarding your statement about the Austrian antipathy to logical positivism, I’d suggest you actually read what Mises had to say on the subject. There are about a half-dozen scattered (index) references in HUMAN ACTION and a lengthy treatment in the chapter devoted to the impossibility of economic calculation under socialism. Then tell me what might be your objection to the Austrian view. To gather some appreciation of the importance of this insight, it’s the essence of the reasoning that led Mises to predict–in 1920– that one day, the USSR would “collapse like a house of cards, simply cease to exist.” Those who do not understand this understand virtually nothing of economic science.

  27. Having lived through all this, let me fill in the background. “Money Illusion” was a key concept behind the Keynesian Philips Curve idea that dominated in the 1960s. The notion was that a small amount of inflation would cut unemployment because people who were sitting around collecting unemployment would get offered higher wages for a cruddy-sounding new job than they expected, so they’d get off their duffs and get back to work earlier than if there were no inflation. But it was all just a trick played on the lazy sods because the wages they were being offered weren’t higher in real terms, just in nominal terms. 
    Of course, in the 1970s, people figured out that they were being tricked, so we had stagflation: higher inflation and higher unemployment at the same time, contra the Philips Curve. 
    That hurt Keynesianism’s reputation. 
    Further, there were unpopular non-illusionary aspects to Money Illusion, such as the fact that as your wages went up to keep pace with inflation, you kept getting bumped up into higher marginal tax brackets, so inflation was making you worse off. Supply Side economics gained a lot of popularity from this mechanism.

  28. Don’t forget that unions were stronger back then and had negotiated COLA’s — automatic cost of living adjustments — to deal with inflation. In other words, they had learned from experience and no longer had “the money illusion.” That’s what caused stagflation — COLA’s didn’t exist when Keynes formulated his “special” theory of employment, which was based on the money illusion and designed to deal with the problem of the downward stickiness of wages, which was an historical phenomenon in the early 20th century. It will be interesting to see if workers today will be willing to accept lower nominal wages. More likely there will be a lot of inflation and they will once again be temporarily fooled by the money illusion, until they wake up and realize that real wages are lower than they have been in a long, long time. The last time this happened (a big bout of inflation) was in the early 1970′s, which not coincidentally was when real hourly wages reached there peak. Since then they have been trending steadily downwards, a phenomenon obscured by the fact that median family income has remained stable. It remained stable because of the two-earner family and longer workweeks.

  29. Interesting that you brought up COLA. At it is explained how in the 90′s the consumer price index was recalculated so it would be lower. I always find it interesting that college costs and medical costs are rising faster than inflation. I think that workers are in fact accepting lower nominal wages. I have several friends whose hours have been reduced, overtime and bonuses eliminated. Kinko’s employees voted to accept pay cuts instead of layoffs. UAW members are reportedly accepting cuts as well.

  30. Check out this prediction from 1998! 

  31. Video (5:43): Peter Schiff crushes fools long before the meltdown began 
    Video (1:16:27) Peter Schiff: Why the Meltdown Should Have Surprised No One 
    The first clip includes some great historical asskickings of Art Laffer and Ben Stein.  
    The second clip is a great speech that explains what happened to our bubble economy and where we are headed. Using just a few basic concepts from the Austrian school of economics Schiff predicted the meltdown with stunning accuracy.

  32. Philip Greenspun’s book report on… 
    The Rise and Decline of Nations: Economic Growth, Stagflation, and Social Rigidities by Mancur Olson 
    Cliff notes: Special interests ultimately triumph over group interests. This unfortunate process drives productivity out of the economy and ultimately stagnation and decline ensues.

  33. Schiller and Roubini in a class by themselves? Not so. Bill Bonner (Empire of Debt), Michael Panzner (Financial Armageddon), Eric Janzsen (iTulip blog), Marc Faber and Michael Hudson are but five of an admittedly small minority of economists, in addition to Schiff, who made the correct call. While Schiller has a modicum of modesty and humility, Roubini’s relentless self-promotion is embarrassing and just makes it seem as though he was the only economist to make the correct call. (Of course, Schiff is a relentless self-promoter as well but, at least to me, in an inoffensive way). Moreover, Roubini is a shill for corporatism and is not correct in what he claims will be the outcome of this mess.

  34. Peter Schiff Video (3:07): “Of course we aren’t going to pay the Chinese back.” (audience laughs at the obvious) 
    When the bond bubble burts the USA will rapidly lose it’s reserve currency status.  
    The result? 
    The USA’s economic growth will slow by about 2.2% per year. 
    Gourinchas and Rey on Exorbitant Privilege 
    2.2% is a sizable hit when you consider that our economy grows by about 4% during good times and 1%+/- of that is simply immigration.

    B – (A and B) = average (non-economist) social scientist who is intimidated by math but can see economists are making crazy assumptions.
    You forgot 
    (not A and not B) = socialist who understands neither math nor basic human psychology

  36. 1. Dean Baker at the Centre for Economic Policy has been calling for a housing slump since at least 2001, with good quantitative backup. 
    2. arguably so has Wynne Godley at Bard Institute (although more focused on the international adjustment) 
    3. Calculated Risk is a housing economist (an ex CFO/ CEO of a tech company). He’s been around since at least 2004 
    4. Andrew Oswald at Warwick University had been writing newspaper columns calling for a housing slump since at least 2002. In fact, when in 2006 UK housing prices kept going up, he pulled from all public commentary. 
    5. There is, of course, the Economist which has been calling the housing bubble since at least 2002. 
    So 1 and 4 are academic economists at the very least.

  37. One can also see money illusion at work in the behavior of the pizzerias of New York City.

  38. The question of whether they are fooled over time is much more relevant.  
    Sure, people don’t notice the immediate loss from inflation, but eventually they start catching on when they notice they have less “stuff” than before and both parents have to slave away to make the family income.  
    At the heart of all this is the conceit that economic planners are invariably more intelligent than their subjects. I personally believe this stems from ancient anti semetic biases against businessmen and bankers, from the sense that they get their money by cheating instead of earning it with intelligence. These people being stupid in reality, it would be easy to trick them with the Keneysian Noble Lie.

  39. but eventually they start catching on when they notice they have less “stuff” than before  
    Of course there’s the other half of the pattern — as when people are amazed at how expensive houses are now, compared to their parents’ or grandparents’ houses that were bought for $10,000, or when people invariably whine about movie tickets costing more and more. 
    These aren’t fleeting reflections. They’re always in people’s minds.

  40. Agnostic, the amazing increase in house prices, even allowing for the bubble and the general rise in the consumer price index, is driven by the rising costs of land in our major cities. Land has gone from roughly 10% to the total cost of a house in 1984 to close to half today in the Midwest and Southeast. On the West Coast it went from half to 90 percent. This is the old Henry George phenomenon abetted by the two-earner household. The numbers were recently estimated by the Federal Reserve. Here is the link: